Principal reduction is back (still?) in the news. Here’s a quick update.
The basic idea is that, as part of a workout package with homeowners, lenders would reduce the principal owned along with or instead of the interest rate. But it’s not simply a matter of homeowners asking for a handout. (One way to think of it is a short sale — to the same owners.)
The Spiral of Doom: More than one in five homeowners is underwater. Thanks in large part to foreclosures, supply of homes is way higher than demand. That pushes values lower — and puts more homeowners underwater. That makes them more likely to default and be foreclosed upon… you get the picture.
The any-day-now deal between the states attorneys general and lenders who broke various laws in the robo-signing scandal is going to include principal reductions.
But if you think that’s letting people off the hook, think again. Most principal reduction plans don’t just forgive a chunk of a mortgage. A common caveat is that if the homeowner sells for a profit, that profit goes to the lender or investors. (So you can’t get a $300K loan written down to $250K, then sell the house for $300K and keep all the proceeds.)
The Obama Administration appears to favor some sort of wider principal reduction plan — or at least the general idea. It would keep people in their homes and reduce the glut of foreclosures — and thus protect property values.
But… the Federal Housing Finance Agency (which now runs Fannie Mae and Freddie Mac) doesn’t support the idea. FHFA Acting Director Edward DeMarco said he’s afraid it would lead to losses that would end up on Fannie or Freddie’s shoulders, and those agencies are already hurting from bailing out the nation’s banks.
About four million loans owned (now) by Fannie and Freddie are currently underwater, meaning the property is worth less than the loan on the home.
An analysis from Fitch Ratings found that principal reductions would have a major and positive effect by reducing delinquencies and foreclosures.
FHFA did its own analysis and promised to share the results — but never has. Congress is considering subpoenas to force the agency to disclose what it found. (The logic being that if FHFA’s analysis supported DeMarco’s contention, the agency would have released the numbers.
The Obama Administration has said that it’s going to be more aggressive in pushing FHFA to offer plans that would protect homeowners and property values.
Finally, principal reduction isn’t all that unusual. Corporations do it all the time. Eastman Kodak, for example, is asking the government to require its lenders to accept principal reduction on the company’s loans. It’s called “filing for Chapter 11 bankruptcy.”