Real Estate Market

Principal Reduction: New Programs, More Controversy

(6/9/2012) With the recent announcement by Bank of America that they will be lowering mortgage amounts to qualifying borrowers, industry experts are touting a new savior for the housing market. This idea of “principal reduction” isn’t necessarily new, but with official programs offering unprecedented help to borrowers it does have everyone talking.

Who can get principal reductions? How does the program work? Will it truly help the housing market? And perhaps the most important question - should principal reduction really be an option?

Principal Reduction Programs

Principal reduction as a formal process stems from the $25 billion foreclosure settlement agreement between federal and state agencies and the country’s five largest mortgage servicers. The settlement, announced this year, was the result of a legal action over fraudulent foreclosure document processing (“robo-signing”).

Many homeowners, politicians, and economists are looking at principal reduction as a promising solution to continuing housing market woes. Today there are over 5 million U.S. loans that are considered delinquent, and/or are in the foreclosure process, according to Lender Processing Services. As principal reduction is aimed at these borrowers, and over 11 million residential properties have underwater mortgages, it seems a case of the right solution at the right time.

Bank of America (BOA) is one of the lenders leading the principal reduction effort. In May, a group of 200,000 BOA borrowers received an offer to reduce as much as $150,000 from their total mortgage amount. The recipients joined a group of 5,000 borrowers that received $700 million in forgiven principal reduction as part of a pilot program earlier this year. In total, Bank of America is committed to at least $11 billion in principal reductions, and bank leaders suggest they will probably go above that amount.

Recipients of the Bank of America offer are current mortgage customers who are at least 60 days late on their mortgage payment, and who owe more on the mortgage than the home is currently worth (“underwater” borrowers). To qualify for the offer, recipients must go through an application process documenting their income, and documenting their inability to pay a monthly mortgage payment of more than 25 percent of gross income.

Those that eventually qualify will have their monthly mortgage payment reduced down to 25 percent of gross income. In public statements, the bank estimates that this could mean as much as $150,000 of forgiven principal per borrower.

While lenders like Bank of America are forging ahead with principal reduction programs, Fannie Mae and Freddie Mac, the government-sponsored enterprises designed to expand and diversify the mortgage market, have stayed out of the principal reduction movement, to the chagrin of economists, state officials, borrowers, and the Obama administration,

Recent reports indicate that Fannie and Freddie could save $1.7 billion by reducing principals on underwater mortgages. But Edward DeMarco, acting director of the Federal House Finance Agency (FHFA, the agency overseeing Fannie and Freddie), has strongly opposed principal reduction. In statements, DeMarco has noted that Fannie and Freddie are essentially owned by taxpayers, and any principal reduction would be adding more to the more than $190 billion taxpayers have covered since September 2008, when the agencies were taken into US conservatorship. Plus, DeMarco suggests the effects will not be that far reaching.

Debate over Principal Reduction

DeMarco’s resistance to principal reduction brings up some thorny issues. Is principal reduction the salvation so many contend? Or are there fundamental problems with this approach?

Experts, policy makers, and homeowners fall on two sides of the fence when it comes to principal reduction. On one side are those who believe principal reduction is a important and helpful step for the housing market and the general economy. Their major point is this: Principal reduction can motivate wavering folks to keep their homes. Right now, borrowers who are underwater and facing mortgages they can’t pay are walking away from their homes, or the bank steps in and forecloses. Research has shown that homes in foreclosure degrade in value much more than homes in some form of mortgage modification. These distressed and devalued properties hit the market and drive overall property prices down. This continues the downward spiral of real estate prices.

In this line of thinking, principal reduction offers a permanent solution for some homeowners, allowing equity to rebuild and avoiding the personal and general economic dangers of foreclosure. Principal reductions stop the devaluation process, and help achieve a new normal in home values.

On the other side of the debate are those who believe principal reduction is a dangerous precedent that benefits the wrong people and rewards the wrong actions.

Offering federal help to a select group of borrowers is laudable, critics say. But these borrowers have not paid their mortgages for at least 60 days. Meanwhile, many borrowers in similar finaicial difficulties are still making payments, and stretching themselves quite thin to do it. These borrowers now have an incentive to stop paying their mortgages with the new principal reduction programs. They can be rewarded for stopping their struggle and ending payments. In fact, research out of Columbia University has shown a statistically significant increase in this behavior since these programs have been announced, according to Ted Gayer, co-director of economic studies and a senior fellow at the Brookings Institution, and Phillip Swagel, professor at the University of Maryland School of Public Policy.

This camp also points to the insufficient nature of this principal reduction program. With over 100 million homes and condos in the U.S. and over 5 million in delinquency or foreclosure, a large proportion of them would need to have principal forgiven to make a real positive impact on the real estate market. But thus far the qualifying numbers are limited.

The main point of these opponents? Principal reductions come at too great a cost, can change consumer behavior for the worse, and do not come with any guarantee that they will end the housing crisis and promote home ownership.

Other Options

If not principal reduction, what will provide the help the housing market so desperately needs? Those that point to the flaws of the program suggest we shoudl also be looking into other solutions for our housing issues.

The FHFA points to existing mortgage modification programs as a good option. These usually involve reducing interest on a portion of the total mortgage loan and deferring its repayment. Experts like Keith Gumbinger, the author of consumer guides on mortgages and numerous industry articles, say this is the way principal reductions need to happen. Only with a combination of lower interest rates, lower loan amounts and restructured terms to make loans more affordable will borrowers and the market start to find lasting and beneficial change.

Other experts are looking at more creative solutions. Geyer and Swagel suggest encouraging programs that turn foreclosures into rentals. In this arrangement, banks could resume ownership of the property, but rent the house back to the homeowners. Families get to stay in their homes, the neighborhood does not have the blight of a foreclosed home, and the bank still receives income.

Principal reduction is probably here to stay for a select group of borrowers. While there are issues and flaws to consider, it may nonetheless provide an important alternative to strapped borrowers and a needed boost to the housing market.