06/06/2009 10:54 am ET Updated May 25, 2011

The Missing Piece in the Foreclosure Solution


Notwithstanding a lot of attention, creativity and money, no one has yet to solve the foreclosure crisis engulfing our country. Amidst signs of improvement in other areas (the stock market, the thawing of the credit markets), we see nothing hopeful on the foreclosure front. Arrearages, defaults and foreclosures are continuing at rapid paces, the result being both human costs (people forced out of their homes) and economic loss (declines in housing values).

The Administration is trying to solve the problem with incentives to lenders and servicers to modify loans. To date, these programs have not made a dent in the problem.

The missing piece is debt relief ... not a reduction in interest rates, not an extension of the loan amortization period, not a temporary abatement in mortgage payments. We need to confront the problem head on and stop nibbling at the edges - we need to discuss principal reduction.

Here is the reality: even assuming that people have jobs (I am very aware of the connection between jobs and foreclosures), when one's home is underwater - meaning more debt than value - the desire to fight the good fight is diminished. Why work your butt off to keep paying on a mortgage, even if your payments are reduced to where you can afford them, when all you are doing is treading water?

Today, about 1 in 4 houses with a mortgage are underwater and many more are close. Since about 2/3 of all homeowners have a mortgage, this means that almost 20% of our housing stock has more debt on it than value. That's 13 or 14 million homes. These residents are now quasi-tenants, paying "rent" to a lender so they can stay in their home with little chance of upside. Obviously that was not the thinking going in when these homes were purchased. Many of these homeowners put in equity and hard work with the hope of cashing in someday. That dream is now gone.

I am not making a value judgment one way or another. All I care about is addressing the foreclosure problem. The bankruptcy "cramdown" proposal would have been a help - allowing bankruptcy courts to reduce principal. What's more if that proposal had become law, it would have motivated creditors to reduce principal in negotiation with borrowers - knowing that a cramdown was possible. But, that idea is gone and perhaps dead.

Still, the discussion of principal reductions should be pursued. Perhaps the U.S. has to step up its incentives and/or subsidies to lenders. Perhaps lenders have to be jawboned a little bit - heck the U.S. taxpayer was there when lenders needed them. Whatever the solution, without the missing piece - principal reduction - the foreclosure problem is not going away quickly.

Jim Randel is the founder of The Skinny On book series - books about financial topics presented in an entertaining and quick read.