Getting Right Side Up

Banks can spur a housing recovery by providing underwater borrowers relief through principal reduction.

March 1, 2012

Negative equity is the biggest threat to the health of the housing sector. It’s causing foreclosures, stifling consumer spending, and preventing home ­owners from selling. Many owners feel hopeless. More than 20 percent of home owners are upside down on their mortgage, and generally, refinancing is not an option. According to the research firm CoreLogic, as of June 2011, underwater home owners owed $709 billion more on their mortgages than their homes were worth.

Government interventions haven’t performed as hoped. Federal programs created to help owners stay in their home have depended on the efforts of large financial institutions to assist consumers and have fallen far short of ambitious but achievable goals.

With a massive shadow inventory still holding back the market and borrower-assistance programs falling short, it’s time to consider new approaches to turning housing around. One solution that could provide some relief hasn’t been given much consideration so far: principal reduction. This would require cooperation on the part of banks, of course. Some of the country’s largest financial institutions have agreed to just that as part of the massive $25 billion settlement with the Justice Department and 49 state attorneys general announced in February.

Why should banks go along with the idea of principal reduction for some borrowers? For starters, many of these institutions contributed to the problem with their securitization schemes and were rescued with trillions of dollars in taxpayer-funded bailout money. Although a substantial amount has been paid back, some has not and will never be returned. (The Web site ProPublica keeps a running tab on bailout repayments.)

If financial institutions wrote down principal amounts and reduced interest rates to market value, this could stimulate the economy by reducing mortgage payments for financially shaky households, putting billions into consumers’ pockets. As consumer demand grew, so would construction, hiring, and economic growth.

Much of the opposition to principal reduction boils down to a couple of arguments. First, there’s the notion that reducing principal will hurt investors behind the pooled mortgages or mortgage-backed securities. Yet short sales and foreclosures pose a greater negative impact on MBS. Principal reduction, on the other hand, could establish a floor as to how low that particular investment might go.

Another major concern is that home owners who don’t need assistance will seek it anyway. After all, who wouldn’t want a lower mortgage payment? The truth is, however, that many home owners already have reduced their monthly payment—to zero—through strategic default. I won’t defend their approach, but it’s happening widely and needs to be addressed. A principal reduction program wouldn’t, and shouldn’t, be open to everyone. It would be limited to households facing imminent foreclosure or some other serious financial hardship.

There’s the question of whether banks can afford to do this. Well, the banks currently have an estimated $1.64 trillion sitting idle in Federal Reserve accounts—largely stimulus funds provided from that very institution—according to a recent report from the St. Louis Fed. If a principal reduction program were spread out over a few years and limited to households facing financial hardship, banks could fund it and still maintain solid financials.

The banks are sitting on a huge stockpile right now, with estimates of the shadow inven­tory’s size ranging from nearly 2 million at the low end (according to CoreLogic) to more than 10 million at the high end (according to Amherst Securities). It’s in their interest to make sure that inventory doesn’t lose even more value from another wave of defaults. Principal reduction seems to offer bene­fits for home owners, banks, and the economy as a whole. It’s time to give this idea a fair hearing.



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Note: Opinions expressed in “Commentary” do not necessarily reflect the position of the National Association of REALTORS® or ­REALTOR® Magazine.