Don't Wait for a Principal Reduction on Your Home

NEW YORK (MainStreet) -- For underwater homeowners and many who want to help them, there is a Holy Grail: principal reduction.

But now, four years after the housing market started to collapse it may be time for a reality check. For most troubled borrowers, principal reduction is a remedy that may never happen.

Edward J. DeMarco, acting director of the Federal Housing Finance Agency that oversees Fannie Mae and Freddie Mac, said in a speech Tuesday that principal reduction could make some economic sense. The agency is expected to make a decision on the matter within a few weeks.

But DeMarco’s comments were lukewarm and accompanied by several reservations. Despite heavy pressure from the Obama administration and many Congressional Democrats, DeMarco seems unlikely to embrace principal reduction for large numbers of borrowers. His sentiments are widely shared among lenders and mortgage securities investors.

What’s the problem?

Advocates argue that reducing the homeowner’s debt balance is a win-win solution. Reducing the debt to the home’s current value, which in many cases is far less than the homeowner originally paid, can encourage the homeowner to keep making payments rather than to fall into foreclosure or walk away.

Lenders would win, too, because they’d lose less through principal reduction than foreclosure. Many foreclosed homes are resold for less than half of their pre-crisis value, while the debt reduction might be only 20% or 30%, perhaps less.

But if it were that easy, lenders would be jumping at the opportunity. They haven’t, in part, because it is very difficult to get the owners of mortgage-backed securities to go along. And there are tricky issues involving private equity loans that may use the same property as collateral.

But one of the biggest obstacles is concern over unintended consequences. If it becomes clear that part of the debt can be forgiven, more homeowners may fall behind intentionally to qualify, making the overall problem bigger than it was.

Also, opponents charge that principal reduction amounts to a “free lunch” that rewards deadbeats. Forgiveness can be seen as unfair to homeowners who keep up with payments, unfair to investors in mortgage securities, unfair to lenders’ stockholders. It also can be seen as unfair to taxpayers, as the lenders have shown they won’t go along with principal reduction without generous tax-supported financial incentives.