Part 2: Our possible solution to principal reductions

Below is part two of our two-part series examining the decision not to use principal reductions as part of HAMP modifications. Rather, Keith Gumbinger, vice president of HSH.com, has developed what he thinks is a fairer concept for a principal-reduction strategy, one which would still provide meaningful debt relief that is needed.

Instead of offering a principal reduction today–when home values are arguably at their lowest and the cost to the taxpayer could be the largest–defer any principal reduction until the home is sold. If the principal reduction is even still needed–that is, if the homeowner is underwater at the time the property is sold–the principal reduction could take place at that time as part of a streamlined short-sale process. If the home is not underwater, there would be no reason for principal forgiveness or a short sale.

Would some homeowners “dump” their properties simply in order to get debt forgiven?

That would be unlikely, given that these would be homeowners who engaged in HAMP modifications in order to keep their homes from foreclosure and retain a place to live. Although a HAMP modification would generally provide a lower interest rate on their loan (creating a “loss of expected interest income” to the investor), they would at least be responsible for trying to pay back the amount they borrowed.

In effect, the borrower can still benefit with a HAMP modification–getting a lower mortgage rate, improved loan terms and a reduced monthly payment, not to mention the considerable benefit of keeping their home–but will receive no “reward” of a reduction in debt simply because they might have bought a home when prices were high.

What DeMarco should have done

It seems to us that rather than refusing principal reductions outright, Mr. DeMarco might have countered with an expedited-short-sale arrangement that reduces principal at the time of a sale.

So, instead of allowing principal reductions today, we could offer them to HAMP borrowers should they need to sell their home. In turn, Fannie Mae and Freddie Mac would agree to forgive the difference between the sales price and the amount owed, and will waive the right to pursue any deficiency judgments.

For borrowers with assets to draw upon, a forgiveness of a larger amount might be done in exchange for the homeowner making up some of the gap between the mortgage amount and the sales price. This kind of arrangement is essentially an expedited short-sale process and consistent with the GSE’s new short-sale policy.

Home prices could help limit losses

Although not much the case at the moment, home prices will generally tend to rise over time, gradually helping to limit losses incurred by the GSEs (taxpayers). All eligible borrowers will still be able to access relief under HAMP, and homeowners will still reap the benefits of a reduction in their home-related debt at the time the home changes hands.

Forgiving principal tomorrow accomplishes several things:

1. It may reduce or eliminate a loss for an investor who owns the loan (e.g. the taxpayer)
2. It provides meaningful debt relief for a borrower who would be otherwise “trapped” in a home, or who might face a large obligation in a short-sale transaction
3. It provides no additional incentive to “strategically default” in order to get debt relief

So instead of flat-out saying no to principal reductions in conjunction with HAMP, perhaps allowing them at the time of a home sale would be much more beneficial to everyone involved.