Principal reduction: A lifeline for underwater homeowners

But the foreclosure crisis that began in 2007 is not yet over and declaring “Mission Accomplished” prematurely could once again be a very bad idea. In the first half of this year, more than a million foreclosure filings have been issued with an additional one million likely by year's end.

And in spite of the recent gains in home prices, they remain down by more than 30 percent and homeowners continue to hold $700 billion of mortgage debt that exceeds the value of their homes. As a result, it’s important for federal policy makers to continue to pursue foreclosure mitigation efforts including reducing the outstanding principal on homes for borrowers whose mortgages greatly exceeds the value of their homes.
Earlier this year, President Obama made receiving principal reductions on loans held by Fannie Mae and Freddie Mac more cost effective for taxpayers. But the director of the Federal Housing Finance Authority (FHFA), Ed DeMarco, objected to allowing these two housing finance giants to provide principal reductions to borrowers whose mortgages are significantly upside down and who are at risk of losing their homes to foreclosure. 

Why Mr. DeMarco is opposed to allowing underwater borrowers in financial distress to reduce the outstanding principal on their homes is unclear. His reasons keep changing, but the rationale doesn’t add up. His first objection was that principal write-downs would cost the taxpayers’ money. But a closer look at FHFA’s own analysis revealed that providing principal reductions would help a nearly half million homeowners – at a net savings of $1 billion.

Next, Mr. Demarco suggested principal reductions would encourage homeowners to default on their mortgages in order to receive a reduction on their outstanding loan balances. But there’s little chance of that occurring since the program would be restricted to borrowers who are experiencing financial hardship and are at imminent risk of default. 

In fact, U.S. Treasury Secretary Timothy Geithner urged Mr. Demarco to support principal reduction, citing a recent study that found little evidence of borrowers strategically defaulting.
In fact, in spite of Mr. DeMarco’s inability to conceptualize an effective principal reduction program, one lender, Ocwen Financial Corp., accomplishes principal write-downs every day that that is economically beneficial to both investors and borrowers. Take, for example, a borrower in Duluth, GA, whose income had declined and whose home was worth $88,000 less than the mortgage owed of $140,000. Ocwen reduced the loan principal to $83,600 and the interest rate from 4.375% to 2.375%. The result--a one-third reduction in the monthly mortgage payment -- from $985 to $630.

Such principal reduction programs can keep underwater homeowners in financial distress from drowning in debt. Principal reduction can also be a lifesaver for a struggling housing market and lagging economy.
The bottom line is that assisting families to keep their homes is a win-win for all homeowners since averting foreclosures will help the housing market get back on track. Moreover, the FHFA can ensure an even more positive return to directly to taxpayers by letting Fannie and Freddie share some portion of future home price appreciation on properties that are granted principal reductions.
Principal reduction is not a silver bullet. But with unnecessary foreclosures hurting families, communities and the entire economy, we need to use every tool at our disposal to fix this problem. In his letter to Mr. DeMarco, Secretary Geithner said limiting costs to taxpayers is only part of the FHFA’s mission. Just as important is promoting “liquid, efficient, competitive, and resilient housing finance markets”.
The current condition of the housing market is proof that the FHFA’s second mandate also demands greater attention. That attention should include providing a lifeline to underwater homeowners. While the recent stabilization of home prices is welcomed news, significant challenges for the housing market remain ahead.

Carr is an independent housing and finance consultant and Closing the Racial Wealth Gap Fellow with the Insight Center for Community Economic Development. He is the former Chief Business Officer for the National Community Reinvestment Coalition, Executive Committee member for Americans for Financial Reform and senior vice president for financial innovation, planning and research for the Fannie Mae Foundation.

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