Government Mortgage Principal Reductions Dead-on-Arrival?

To advocates for foreclosure prevention, principal reductions are the Holy Grail of mortgage modifications. They're the one way you can get two benefits with one change: make the payment burden easier on the borrower and provide an incentive to keep the homeowner paying. But thus far, principal reductions have been fairly elusive. Although the Treasury announced an effort about a year ago to encourage banks and servicers to provide them, we haven't heard a word since. Today, at a press round table discussion I asked for a status update.

Several senior Treasury officials were present, including Consumer Financial Protection Bureau architect Elizabeth Warren, Treasury Secretary Timothy Geithner, and Acting Assistant Secretary for Financial Stability Timothy Massad. About a dozen journalists fired questions at officials for nearly two hours. A good chunk of those inquiries centered on mortgage modifications, particularly the Homes Affordable Modification Program (HAMP), which has slowed to a sputter in recent months. It's currently a big target for Congressional Republicans looking to trim government fat to cut the deficit. 

But what about the principal reduction effort? We have yet to get any data on the program announced last March. Its implementation was set to be complete last fall, however. So we should have some early signs of its success or failure. We might get some results for the program by June, according to Treasury officials I have spoken with in the past.

But senior Treasury official present at the discussion today made it sound like the program is off to a rough start. The senior official who spoke about the program began by explaining the big obstacles that stand in the way of principal reductions.

First, there's the sheer magnitude of negative equity in the market - probably somewhere between $300 billon and $1 trillion. CoreLogic estimated earlier this week that the tally was at $751 billion in the fourth quarter.

The second challenge the official spoke of was the difficulty in tackling a problem of this magnitude with limited monetary resources and still making it fair. Approximately one-quarter of Americans with a mortgage are underwater. You can't provide a principal reduction to all of them, so who do you choose? And how big a principal cut do they get?

Finally, there's the moral hazard issue. Once people hear that the government is cutting the balance of people's mortgages, everybody wants a dime from Uncle Sam. That could further exacerbate housing market problems, as strategic defaults may rise and prices may decline more steeply.

But in theory, shouldn't the Treasury have worked out all of these problems before creating their program? It certainly had some attractive features, like graduated principal reduction and decent incentives to lenders. Yet, a senior official indicated that there has not been a huge adoption of the program by servicers. In fact, even the Federal Housing Authority, Fannie Mae, and Freddie Mac have decided not to participate. They alone own more than half of the mortgages that might qualify for these modifications.

Instead, the senior official indicated that most sevicers prefer other modification strategies, like principal forbearance, instead of principal modification. This isn't terribly surprising: if they liked principal reduction, then they probably would have done them already, without a Treasury program encouraging the practice by throwing them a few little carrots.

So for now, it doesn't sound like principal reduction is taking off -- at least not the Treasury's effort. But hopefully we'll know more by June. Keep your eye on the negotiations between banks and servicers and the states attorneys general, however. The draft settlement provided by the states this week would pave the way for more principal modifications. And this time around, there might be a stick involved. But expect banks and servicers to continue to fight. They appear to view principal modifications as a sticky practice that they don't want to get anywhere near.