At Last, One Government Agency Considers Cutting Mortgage Principal For Distressed Homeowners

FDIC Chairman Sheila Bair indicated Thursday that she is exploring the idea of reducing the principal on as much as $45 billion in mortgages her agency has acquired from failed banks.

That would be the first significant government attempt to employ a measure that some economists and consumer advocates have long argued is the only really effective way to stop foreclosures.

Although the $45 billion in mortgages only amounts to less than half of one percent of mortgages nationwide, the move would be significant because the idea of reducing principal has been all but dismissed for the last nine months by the Obama administration.

Economists like Yale University's John Geanakoplos, however, have argued that cutting the principal on delinquent loans should have been the administration's practice all along. For the nearly quarter of American homeowners who owe more on their mortgage than the house is worth, it's by far the best way to keep them in their homes and reduce foreclosures, Geanakoplos said in an interview last month.

Bair made her comments in an interview with Bloomberg News. She has not yet discussed her proposal with the Treasury Department, a senior administration official said Thursday in a brief interview. Though unfamiliar with the details of her proposal, the official said it was promising.

The Federal Deposit Insurance Corporation no longer owns the mortgages directly; but when it sold them to solvent banks, it agreed to shoulder some of the future losses. Bair's move would effectively make sure that homeowners directly benefit from that guarantee, not just the lenders.

The Obama administration's $75 billion plan to help distressed borrowers has yet to make a serious dent in stopping foreclosures. In addition, when the plan was launched in March it was largely designed to help those homeowners with jobs, as the terms depended on minimum levels of income. Back then the unemployment rate was at 8.5 percent. Since then, the economy has shed about 2.5 million more jobs.

"Now you're in a situation where even the good mortgages are going bad because people are losing their jobs. So you have other factors now driving mortgage distress," Bair told Bloomberg.

The Congressional Oversight Panel, the Elizabeth Warren-led group keeping tabs on the bank bailout, said in an October report that "it increasingly appears" that the Obama foreclosure plan "is targeted at the housing crisis as it existed six months ago, rather than as it exists right now."

Instead of encouraging principal reductions, the Obama plan has led mostly to modifications that either lower interest rates or lengthen the duration of the loan, or both. But both of those practices leave homeowners who owe more on their homes than they are worth "underwater". And while stretching a 30-year mortgage to a 40-year does cut monthly payments, it actually increases the total amount of the debt because the payments are stretched over time, meaning more interest charges. Some modifications even increase principal, by tacking on missed payments and fees.

Another glimmer of hope for supporters of principal reduction: A September report by the Office of the Comptroller of the Currency on mortgage modifications done by banks outside the administration's plan found that principal reductions, while still uncommon, tripled from 3.1 percent to 10 percent. The amount of principal reduced, though, was oftentimes very small.