The Obama administration's plan to help struggling homeowners has had the unintended consequence of making it harder for them to get the most effective kind of mortgage relief -- principal reductions.
Less than two percent of mortgage modifications in the administration's year-old $75 billion Home Affordable Modification Program involved principal writedowns, according to a critical new report by a government watchdog. Yet, before the program began last year, mortgage servicers were cutting principal in about 10 percent of modifications, the report notes.
About one in four homeowners with a mortgage is underwater, according to real estate research firm First American CoreLogic, meaning they owe more on their mortgage than the underlying property is worth. These homeowners are the most likely to default on their mortgages, analysts say. The average homeowner in the Obama plan, called HAMP, is underwater -- they owe $1.14 on their mortgage for every $1 in their home's current market value.
Cutting principal -- the outstanding debt on a mortgage -- is the "primary method of quickly addressing negative equity," notes the government report.
Yet while rumors circulate that the Treasury Department may soon introduce a principal reduction program, thus far it refuses to mandate principal cuts.
According to analysts and consumer advocates, the reason why such cuts have been so rare under HAMP is because the Treasury Department's guidelines emphasize interest rate reductions over principal reductions.
Under the program's guidelines, servicers must lower borrowers' monthly payments to 31 percent of their income.
The first step involves reducing the interest rate. For the majority of borrowers who convert from temporary trial plans to five-year plans, interest rate cuts are enough.
If that doesn't get to the 31 percent ratio, then servicers extend the life of the loan, up to a max of 40 years.
If those two steps still don't achieve the 31 percent ratio, servicers will delay -- not forgive -- payment on mortgage principal. At the end of the loan, these borrowers will face balloon payments.
Finally, if those three steps aren't enough, servicers can write down principal. While servicers can move principal writedowns to the top of the list, there's little incentive to do so if Treasury isn't pushing for it. Also, writing down principal means taking immediate losses on those mortgages.
Meanwhile, lenders operating outside the government's program are writing down principal. In the three-month period ending last September, more than 13 percent of mortgage modifications by the nation's largest banks and thrifts involved principal cuts, more than quadruple the level achieved during the three-month period ending last March, according to a December report by federal bank and thrift regulators the Office of the Comptroller of the Currency and the Office of Thrift Supervision.
For those loans held in-house by banks and thrifts -- rather than by investors -- principal cuts were featured in nearly 37 percent of mortgage modifications.
Of the 17,412 mortgage modifications involving principal cuts to take place outside of HAMP during the third quarter of last year, just 153 of them were for investor-owned and government-backed mortgages. The rest were owned outright by the banks and thrifts themselves, according to the federal report.
Treasury, meanwhile, has yet to deliver a concrete plan addressing principal reductions for underwater homeowners. The failure to do so, analysts warn, could render current foreclosure-prevention efforts moot since not enough homeowners would be helped, and those who were may end up re-defaulting on their mortgages anyway.
As noted mortgage bond analyst Laurie Goodman of Amherst Securities told a Congressional panel in December: "The evidence is irrefutable. Negative equity is the most important predictor of default."