Should The Federal Government Forgive Mortgage Debt?

Tens of thousands of homeowners will be able to avoid the loss of their homes under a new principal forgiveness program from the federal government. The trick is …

Tens of thousands of homeowners will be able to avoid the loss of their homes under a new principal forgiveness program from the federal government. The trick is not to lower interest rates or somehow raise borrower incomes, instead the government will simply cut loan balances to the point where the mortgages become affordable.

There are several problems – huge problems – with principal reductions.

First, lenders never, ever, want to convey the idea that debt is negotiable. You can talk about modifying the interest rate or loan length and maybe delay a few payments but anything less than full repayment of the debt is typically seen as off-limits and non-negotiable. Once debt is negotiable, when do the negotiations end?

Second, if Smith can get a principal reduction then why not Jones? A lot of people run into tough times; if lenders allow Smith’s loan balance to be reduced because an employer downsized then why not offer the same benefit to co-workers and neighbors? And if similarly-situated co-workers and neighbors can’t get a reduction then how is the system fair to them?

Third, speaking of fairness, when property values go down there’s often a widespread call for principal reductions, but when home prices rise no one says lenders should get more, that mortgage debt should grow. If what’s good for the goose should also be good for the gander, there’s a lack of balance here.

The One & Only Case For Principal Reductions

There is, however, one situation when principal reductions make sense, the very second every other possible option is worse. Not marginally worse or slightly worse, but vastly worse, a potential result so awful that in a moment of lender desperation and despondency even principal reductions seem tolerable, in the sense that cutting off a toe is better than losing a leg.

The issue is so complex that according to Mel Watt, director of the Federal Housing Finance Agency, his organization spent two years weighing every argument before coming to the conclusion that government-controlled Fannie Mae and Freddie Mac should begin offering principal reductions as a way to hold down foreclosures.

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Speaking in March, Watt explained that “it would not be an overstatement to say that this has been the most challenging evaluation the Agency has undertaken during my time as Director. We are, however, drawing close to the end of this difficult process, and I expect to announce a decision within the next 30 days about whether we have been able to find a ‘win-win’ principal reduction strategy or whether, on the other hand, we will take principal reduction off the table entirely.”

This, in the language of Washington, is a trial balloon. If the public blow-back is too great Watt could always say principal reductions had been considered and rejected, there’s wiggle-room in his statement. Alternatively, if financial lobbyists cannot produce enough yelling and screaming on Capitol Hill to make front pages nationwide, then principal reductions will become a reality.

In fact, barring a massive public outcry, the Watt plan was already cast in concrete. We know this because the day BEFORE his speech The Wall Street Journal reported that “the plan approved by the Federal Housing Finance Agency marks the first time that Fannie and Freddie will reduce mortgage balances on a large scale for struggling homeowners since the housing crisis erupted. But it doesn’t go as far as some housing advocates wanted.”

Notice the expression, the plan approved…. Does anyone doubt that this was a done deal?

Because it was a done deal, there was no surprise when in mid-April FHFA announced that after due consider it had decided to go through with principal reductions.

It’s estimated that 33,000 borrowers can potentially be helped with principal reductions, about 16 percent of the deeply-underwater loans held by Fannie Mae and Freddie Mac.

The two GSEs own 200,000 loans which are at least one-year delinquent. On average, such loans have not generated payments in three years and roughly 18,000 have been on the books without a payment for five years or more. Foreclosing on such properties will simply seal their fate as massive losers, but foreclosure will not get back lost value. Alternatively, forgiving principal that would have been lost anyway might get some of the loans back into the “win” column, producing monthly income, higher asset values and fewer claims against mortgage insurers.

Why Not Before?

The obvious question raised by the Watt plan is why principal reductions were not done earlier. How many of the more than seven million homes lost to foreclosure could have been saved? Would so many homes continue to be underwater? How much in lender losses could have been avoided? Why didn’t the government offer liability relief to lenders in exchange for principal reductions and prevent years of court battles and litigation costs? Could we have avoided the Federal Reserve’s zero interest rate policy (ZIRP) if real estate losses could have been reduced early in the crisis?

“Investors lost hundreds of billions of dollars as a result of mortgage-related declines in the financial sector,” said Rick Sharga, executive vice president at, an online real estate marketplace. “Investors have every reason to ask if the ‘rules’ have been changed, if a future mortgage crisis will see faster principal reduction efforts, when debt forgiveness delivers a better financial outcome than other loss mitigation strategies.”

As examples, Bill Gross, the famous bond investor now with the Janus Capital Group, pointed out in early March that Citibank was priced at $500 in 2007 and had fallen to $38; Bank of America was at $50 a share and dropped to $12; Credit Suisse fell from $70 to $13; Deutsche Bank went from $130 to $16, and Goldman Sachs saw share values drop from $250 to $146.

If there’s another mortgage meltdown you can bet that principal reductions will be high on the list of potential remedies, a lot higher than in 2007. The Watt plan will make principal forgiveness increasingly acceptable, a concept no longer seen automatically as a financial evil to be avoided at all costs.

Bill Gross, for one, seems to have already outlined his position.

“Banking/finance,” he says, “seems to be either a screaming sector ready to be bought or a permanently damaged victim of write-offs, tighter regulation and significantly lower future margins. I’ll vote for the latter.”  


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