Principal Reduction: Is Debt Forgiveness Fair?

Doreen Thomas principal reduction
Few topics have sparked more debate among housing market watchers than mortgage principal reduction. Its proponents tout debt forgiveness as one of the surest ways to counteract the housing slump. Its critics label it a handout that would cost taxpayers and spur further defaults.

The arguments for and against are only going to get hotter. In 2010, principal reduction was included in just 11 percent of those mortgage modifications without government guarantees. But by the fourth quarter of 2011, the number had jumped to 40 percent, according to a report by mortgage research firm Amherst Securities Group. And it's likely to rise still further: The "robo-signing" settlement reached in February requires the country's five major mortgage servicers to perform at least $10 billion in write-downs, mostly on loans that they own, to atone for illegal foreclosures.

Now principal reduction is nipping at the heels of Fannie Mae and Freddie Mac. Many consumer advocates and policymakers are calling for the twin mortgage guarantors to adopt the loss-mitigation tactic, but so far the mortgage giants' conservator, the Federal Housing Finance Agency, has resisted.

Simmering beneath the surface of data-driven arguments both for and against principal reduction burns a more profound question, one that no doubt colors how most people view the proposed method:

Is principal reduction fair?

The question isn't just academic to borrowers like Doreen Thomas, a 78-year-old widow who has lived in her Maplewood, N.J., home since 1999.

Thomas (pictured above) receives $604 a month from Social Security, but with a $1,444 monthly mortgage payment, she's looking at eventual default. At this point, she has used up her savings and no longer can rely on assistance from her daughter, who has her own children to support.

Thomas has tried off-and-on for three years to acquire a loan modification. Recently, she said, Wells Fargo rejected her latest application.

"The little help I used to get, I don't know how much longer I will get it," Thomas said. "But then, something else might turn up. I do a lot of praying."

The Specter of 'Moral Hazard'

If she does stop paying her mortgage, she may then be eligible for principal reduction, which often requires that homeowners be in default to qualify. That raises the "moral hazard" objection: If Thomas stops paying, then other homeowners might do likewise in order to receive the same aid, said Mark Calabria, director of Financial Regulation Studies at the conservative Cato Institute.

FHFA acting director Edward DeMarco has said that this is one reason why he has resisted allowing Fannie Mae and Freddie Mac to use principal reduction.

"A key risk in principal forgiveness targeted at delinquent borrowers is the incentive created for some portion of these current borrowers to cease paying in search of a principal forgiveness modification," DeMarco said at a speech at the Brookings Institution in April.

All forms of mortgage modification, not just principal reduction, carry some of the same risk, but critics say that principal reduction offers more of an incentive for a homeowner to strategically default. Calabria points out that principal reduction, unlike a break on an interest rate, offers a lasting reward in the form of increased home equity. And, he added, debt forgiveness also puts a homeowner closer to having a home value that exceeds his or her loan, which makes it much easier for a borrower to sell.

Whether or not you buy into the argument of moral hazard often depends on whom you hold responsible for the housing bust. Kathleen Day, a spokesperson for the Center for Responsible Lending, puts it on the lenders.

"It's the banks that were bailed out," she said. "It is they who incurred the moral hazards.... They got to keep all their executive pay, so they privatized the gain, but when it came time to bail out, they socialized the risk."

Five years into the housing crisis, Day said, there is no evidence that principal reduction, which has been used by some lenders, has spurred many homeowners to default: "It was a bogus argument, and it is a bogus argument."

The Blame Game

Thomas Martin, president of America's Watchdog, a consumer advocacy group, believes too-big-to-fail lenders acted on a moral hazard, knowing that the U.S. government would bail them out if the music stopped -- as, of course, it did.

That rash approach to business, along with some lenders' tendency to lure borrowers into loans that they could not afford, justifies debt forgiveness in the minds of many -- regardless whether it costs lenders money.

"The ignition point was bank fraud on a scale never seen before," Martin said. "Should those guys pay? I mean, yeah!"

But what about those homeowners who didn't know when to stop in their drive to buy bigger or better, or who didn't seriously weigh the risks of buying a home to begin with?

Should You Pay for Your Neighbor to Stay?

The question of whether lenders should reduce principal on some distressed mortgages grows even more fraught in the case of write-downs performed under government-sponsored programs like the Home Affordable Modification Program.

