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Principal Cuts May Be Coming For Troubled Homeowners, Yet Questions Remain About Program's Effectiveness

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More than one year after the Obama administration launched the most ambitious effort to help struggling homeowners since the Great Depression, the White House took another step forward Friday by announcing a plan to reduce the amount owed by underwater borrowers

The administration's much-criticized $75 billion effort, Making Home Affordable was supposed to stem the rising foreclosure crisis through multiple initiatives, the most prominent being the Home Affordable Modification Program (HAMP), an incentives-based approach to helping homeowners avoid foreclosure by paying lenders, services, investors and homeowners for every successful loan modification.

That approach has largely been ineffective, according to analysts, consumer advocates, and government watchdogs, because it doesn't attack the core of today's foreclosure problem -- underwater homeowners and unemployment. One top analyst said it was "destined to fail."

There are more than 11 million homeowners who owe more on their mortgage than the property is worth, representing about a quarter of all homeowners with a mortgage, according to real estate research firm First American CoreLogic. But the administration's offers of assistance have largely failed to help them.

The new plan consists of two parts. One, through HAMP, will work by encouraging lenders and servicers to consider principal cuts early on in the mortgage modification process, rather than first relying on interest rate cuts and extending the life of the loan. Mortgage servicers forgave principal on less than two percent of HAMP trial loans, according to a report this week by the Office of the Special Inspector General for the Troubled Asset Relief Program. That's despite the fact that on average, homeowners in HAMP owe $1.14 on their mortgage for every $1 in their home's current market value, according to Treasury Department estimates cited in the report. "HAMP allows principal reduction, but it is not typically implemented in practice," the report states.

The second is through the Federal Housing Administration. About $14 billion from Making Home Affordable will be earmarked for the agency to fund the refinancing of severely underwater mortgages. Only homeowners current on their loans are eligible. Eligible homeowners owing more than $1.15 for every dollar in their home's current market value will be able to lower their total mortgage debt to that $1.15 level; anything higher than that will be extinguished. The outstanding principal has to be reduced by at least 10 percent, though the administration "expects" the write-down to be "significantly more than that," according to an announcement.

But by lowering their overall mortgage debt, the administration may be taking its most aggressive step yet in helping underwater homeowners stay in their homes. By giving borrowers much-needed equity, severely underwater homeowners who may have been looking to strategically default on their mortgages, also known as "walking away," now may be incentivized to stick with their mortgage.

It comes with a cost. Taxpayers will be on the hook for billions. The Obama administration, facing criticism for the sky-high foreclosure rate, needs to appear to be doing something -- anything -- to help homeowners stay in their homes. With banks repossessing homes at record rates -- last year lenders foreclosed on more than 2.8 million homes, according to real estate research firm RealtyTrac -- and no signs of that rate abating, the administration has been under political pressure in the face of Congressional elections less than nine months away. RealtyTrac estimates three million homes will get foreclosure notices this year; more than one million of them will be repossessed by lenders.

"It's a tricky balance... to ensure that this nascent recovery that has just started is sustained and we don't have another fallout, and that we help all those borrowers who are in fear or danger of foreclosure when we can help them," said Diana Farrell, deputy director of the White House's National Economic Council. "But it's really important to recognize that we won't stop every foreclosure."

And the principal-reduction plan is entirely voluntary. Lenders, investors and services will be given cash payments to cut mortgage principal, and in some cases writing off all together a junior lien or home equity line of credit. But the payments to those owning the debt -- which the administration estimates to be between 10 to 25 cents on the dollar -- are low. The debt-holders will essentially be getting upfront cash now in exchange for pushing the risk of foreclosure onto taxpayers. The administration consulted with industry experts, banks, mortgage servicers, and bank regulators before determining the payout schedule, said Michael Barr, the assistant Treasury secretary for financial institutions.

"There will be some second-lien holders who may find that sufficient," said Tom Deutsch, executive director of the American Securitization Forum, an industry group which represents lenders and investors. "There may be a lot that don't find that sufficient, and they will just continue to hold out for better times."

Worse, some investors and analysts, like Joshua Rosner, managing director at independent research consultancy Graham Fisher & Co., say the program is a huge gift to megabanks JPMorgan Chase, Wells Fargo, Citigroup and Bank of America.

When a borrower is foreclosed on the first-lien owners get paid out first. Those owning subsequent liens on a property -- like second liens or home equity lines of credit -- are paid only after the first is fully paid out.

So it's wrong for first-lien holders, many of whom are investors like pension funds and unions, to be forced to forgive some of the money they're owed unless subsequent lien holders are also forced to take a hit, argues Rosner. Otherwise, the first liens become less valuable.

