Is Slashing Mortgage Principal the Answer? By James R. Hagerty Wall Street Journal 01-17-2010

Is Slashing Mortgage Principal the Answer?
By James R. Hagerty
The Wall Street Journal
January 17, 2010

Many critics of the Obama administration’s mortgage loan-modification program say it won’t work because it doesn’t do enough to address “negative equity,” the plight of people who owe more on their home loans than the current value of those properties. Without equity in their homes, these critics say, borrowers have little incentive to keep paying and are apt to walk away as soon as things get tough, if not before.

There is even a new word to describe this approach: Lenders need to “re-equify” borrowers by chopping the loan balances to something less than their homes’ values. That would go well beyond the usual loan-mod formula of cutting the interest rate and giving the borrower more time to repay. It also would force banks to admit that the collateral backing their loans is greatly diminished, bringing their balance sheets closer to reality.

But some important voices are raising questions about whether widespread principal reductions are the answer.

When he was asked about that in a news briefing Friday, Assistant Treasury Secretary Michael Barr didn’t rule out broader use of principal reductions. But he suggested that there would be a risk that such a program would change a lot of borrowers’ behavior. “Most people, most of the time, make their mortgage payments …even if they’re underwater,” Mr. Barr noted. “You have to be quite careful not to design a program that induces more people to walk away” or one that strikes people as unfair.

How would principal reductions induce more people to walk away? Let’s say your neighbor, who hasn’t made any payments on his loan for months, gets a huge reduction in his loan balance. Meanwhile, you’ve been working three jobs and dining on cat food to pay your note each month. Your reward from the bank? Zilch.

So maybe you’d decide to stop paying, too, in the hope of the same deal your neighbor got.

Goldman Sachs also is questioning the idea that principal reductions are coming on a huge scale. In a report last week, the Wall Street firm’s economists wrote that the government is likely to make “some additional response” to improve the loan-mod program. “But,” the economists wrote, “the notion that the Treasury will implement a principal-reduction scheme could be a setup for disappointment. While principal reductions would be more effective than rate reductions for many borrowers, well-known obstacles still haven’t been overcome: second-liens pose obstacles; broadly applied principal reductions would involve significant costs, and selective relief could have negative political ramifications.”

This debate isn’t over. Others insist lenders will have to grant principal reductions in many cases. Here’s one formula: The lender or other owner of the mortgage sells it at a big discount to an investor. That investor then reduces the loan balance and refinances the borrower into a mortgage insured by the Federal Housing Administration. Now Uncle Sam is holding the bag on a loan that (we all hope) might be sustainable.

Tom Capasse, a principal at Waterfall Asset Management LLC, a New York-based investor in mortgages, says it’s too late to prevent a “seismic shift” in borrower behavior away from the old model of paying off the mortgage no matter what. Many Americans already see walking away as a legitimate option if they can’t get a better deal from the bank.

“There used to be a scarlet D on your forehead if you defaulted,” says Mr. Capasse. “Now it’s a badge of honor.”