Lenders less leery of reducing homeowners' principal

hsangree@sacbee.com

Published Sunday, May. 13, 2012

Principal reduction, long a nonstarter with lenders, has suddenly become a potential reality for thousands of homeowners who owe far more than their houses are worth.
Some economists and politicians have argued for years that the only way to revive the housing market and jumpstart the economy is to vastly reduce the amount Americans owe on their mortgages. But lenders have balked at writing down debts.


Now, however, as part of the $25 billion mortgage settlement announced in February, some of the nation's largest lenders have agreed to reduce loan balances for thousands of customers. Bank of America announced this week that it would offer more than 200,000 borrowers relief by reducing principal to as low as a home's current value.




And in a key development, Keep Your Home California, the state's major housing-aid effort, said this week it was changing its rules to no longer require a lender contribution to its Principal Reduction Program, which provides up to $100,000 in loan forgiveness. That change will benefit as many as 9,000 borrowers in the state, program officials said.


In addition, Fannie Mae and Freddie Mac, the government-backed mortgage giants that control the majority of mortgages in the state, will now allow loans to be paid down by the California program. Before, when a lender contribution was required, Fannie Mae and Freddie Mac would not participate.


Diane Richardson, head of Keep Your Home California, said the changes will "level the playing field" for underwater borrowers, who have been unable to refinance homes in which they have no equity. "It gets them back to the point where they won't be so underwater that they just feel helpless," she said.
Even as it gains momentum, principal reduction remains deeply controversial, with some experts calling it a potential cure for the economy and others expressing concern about its effectiveness and fairness.


Keep Your Home California's Principal Reduction Program, for example, benefits homeowners who have experienced economic hardship, such as job loss, and who are delinquent on their loan payments or facing foreclosure. A borrower in that situation could receive a principal write-down of up to $100,000, while their neighbor, who has made mortgage payments on time but who is also deeply underwater, receives no debt reduction.


About 30 percent, or more than 2 million, of California's 6.8 million mortgaged properties were underwater in the fourth quarter of 2011, Santa Ana-based CoreLogic reported.
The question with principal reduction is "who do you give it to?" said Mike Himes, vice president of NeighborWorks in Sacramento, a nonprofit that helps struggling homeowners.


Himes, who stressed he was expressing his own views and not those of his organization, said those who have their loan balance reduced – in some cases because of only temporary job loss – will be better positioned to build equity as the housing market recovers.


Those who stayed employed and kept paying, on the other hand, may never catch up. "Selected people will get back (lost equity) and some won't," he said. Himes said loan modifications, which reduce interest rates and extend payment terms, can make mortgage payments affordable without giving some homeowners a big advantage.


Many critics of principal reduction say it creates an incentive for borrowers to default on their loans in order to take advantage of assistance programs. Some economists call such incentives for bad behavior, with others paying the costs, a "moral hazard," and warn against them.


"Principal reduction should be the absolute reduction of last resort," said Anthony Sanders, a professor of real estate finance at George Mason University.

Effectiveness challenged

Democratic politicians have criticized DeMarco for refusing to let the government-sponsored enterprises reduce the principal of loans they own or back. To do so, he has argued, would undermine his responsibility to preserve their assets and minimize losses to taxpayers, who invested more than $187 billion in Fannie Mae and Freddie Mac following their near collapse in the housing crash.
In his April speech, DeMarco said it might make sense in some circumstances to offer principal reductions. But he said a large-scale effort would come at net cost to taxpayers of $2.1 billion and would affect less than one-tenth of the estimated 11 million underwater homeowners in the United States.
"This is not about some huge difference-making program that will rescue the housing market," DeMarco told the Brookings audience.
Others disagree. California Attorney General Kamala Harris, a key player in negotiating the national mortgage settlement, has been one of DeMarco's critics. In February, she wrote him saying the settlement would help borrowers of Bank of America, Chase and Wells Fargo, who promised to provide at least $12 billion for principal reduction and short sales, where lenders agree to accept less than what they're owed.
The settlement did not include Fannie Mae and Freddie Mac, Harris noted. She urged DeMarco to cease foreclosures in the state and to conduct a "straight-forward analysis" of whether a broad program of principal reductions would help homeowners and save taxpayer dollars. Harris expressed confidence that the agency's potential findings would confirm her views.
DeMarco wrote back denying her request. He said the agency had already analyzed the benefits of principal reduction, and had concluded it was no more effective than other tools that reduced monthly payments without such high costs. Those tools included cutting interest rates and extending loan terms.
"There is no question that underwater borrowers in California would benefit from other taxpayers across the United States paying off the underwater portions of their mortgage debt," he wrote to Harris. But DeMarco said his obligation was to taxpayers and to ensuring maximum assistance at minimum cost.

An incentive to stay

The biggest benefit to all taxpayers, he said, would be to pull the economy and the housing market out of its slump by erasing debt that may never be repaid – and which will only lead to more foreclosures and economic turmoil.
Principal reduction should be open to a broad range of borrowers, not just to those who are delinquent, to address the fairness issue and to avoid providing incentives for borrowers to stop paying, he said. He said borrowers don't need to see their negative equity erased, but suggested that loan balances should be no more than 120 percent of home values.
"It gives them an incentive to stay in their home and gives them light at the end of the tunnel," he said.
Who would pay the billions of dollars such a program would cost? Taxpayers, he said.
It makes sense, he said, because those same taxpayers will pay regardless, though depressed home prices, lagging job recovery, neighborhood blight and under-funded schools.
The downward spiral will only continue as long as there's a massive amount of negative equity on the books, he said. With a broad-ranging debt reduction, he said, "I think we'll all be better off."

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That's the wrong way to look at it, said Jeffrey Michael, director of the Business Forecasting Center at the University of the Pacific in Stockton. Sanders made his comments during a panel discussion on principal reduction last month at the Brookings Institution, a public-policy think tank in Washington, D.C. The keynote speaker at the event was Edward DeMarco, acting head of the Federal Housing Finance Agency, the government conservator that oversees Fannie Mae and Freddie Mac.