The debate on "principal forgiveness" goes on. Policymakers from Treasury Secretary Timothy Geithner to numerous members of Congress are urging lenders and mortgage servicers to reduce loan balances to help homeowners remain in their houses and prevent additional foreclosures, given the fact that 12 million homeowners are "underwater" on their mortgages and in danger of defaulting.
Even Christine Lagarde, the head of the International Monetary Fund, has called on the U.S. government to reduce mortgage debt "as a way to help revive that nation's economy and stimulate growth in the wider industrialized world."
The debate seems to be particularly intense with regard to loans held or guaranteed by Fannie Mae and Freddie Mac, where acting Federal Housing Finance Agency director Edward DeMarco seems unconvinced that principal write-downs are in the best interests of the institutions he oversees and, ultimately, the taxpayer.
We have sympathy for DeMarco's position for numerous reasons, among which are the following:
1) There would appear to be
2) As a loss mitigation tool, principal reduction would only apply to those borrowers who are severely delinquent or in danger of imminent default and not to borrowers who honor the terms of their note through timely payment. But what sort of perverse incentive is that? Wouldn't it encourage all borrowers to stop their monthly payments so that they could qualify for principal reduction? And how would this affect Americans' future behavior toward other contracts they enter into to borrow money?
3) To the extent that individual mortgages are pooled together into mortgage-backed securities, how would the prospect of principal reduction affect the decision making of investors in mortgage securities in the future, knowing that repayment might be optional, contingent on a number of economic circumstances and political reactions? One would expect that mortgage investors would demand a higher return for a higher risk, which would lead to increased costs for all mortgage borrowers.
4) A number of studies have shown that the aggregate amount of negative equity is highly concentrated in certain states. A recent
5) It has been suggested that Acting Director DeMarco may be reconsidering the issue of principal reduction if there are leftover funds in the Troubled Asset Relief Program to fund the reductions. But surely such a decision should be made only upon solid evidence that the overall cost to the taxpayer is reduced by such forgiveness, whether financed in the form of TARP funds or additional governmental funding for Fannie and Freddie.
First, it must be determined that the borrower was induced to enter into a complex mortgage transaction whose terms were readily capable of misinterpretation. Secondly, it must be determined that the borrower did not falsify income, employment, or other information in obtaining the mortgage. Thirdly, if the first two hurdles have been crossed, the amount of the principal reduction must be converted into a second trust which could be repaid if property appreciation were to occur in the future.
Otherwise, policymakers should stop talking about principal reduction and focus on loan modifications, short sales, deeds in lieu of foreclosure, leasing arrangements, or other
Alexander R. M. Boyle is the retired vice chairman of Chevy Chase Bank. Robert D. Broeksmit is a senior director at Treliant Risk Advisors and a former president of B.F. Saul Mortgage Co., a unit of Chevy Chase.