Principal reduction


 

For most of the 22 million homeowners who owe an average of $40,000 – $65,000 more than their home is worth, the recent $25 billion dollar settlement with the banks will bring no relief. According to Robert Menendez, Chairman of the Senate’s housing subcommittee, “When you owe more than your house is worth, relief can be hard to come by.”   Among borrowers whose homes have dropped in value through no fault of their own, many choose to simply walk away, which according to Menendez, “Only exacerbates the problem.”

Menendez has introduced a bill that provides an interesting twist on the idea of principal reduction.  The Preserving American Homeownership Act would encourage lenders to write down principal balances by allowing them to share in the home’s appreciation at a later date.  The principal balance would be written down in increments over a three year period to 95% of the current value, so long as the homeowner remains current on their payments.

In exchange for the write-down, the lender would receive a fixed percentage of any future appreciation when the home is either sold or re-financed.  That share could not exceed 50%.  So if a principal balance was reduced by 25%, the bank would receive 25% of any future appreciation.

The Act would apply to primary residences only, but any homeowner could apply.  Borrowers who are in default or even in foreclosure could qualify, but would be required to make their reduced mortgage payment on time in order to remain in the program.

The article in DSNews where I read about the bill did not indicate if the Act would apply to all types of loans or whether or not the modified loans would be re-written at today’s lower interest rates. Presuming so, this Act could provide enough incentive to many underwater homeowners to persuade them to stay in their home versus initiating a strategic default.

As a fan of principal reduction, I like this idea as it seems to be a win-win situation for both homeowners and the banks.  Banks don’t take as big a hit as they would with a short sale or foreclosure, and the write-down is taken over a three year period, AND homeowners get to keep their homes with reduced payments and principal.  Even the opponents of principal reduction might find something to like about this plan!

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As I’ve mentioned more than once, I’m no Economics genius. So I was pleasantly surprised to read the October 12th NY Times article by Martin S Feldstein, a Harvard professor of Economics and former chairman of the Council of Economic Advisors. It appears that Professor Feldstein and I agree that the only way to stop the drop in home values is by principal reduction.

The professor points out that for most Americans, their homes are their primary source of wealth. Since the housing bubble burst in 2006, Americans have lost $9 trillion or 40% of their wealth. This sharp decline in wealth means less consumer spending, fewer jobs and a stalled economic recovery.

Today, nearly 15 million homeowners owe more than their homes are worth and of this group about half of the mortgages exceed the value by more than 30%. The professor maintains that housing prices continue to fall because millions of homeowners are defaulting on their mortgages and the sale of the foreclosed properties drive down prices. Because most mortgages are non recourse loans, underwater borrowers have a strong incentive to simply walk away.

Professor Feldstein suggests that instead of throwing tax dollars at ineffective programs aimed at reducing interest rates, the government should address the real problem which is that the amount of the mortgage debt exceeds the value of the home.

Here is a summary of his idea: The government would reduce mortgage principal to 110% of the home value. The cost for doing this would be split between the government and the banks. This would help about 11 million of the 15 million underwater homes at a cost of under $350 billion. Considering the millions of mortgages held by Fannie and Freddie, the government would in essence be paying itself.

This would of course be a voluntary program. In exchange for the principal write-down, the borrower would agree that the new mortgage was a full recourse loan and the government could go after other assets if he defaulted on the loan.

I think it sounds fair, as everyone makes a sacrifice and we put the brakes on strategic default. It is a huge one-time cost, but continuing to allow housing prices to fall could risk another, even more costly recession. And speaking for my short sale clients, I know that most would have gladly signed up for a principal reduction if it meant saving their home.

What do you think?