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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 many cases where the person's income has dropped substantially, they decide it's better to foreclose," explained Ms. Cohen.

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For homeowners who do qualify for a modification, few are offered principal reductions. Because less than 30 percent of the mortgages modified so far (about 98,000) included any reduction in the loan amount, many homeowners with modifications remain underwater. Some blame continued negative equity for HAMP's high redefault rate – about half of the loans modified through the program go into default.

The Treasury Department has taken sweeping steps to address problems with the program. In late March it announced a new initiative for unemployed homeowners – starting this month they will be given a three-month forbearance period before applying for a loan modification.

Underwater homeowners current on their loans will also be able to apply for refinancing from the Federal Housing Administration. This is the first time that modifications for people not yet in arrears will be performed as part of the program.

Perhaps most significantly, HAMP will now incorporate principal reduction into the refinancing process. Servicers will be required to consider the advantages of reducing principal to match the current value of the home. As an incentive, banks that reduce principal on loans will also get a fee based on how much debt was forgiven, and how deeply underwater the modified loan was beforehand.

The changes to HAMP have been hailed by housing and consumer lending advocates as a move in the right direction. But some insist that Treasury's reluctance to make one key change could significantly limit the revamped program's reach: principal reductions remain voluntary for banks.

As long as servicers can opt out of reducing principal, they will, say housing advocates – even when the only other options are a foreclosure or a short sale, which ultimately results in the property being devalued to the current market price.

"The way loan servicers get paid is that they earn a percentage of the principal balance of their book of business," said Julia Gordon, a Washington-based senior policy counsel for the Center for Responsible Lending. So when the dollar value of the principal outstanding on a mortgage is reduced, so are the bank's fees, she added. "You can see right there why the servicer doesn't want to write down principal."

Balancing risks

Mortgage bankers, though, insist that that argument is misguided.

"The servicer would find some very minimal reduction [in fees] if a principal reduction is made," said Jay Brinkman, chief economist for the Mortgage Bankers Association. "But they're not the one making that decision – they make the recommendations, but the principal reduction has to be made by the investor."

Ultimately, the issue boils down to balancing risks: the possibility that banks are pushing too many people into foreclosure versus the danger that banks' leniency will encourage more homeowners to default so they can get their mortgage principal reduced.

There are effective ways to modify loans (like reducing interest) that won't encourage such defaults, Mr. Brinkman says. "While [principal reduction] might improve things for one borrower, will it help the economy if 10 more homeowners default and ask for a reduction?"

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