Taxpayers fund HAMP, which subsidizes modifications on distressed mortgages. So when a lender performs a HAMP modification, taxpayers are footing some of the bill.

"It's picking winners and losers," Calabria said. "It's implicitly transferring income from one party to another."

Even in the case of principal reductions performed by lenders without HAMP subsidies, the cost may reach everyday Americans. Investors, such as pension funds, who own packaged loans (mortgage-backed securities) take a hit. "It's a wash," Calabria said. "You're redistributing income instead of creating it."

Fannie and Freddie in a Fix

Lawmakers, government officials and consumer advocates continue to pressure the FHFA -- which has controlled Fannie and Freddie since the government bailed them out in 2008 -- to approve principal reductions.

Previous FHFA studies found that principal reduction would end up costing taxpayers billions of dollars. However, a recent analysis upended that conclusion. It found that, even after accounting for the cost of HAMP subsidies paid by taxpayers, a debt-forgiveness program would save the public $1 billion, The Wall Street Journal reported.

Nonetheless, FHFA Acting Director DeMarco announced today that taxpayer-owned Fannie and Freddie, which back 60 percent of U.S. mortgages, still wouldn't approve a principal-reduction program. He said that the potential costs of a debt-forgiveness program outweighed its potential benefits, mentioning specifically the possibility that such a program could create a moral hazard where homeowners would default just to qualify for principal forgiveness.

In such a scenario, questions of fairness would surely come back into play. "Somebody has got to pay the taxes for it," Calabria said. "It's taking from a hand and giving to another."

principle reduction Mark Ritter

An Ethical Dilemma, Even for Those Who Benefit

Even some of those who have benefitted from principal reduction feel the conflict.

Mark Ritter (pictured above with his wife) stopped paying his mortgage in early 2011, after he was forced to quit his job in order to care for his wife, who suffered from a form of Alzheimer's that made her visually disabled. After sliding into delinquency, he struggled for almost a year to get his lender to lower the 10 percent interest rate on his mortgage.

But his persistence paid off: After persevering through countless paperwork headaches, Ritter, with the help of free counseling services offered by NeighborWorks HomeOwnership Center, finally prevailed. He said that his lender reduced his rate to 2.0 percent, and promised that he would receive $18,000 in principal reduction if he keeps up on his payments.

The end result, he said, has made him feel "wonderful." Nonetheless, even he isn't sure if he fully agrees with the modification technique that has helped make it possible for him to hold onto his home.

"From one point of view, I don't know," Ritter said. "I don't know if it is justified because you agreed to pay a certain amount.

"On the other hand, the exorbitant interest -- the fact that I paid already going on $50,000 interest to the financial institutions -- maybe an $18,000 reduction isn't a huge deal to them."

Thomas, despite her financial situation, doesn't want others to help pay off something that she made a promise to pay herself.

"I don't agree with it," she said. "Yes, [lenders] should help. But only through interest rate."

See also:
Banks' Paperwork Foul-Up Cost Atlanta Woman Her Home
'This Is Crazy': Company Snatches Condos from Owners
90% of Bank-Owned Homes Held Off Market, Estimates Suggest

10 Emptiest U.S. Cities 2012
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Principal Reduction: Is Debt Forgiveness Fair?

12-Month Averages:

Rental vacancy rate: 11.5%
Homeowner vacancy rate: 3.8%

Of the 75 largest U.S. cities in the first quarter of 2012, Toledo recorded the highest rate for homeowner vacancies, at 5.6 percent. However, in three of the past four quarters listed by the Census Bureau, that rate has hovered between 3 and 3.6 percent, significantly bringing down the city’s 12 month average, and its overall ranking in this list. Regardless, the 3.8 percent 12 month average still ranks Toledo as the fifth highest in the country for homeowner vacancies alone.

12-Month Averages:

Rental vacancy rate: 12.8%
Homeowner vacancy rate: 3.2%

It’s no secret that the Florida real estate market has seen better times — and the situation in Tampa appears to be getting worse. In May, RealtyTrac reported that foreclosure activity in the Tampa-St. Petersburg-Clearwater area rose by nearly 111 percent from May 2011, with one home in every 304 in foreclosure. The rental vacancy market has been following this downward trend, with the rental vacancy rate going up or remaining flat every quarter since the beginning of 2011.

