The mortgage modification conundrum continues to confound policy wonks. The Treasury's difficulty achieving success with its Home Affordable Modification Program (HAMP) demonstrates this fact well. Lowering interest rates and increasing terms don't appear to be doing the trick. So the obvious alternative is to rework mortgages so to lower their principal. The FDIC is considering this approach. Unfortunately, it's not easily done in practice. I have a few ideas to make it work.
How much you love or hate principal reductions depends on your perspective:
If you're the distressed homeowner, then you absolutely adore the idea of a principal reduction. It's like you're getting the same house, but for less money. Many borrowers who are very underwater are walking away from homes because they can't comprehend modifying a mortgage with a principal amount higher than what the home is now worth. Why do that when you can just foreclose and buy a similar home for less?
There's another nice added bonus for the homeowner through a principal reduction: if the market rebounds, and your home appreciates, you get to keep any excess funds when you sell the home again.
Banks and finance companies hate -- hate -- the idea of principal reductions. First, they have to declare a loss on the mortgage immediately for that amount. Since many banks are still in a very fragile state, the last thing they want is widespread losses on their delinquent mortgages to all hit at once. That could result in a devastating market shock. At least if they slowly foreclose on homes, those losses will be more spread out and easier to bear.
They must also worry about precisely what I explained as the bonus to a homeowner above: if the market rebounds and the price appreciates, it doesn't seem fair that the borrower gets those excess funds. After all, the bank took a loss to keep the borrower there -- shouldn't it get that extra cash?
In general, all of those homeowners who aren't having trouble paying their mortgage are quite resentful of the idea that underwater borrowers would get a principal reduction, and for good reason. Their homes have generally declined in value too, but their mortgage principal remains the same. How is it fair that those borrowers get a reduction just because they can't pay what they agreed to?
Of course, in the long run, these homeowners would probably be better off if there are fewer foreclosures. A smaller housing inventory will result in home prices rising again sooner than if the market remains unstable for several years.
So how do we get all of these parties on the same page? We need a compromise. What if lenders offered conditional principal reductions? Here's how they could work.
The bank first determines the amount the borrower can afford to pay. Then, it appraises the home. Next, it backs into an interest rate. And this is the subtlety: that interest rate might not always be terribly low, given how much the home has depreciated.
I ran a few models so to give an example. If you had a $300,000 home with a 7% interest rate, then your monthly payment was nearly $2,000. But let's say you can only afford about $1,430. One option would be to decrease your interest rate to 4%. That would do the trick. But then your mortgage principal would exceed the value of the home, which is now only worth $215,000 after declining in value by about 28%.