Friday, February 26, 2010; A20
The Federal Deposit Insurance Corp. is developing a program to test whether cutting the mortgage balances of distressed borrowers who owe significantly more than their homes are worth is an effective method for saving homeowners from foreclosure.
The program would be aimed at a growing population of homeowners who are underwater on their loans, estimated at more than 20 percent of borrowers, or 11 million homeowners. Economists consider these borrowers among the most vulnerable to foreclosure, and some industry officials worry that more of them will simply walk away from their mortgages, or "strategically default," rather than spend a decade or more trying to regain positive equity.
Under the FDIC program, borrowers would be eligible for a reduction in their mortgage balances if they kept up their payments on the mortgage over a long period. The performance of those borrowers would be compared with borrowers given more traditional mortgage relief packages, such as those that cut the interest rate on loans.
"We're thinking about it in terms of earned principal forgiveness. If you stay current on your mortgage, you would earn a principal reduction. It would only be for loans significantly underwater," said FDIC Chairman Sheila C. Bair.
The program would have a small reach and apply only to loans acquired from a failed bank seized by the FDIC. That would be less than 1 percent of mortgages currently outstanding. The initiative could be launched later this year, FDIC officials said, but a date has not been set.
The effort adds to the growing debate about whether principal reductions should become a larger part of mortgage-relief efforts. Another government program, known as Hope for Homeowners, sought to reduce mortgage balances of underwater borrowers but has floundered since its launch, and legislation to allow bankruptcy judges to cut the principal on a borrower's loan failed in the Senate last year.
Treasury officials have said they are considering proposals to address negative equity but have not offered any specifics. Under the federal foreclosure relief program known as Making Home Affordable, borrowers can receive up to $5,000 to lower their loan balance if they keep up their payments. But that amount would make only a small dent in the problem facing millions of homeowners, housing advocates said. During the fourth quarter of last year, the average underwater borrower owed $70,700 more than the value of their home, according to First American CoreLogic data released this week.
"Whether homeowners have equity in their home is a key predictor of whether they will default on their mortgage or redefault on a loan modification," said Julia Gordon, policy director of the Center for Responsible Lending. "That's why any serious plan to prevent foreclosures has to include principal reduction for those who owe more than their home is worth."
Lenders have been reluctant to cut the principal balance owed by distressed borrowers, arguing that it would encourage homeowners to become delinquent even if they can afford their mortgage. Instead, the industry has focused on providing mortgage relief by lowering a borrower's interest rate or extending the terms of a mortgage to 40 years. In some cases, a portion of the principal balance is put into a second mortgage that does not have to be paid off until the borrower sells the home or refinances.
Yet, some in the industry have started to relent. During the third quarter of 2009, 13 percent of loan modifications included a reduction in the borrower's principal, according to a report by the Office of the Comptroller of the Currency. That was up from about 10 percent during the second quarter.
Wells Fargo, for example, has increasingly used principal reductions for homeowners with a risky mortgage, known as "option" ARMs. These loans, also called "pick-a-pay" mortgages, allow borrowers to choose how much to pay each month. Many of these borrowers pay less than the amount of interest due, and the unpaid interest is tacked on to the balance. These loans also tend to be concentrated in places where home prices soared and then plunged precipitously, leaving many homeowners significantly underwater.
Wells Fargo, which acquired many of these loans as part of its 2008 purchase of Wachovia, says it forgave $2.6 billion in borrowers' principal balances for these types of mortgages last year. But even when principal reduction is offered, it will not necessarily be enough to bring a borrower back to full equity, company officials said.
"It needs to be done on a case-by-case basis, either in certain geography types, or with certain customer types," said Mike Heid, co-president of Wells Fargo Home Mortgage. "I do not believe that you can do a programmatic-wide or country-wide principal forgiveness [program]. You end up with many problems if you try to do this across the board."