Earlier this month, we reported that the Treasury's principal reduction program is off to a rough start. Banks don't seem to be eager to embrace the technique for modifying mortgages, despite some housing policy experts saying that reducing principal is the most effective way to prevent redefault. A report today indicates that states with similar programs aren't having much luck either. What's the problem?

A Wall Street Journal article by Nick Timiraos says that state programs that offer principal reduction are also failing to get off the ground. He writes:

Arizona and California have allocated a total of $1 billion in federal funds for a write-down program that offers to match as much as $50,000 in principal reductions by banks. Both states have barred borrowers who did a "cash-out" refinancing from being eligible for a write-down, and loan balances aren't immediately forgiven.

Despite the financial incentives, the Arizona program has received fewer than 500 applications since its September launch. Only one borrower's loan balance was sliced, and by just $40,000.

If fewer than 500 applications were submitted, then this indicates that the problem isn't necessarily banks philosophical qualms with the strategy. Something else must be going on here.

One possibility is that banks have created stipulations so strict for applying to the programs that most struggling homeowners feel they don't qualify. The WSJ article hints at this possibility since borrowers who got cash-out refinancing are forbidden from participating.

Another possibility is that banks are intentionally failing to advertise these programs. If no one ever hears about a program, then it won't have any applicants. If banks were aggressively marketing such modification efforts to delinquent and defaulted borrowers, then it's hard to believe applications wouldn't come flooding in.

But that brings up the third possibility: maybe borrowers just aren't interested. Considering that we're talking about principal reductions, this would be a little surprising. But in many cases, borrowers have been defaulted for many months and are essentially living in their homes for free until banks get around to seizing the property. This can take over a year in some cases. While a principal reduction might seem attractive in theory, it's not as good a deal as living in your home indefinitely without paying a penny. In other cases, perhaps borrowers are so far underwater that they don't believe a principal reduction of even up to $100,000 would be big enough to make it worthwhile to keep their home, as it could remain underwater even then.

Whatever the reason, it's pretty clear that these principal reductions aren't moving forward. The carrots that the government has offered banks and servicers aren't enough to motivate them to aggressively pursue this method of mortgage modification. At this point, the only possibility left for the modification strategy would be if state attorneys general manage to coerce banks and servicers into providing more principal reductions as part of the proposed foreclosure mess settlement.

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