Forced Modifications Dropped from State AG Mortgage Servicing Settlement Proposal

State attorneys general that are seeking restitution for homeowners wrongly evicted from their homes due to mistakes by mortgages servicers offered a new proposal to banks last week. The revised term sheet does not list a dollar figure (a few months ago $20 billion was the number being floated in the press, though that is considered to be unfounded now) but it does remove a key provision from the previous term sheet: forced principal write-downs. From American Banker:

the state attorneys general have proposed new terms to the top five mortgage servicers that drop some controversial provisions of their first attempt at a settlement, including a push to force banks to reduce principal on thousands of mortgages.

Back in March I wrote an article for Forbes outlining the problem with principal write-downs being forced on banks…

There would also be substantial moral hazard problems associated with lowering mortgage balances, just because housing prices have fallen. There is currently $744 billion in negative equity in the American housing market, according to CoreLogic. Beyond the legal complexities of determining who in this pool would get one of the $20 billion in forced modifications, imagine if just a fraction of those who are falling behind on their mortgages decided to forgo payment in the hopes of getting further government concessions to force banks into modifying loans. A nightmare on Wall Street, to be sure.

Even Fannie Mae and Freddie Mac , now wards of the Treasury Department, have been slow to embrace principle write-downs for fear that more homeowners would stop paying their mortgages in order to get in on the action. More legal problems could arise from investors who don’t want the mortgages they own modified.

…and why it should be removed from the negotiations over mortgage servicing failures…

Forcing the banks to extend modifications to those who can currently afford their payments, on the other hand, could inspire waves of strategic defaults, clogging the system further. This is not to say banks are an innocent bunch. The question is whether forcing modifications is the equitable way to provide restitution for those who were wrongly foreclosed on and whether $20 billion is an appropriate penalty for sloppy bookkeeping of mortgage servicing.

The final terms in this battle remain far from unclear. And it sounds like the AGs want to use what money they do get ($5 billion maybe?) to help out homeowners in other ways, possibly even by buying mortgages and then modifying them. The key on this issue in the debate though, is that banks should not be forced to modify an arbitrary number and group of mortgages. And if this stays off the table as it is now, we have at least one less thing to worry about.