12-Month Averages:

Rental vacancy rate: 15.5%
Homeowner vacancy rate: 1.9%

Houston is home to the nation’s third-highest rental vacancy rate over the past 12 months, standing at 15.5 percent. The city hit a three-year high for rental vacancies in 2009, when the rate rose to 18.4 percent in the third quarter of that year, according to Census Bureau data. However, Houston’s homeowner vacancy rate has been recovering, dropping below the average for the 75 largest cities for the past three quarters to as low as 1.1 percent at the end of 2011.

12-Month Averages:

Rental vacancy rate: 11.3%
Homeowner vacancy rate: 4.2%

Atlanta’s average homeowner vacancy rate is the third-highest among major U.S. cities, standing at 4.2 percent. Fortunately for Atlanta, the rate has been dropping since early 2011, when it stood at 5.4 percent. The trend for rental vacancies has been worse for Atlanta, however, rising from 9.4 percent in the third quarter of 2011 to 12.4 percent in the first quarter of 2012.

12-Month Averages:

Rental vacancy rate: 11.9%
Homeowner vacancy rate: 3.9%

Over the past five years, the Las Vegas housing market has experienced one of the country’s most dramatic boom-and-bust cycles. The city continues to feel the pain. At the end of 2011, Las Vegas ranked second in the country for gross vacancy rates, at 16 percent, and currently has an unemployment rate of 11.8 percent. 

In the past 12 months, Las Vegas’ rental vacancy rates have dropped from a high of 13.2 percent in the third quarter of 2011 to a low of 11 percent in the first quarter of 2012, the most recent number available. Although Las Vegas remains one of the most vacant U.S. cities, homeowner vacancies are a bright spot, dropping from 5.5 percent over the past year to 2.3 percent in the most recent quarter.

12-Month Averages:

Rental vacancy rate: 15.1%
Homeowner vacancy rate: 2.4%

With a rental vacancy rate of 15.1 percent, Virginia's capital ranks fourth among all major U.S. cities for empty rentals over the past year, with the first quarter of 2012 showing a 19 percent rental vacancy rate. However, Richmond’s homeowner vacancy rate ranks only 27th among the country’s 75 largest metro areas, and stands just 0.2 percent higher than the average for large metro areas.

12-Month Averages:

Rental vacancy rate: 16.9%
Homeowner vacancy rate: 1.7%

Detroit was one of the hardest hit cities in the recession, and with an unemployment rate of 9.9 percent as of May, it's little wonder that its 16.9 percent rental vacancy rate is the second highest in the country. Surprisingly, though, the homeowner vacancy rate remains below the 75 largest metro area's average of 2.18 percent. According to the Census Bureau, at the end of 2011, Detroit had a gross vacancy rate of 12.2 percent, a level the city has virtually maintained since 2006.

12-Month Averages:

Rental vacancy rate: 15%
Homeowner vacancy rate: 3.1%

Memphis's proportion of vacant homes, both owned and rentals, puts it third overall, thanks to an average rental vacancy rate of 15 percent that is the fifth highest in the nation and the 3.1 percent homeowner vacancy rate that ranks 13th.

12-Month Averages:

Rental vacancy rate: 11.3%
Homeowner vacancy rate: 5.4%

The good news is that Dayton's homeowner vacancy rate has been trending downward since its peak in the third quarter of 2011, when it stood at 6.5 percent.

However, even this improving number gives Dayton the distinction of having the highest average homeowner vacancy rate in the country, according to the Census Data. And Dayton’s average rental vacancy rate, at 11.3 percent, is higher than the 75 city average of 9.2 percent. The Census Bureau calculations put Dayton’s gross vacancy rate at 16.9 percent, more than 6 percent above the large city average, and the highest in the country.

12-Month Averages:

Rental vacancy rate: 18.8%
Homeowner vacancy rate: 2.2%

The emptiest city in the United States is Orlando, Fla. The 12-month average for rental vacancies stands at a staggering 18.8 percent, while in the first quarter of 2012 this number was 22 percent, highest in the nation. Florida's third largest city also has an above-average homeowner vacancy rate, but this metric has been rising during the past two quarters, according to Census Bureau data.

Despite its housing woes, Orlando has been able to avoid the financial woes of other cities, such as Harrisburg, Pa., and San Bernardino and Stockton, Calif. According to Orlando’s most recent annual report, the city has more than $125 million of cash in its general fund and over $1.1 billion in total assets (including nearly an additional $300 million in cash and cash equivalents in other funds), compared with just under $600 million in total listed liabilities.


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