"First-lien investors understand that a re-performing loan with a 20 percent write-down is better than losing 60 percent of the investment if a borrower defaults," Rosner said. First-lien holders "are willing to write down the principal but only if the big banks are required to share the pain. The [Obama administration's] plan asks nothing of the banks that hold the junior liens and will actually pay them for those liens at prices above their value in the market," he said.

Those four firms -- the largest bank-holding companies in the country -- own more than $440 billion in junior liens, representing more than 40 percent of all outstanding junior liens, according to a Feb. 2 presentation by Laurie Goodman, senior managing director at Amherst Securities and one of the country's top-rated mortgage bond analysts by Institutional investor magazine.

"It's a back-door way of bailing out the big banks," Rosner added.

"There's a lot of political pressure to do something about principal reductions," said Edward Pinto, a mortgage finance consultant and former chief credit officer at Fannie Mae. "They're struggling to find a way to make principal reductions work, so they threw out two programs to see which gains traction. They're desperate for something."

But while investors have already largely realized their losses, banks are carrying these mortgages at inflated values, analysts and mortgage bond investors say. They argue that the reluctance to write down the loans on their books -- particularly on junior lien mortgages -- has been a major roadblock to both principal write-downs and stemming the foreclosure crisis.

Bondholders have to mark their assets to market prices, investors say, which have already priced in eventual defaults and foreclosures. Banks largely don't need to, so there may be a reluctance to write down these loans and take pennies on the dollar when the banks can simply ride out the recession and wait for housing prices to rebound.

Rosner estimates that, on average, the big banks are carrying junior liens at about 87 cents on the dollar, which he says is far too high. A recent Moody's Investors Service report noted that second-lien mortgage-backed securities will face substantial losses.

"We've got loans on the books that are worth more than anyone believes they're worth, and yet there's no process by which people can either refinance out of them or work out of them," said Farrell.

Rosner said that if federal regulators forced megabanks to properly reserve for these assets on their balance sheets, the banks would have little remaining reason not to cooperate and help homeowners and the first-lien investors stabilize the market.

"It's actually in the efforts of the lenders to reduce the balance so it will be sustainable, higher-quality loans," said Farrell. "Similarly, it would be in the interest of borrowers to get into a loan that they can actually afford, that they can sustain over time, but there's no mechanism by which they can restructure their loan and get some kind of loan forgiveness to do it.

"All of these are attempts to clear what is otherwise a market-clearing process, and we hope that it is successful in unleashing that," Farrell added.

Deutsch said some of the challenges include the negotiations that will take place between first-lien holders and those that own junior liens -- who will cut more principal, and by how much -- and the basic operational one of finding lenders who will originate these new FHA refinance loans.

Investors and lenders will surely fight over who gets what.

With more than five months until the program's September launch date, the interested parties have time to sort some of these issues out, he said. The first report on the program's effectiveness isn't due until after the November election. Until then, there won't be any empirical way of measuring the program's effectiveness.

The administration was careful to underplay expectations on Friday. Last March, the administration launched Making Home Affordable with a promise to help up to four million homeowners avoid foreclosure. That promise has since been revised to offering those homeowners "an opportunity" to avoid foreclosure. The administration has been slammed for the failure to help millions avoid foreclosure by government auditors, members of Congress and consumer groups. The new effort is geared towards helping that original lot of four million homeowners -- the administration doesn't expect to help more borrowers, officials said. Some analysts forecast up to 12 million foreclosures over the next few years.

"There's no intention of tackling what may be 10 to 12 million foreclosures over the course of the next few years," Barr said. "The purpose here is to deal with just enough of the overhang for people who we believe whose foreclosures are preventable where we have a real chance of changing the dynamics so that they can stay in their homes and prevent it."

"I think this program's success will be measured in the tens of thousands," Deutsch said of the FHA program. "Maybe in the hundreds of thousands. But certainly not into the millions."

The $14 billion for FHA will be used to provide cash payments to investors, servicers and lenders, and to protect against expected losses from re-defaults. Robert Ryan, FHA's chief risk officer -- the agency's first -- told HuffPost he expects the re-default rate on these new refinance loans to be no higher than the re-default rate on existing FHA refinance loans. About half of all loan modifications in the first quarter of 2009 re-defaulted within nine months, according to a report this week by the Office of the Comptroller of the Currency and the Office of Thrift Supervision. FHA expects its refinance loans through this new program to have substantially lower re-default rates, Ryan said.

Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, applauded the initiatives: "I welcome the most recent steps by the Administration to help deal with the foreclosure crisis. It must be emphasized that this is important not just for those who are themselves facing foreclosure, but for the broader economy because this wave of foreclosures has had a general negative effect. I was particularly pleased that the administration has adopted the proposal that many of us have been advocating to provide help to the unemployed. While clearly there are some people in trouble on their mortgages who bear some of the responsibility for their plight, this is not true of the unemployed who are fully deserving of this help."

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