Fed Downplays Principal Reductions as Fix for Foreclosure Crisis

The Federal Reserve concedes mortgage principal reduction is widely debated and has the potential to ease the foreclosure crisis, but its benefits are hard to quantify, the central bank concluded in an assessment of the strategy.

The Fed also points out issues of cost and fairness associated with such a foreclosure prevention program that lawmakers would need to seriously consider.

“Targeting principal reduction efforts on those most likely to default raises fairness issues to the extent that it discriminates against those who were more conservative in their borrowing for home purchases or those who rent instead of own,” the Fed said.

The central bank’s position on principal write-downs – advocated by consumer groups and housing market analysts to some degree – was made clearer this week in its assessment of the ailing housing industry, which was presented as a “white paper” to the chairmen and ranking members of the House and Senate banking committees.

The paper provides a “framework for thinking about certain issues and tradeoffs that policymakers might consider,” Fed Chairman Ben Bernanke wrote in an introductory letter.

However, not all Fed members are in agreement on the issue of principal write-downs. In a speech yesterday, William Dudley, president of the Federal Reserve Bank of New York, said U.S. taxpayers and mortgage bond investors should fund loan principal reduction for distressed homeowners.

But Dudley acknowledged the complexity of coordinating such a program, particularly with various creditors in the pipeline and needing first-lien holders to take the biggest hit.

“The costs of large-scale principal reduction would be quite substantial,” the Fed said in its assessment for lawmakers.

Currently, 12 million mortgages are underwater, with aggregate negative equity of $700 billion, the central bank reported.  Of these mortgages, about 8.6 million borrowers, representing roughly $425 billion in negative equity, are current on their payments.

Principal reductions could prevent default – the primary precursor to entering the foreclosure process – among many “underwater” homeowners owing more than the values of their homes.

But “the effect of reducing negative equity on default is hard to estimate because borrowers with high LTV (loan-to-value) ratios tend to have other characteristics correlated with default,” the Fed said.

And there are several factors at play that make it hard to quantify if mortgage balance write-downs alone can prevent foreclosure.

“For example, high-LTV homeowners often made small initial down payments – perhaps due to a lack of financial resources – and tend to live in areas with greater declines in house prices, where unemployment and other economic conditions also tend to be relatively worse,” the Fed said.

The Fed did not provide clear direction to lawmakers in finding alternatives. It suggested intensifying approaches already underway, such as mortgage modifications, and expanding refinancing opportunities to underwater mortgage holders.

“An alternative to large-scale principal reduction for addressing the barriers that negative equity poses for mortgage refinancing and home sales could involve aggressively facilitating refinancing for underwater borrowers who are current on their loans, expanding loan modifications for borrowers who are struggling with their payments, and providing a streamlined exit from homeownership for borrowers who want to sell their homes, such as an expanded deed-in-lieu-of-foreclosure program.”

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