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Foreclosure crisis phase 2: The negative equity dilemma

Many prime borrowers are being caught between devalued homes and job losses. Will Congress step in?

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In the year that the program's been running, almost 70 homes have been either sold back or rented to foreclosed homeowners. None have redefaulted. When the group buys a foreclosed property, it routinely asks the selling bank if it wants to participate in the shared equity deal. Every one has declined the offer.

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"They said it was too complicated; it wasn't something they were used to doing, they didn't want to get involved in it," said Ms. Hanratty. "Maybe that will turn, that will change in time."

A lesson from the farm?

There is a precedent for widespread principal reduction on property loans. During the farm crisis of the 1980s, young farmers who had bought farmland at inflated prices suddenly saw crop prices plunge and, soon after, land prices fall as well. It was a debt squeeze not unlike today's crisis for underwater homeowners who have lost their job. Seeing the unfolding rural disaster, Congress created a new chapter in the bankruptcy code. It allowed bankruptcy judges to modify loans, including partial debt write-downs, so family farmers could stay on their farm.

"People who will pull themselves out of trouble and be good credit risks again, those are the people who merit this kind of intervention and who will also help stabilize the markets," said Neil Harl, an agricultural economist at Iowa State University who helped write the bankruptcy language.

In 2008, Sen. Harry Reid (D) of Nevada introduced a similar bill for the housing crisis. But the measure languished, in large part because, at the time, subprime borrowers were in the eye of the storm and many of them had stretched to buy homes they really could not afford. Will the new foreclosure wave of prime borrowers change the political calculus? Professor Harl isn't optimistic.

"Unfortunately, people in Congress listen to [lobbyists]" said Harl. "They tend to drown out those that don't have as much money."

Instead, homeowners facing foreclosure can try to get their loan modified through the administration's Home Affordable Modification Program, or HAMP. Typically, the bank servicing the loan tries to make monthly mortgage payments affordable by extending the mortgage to a 40-year loan and reducing the interest rate. One year into the program, however, only about 300,000 of an estimated 4 million eligible homeowners have received permanent loan modifications.

"It is pretty much not working," said Nadine Cohen, a lawyer with Greater Boston Legal Services, which helps homeowners obtain loan modifications.

Why modification requests get denied

That's partly because loan servicers were unprepared for the massive influx of loan modification requests. It's also because a loan modification is difficult to qualify for. This is particularly true for owners with big mortgages whose income has decreased, like Cynthia Johnson.

Her spiral toward foreclosure began with a divorce in 2006, which halved her $160,000 a year household income. She took equity out of her home to buy her husband out of the mortgage. When she was forced to take a $22,000 pay cut, her $2,000 monthly mortgage payments became impossible to manage.

She's gone through about $14,000 in savings to keep paying her mortgage – which now eats up more than 40 percent of her paycheck. Still, she's about $60,000 underwater and, because of that, she can't refinance again or borrow off the equity on her home. Johnson appealed to her loan servicer to adjust her monthly payments, but because she is not yet in arrears, her request was denied.

Lenders test to determine whether it is more beneficial for the investor to modify the loan and get a lower monthly payment or foreclose on the home.