This story has been updated: See below.
Even as the Obama administration's signature foreclosure-prevention program has foundered, Treasury Department officials have known that a key driver in keeping people in their homes in the long run is reducing mortgage principal, senior Treasury advisor Seth Wheeler told the Huffington Post. Wheeler is one of the architects of the administration's housing plan.
But rather than pressure the mortgage companies to start reducing the amount mortgage-holders owe, the administration simply sat back and hoped servicers would do it on their own.
"When the administration came into office last year, from the get-go, it has certainly been aware of the link between negative equity and challenges in housing," said Wheeler. "As the administration initially designed the modification program last year, it was aware of negative equity, was aware that some servicers were doing principal reductions."
But the administration "specifically had designed the program to allow principal reductions without taking a position of where principal reductions would be most advantageous," he said.
So for the past year, the administration had a policy of "rather than us endorsing a uniform approach to principal reductions, let's give flexibility to servicers and hope that they do it on their own in the right circumstances," Wheeler said.
Now that the program has been universally panned, the administration is working on ways to be more assertive on that point, he said.
In the meantime, mortgage delinquency rates and foreclosures have continued to rise. The number of homeowners "underwater" -- those owing more on their mortgage than the home is worth -- now stands at roughly 11 million, about a quarter of all mortgage holders, according to real estate research firm First American CoreLogic. It's expected to increase.
"Negative equity is the single most important driver of defaults," Laurie S. Goodman, senior managing director at Amherst Securities and a top mortgage bond analyst, said Tuesday during a panel discussion at the American Securitization Forum's annual conference.
Wheeler, who was on the panel, listened for an hour as mortgage experts lambasted the administration's foreclosure-prevention efforts, saying it's been inadequate; will ultimately be ineffective in its current form; and doesn't address the underlying causes driving foreclosures. In short, as it's currently constructed, it's destined to fail.
"Clearly negative equity creates -- especially for borrowers that have a financial hardship and have a high LTV [loan-to-value ratio], a very high LTV -- a complicating factor, and it certainly makes it more challenging to make a modification work for borrowers," Wheeler told HuffPost.
In an interview, Wheeler said the administration is trying "to understand how to encourage more principal reductions."
Less than 10 percent of permanent modifications under the administration's Home Affordable Modification Program have involved principal reductions.
"I won't take a position on whether there's been too much or too little, but we are studying if it is being used as effectively as it should be," Wheeler said. "There could be better outcomes." Referencing those mortgages that have been sliced and diced and sold to investors, Wheeler said the administration "is encouraging more principal reductions in instances where we find that it would maximize recovery to investors."
Simply reducing interest rates for five years, which the Obama administration's program does for homeowners who transition out of three-month trial periods, is "a purely temporary modification [that] ultimately doesn't solve the problem," said Micah Green, a partner at Patton Boggs LLP, a Washington law firm that represents a mortgage-investor group of asset managers who hold more than $100 billion in residential mortgage-backed securities.
Without principal reductions, "there is a growing realization within the administration and on Capitol Hill that it's very difficult to bottom out the housing market," Green said.
"The interests of investors are totally aligned with those of homeowners," he added. "Investors are willing to put money on the table and frankly take their losses, which they already have."
Wheeler acknowledged that, from an economic perspective, principal cuts are the way to go.
"Certainly on both second [lien mortgages] and first [lien mortgages], principal reductions can actually reduce total losses from an economic perspective [and] from a finance perspective," he said.
The administration is also under pressure because losses on AAA-rated subprime mortgage-backed securities are growing.
These securities were designed so that different classes of investors got different rates of return depending on the risk they were willing to take. Those who agreed to take on the first losses, for example, got higher rates of return.
But increasingly over the past few months, the amount owed to investors has begun to eclipse the value of the mortgage principal in the securities, said Alan M. White, a professor at Valparaiso University School of Law and an expert on mortgage-backed securities and housing issues. Those at the bottom rung -- the ones who agreed to take first losses -- had already taken their lumps as homeowners fell behind on payments or defaulted. Now it's investors at the top of the food chain who are recording losses.
White said that is creating a growing sense of urgency among investors to do something now to keep homeowners in their homes so they can keep making their monthly payments, which go to investors.
Despite the fact that many experts -- including some in the administration -- agree that principal cuts are the best way to resolve the foreclosure crisis, there are impediments.
Wheeler said issues of fairness are complicating efforts. So is moral hazard, a theory that posits that when people enjoy the fruits of their actions without having to suffer any of the consequences they do it more. It's something Treasury officials have repeated on conference calls with reporters when discussing the administration's foreclosure-prevention efforts.
"Not just in a general sense," Wheeler said. Specifically, he pointed out, "there are many analysts on Wall Street who say do not reduce principal because anything you do to encourage borrowers to behave differently, so as to obtain a certain outcome, that could actually encourage more delinquencies."
But that's not the real problem, said one mortgage expert. It's politics.
"They've been preoccupied with this whole moral hazard idea. The administration has been obsessed with it," White said. "It's more of a political hazard issue."
White argues that the administration is scared of the political fallout if some homeowners are seen as being bailed out by the government while their neighbors struggle. After hundreds of billions of taxpayer dollars were used to bail out banks and the financial system -- a tab that could reach into the trillions -- moral hazard should no longer be a concern, White says.
Asked if the housing situation has deteriorated to a point where moral hazard should no longer be an issue, Goodman of Amherst Securities said: "I think so."
White points out there are ways to ensure only the most deserving homeowners catch a break. On that point, Wheeler agreed.
As White put it: "They're going to lose the ability to be in denial very soon."
UPDATE AT 4 P.M. ET FEB. 4, 2010:
Meg Reilly, a Treasury spokeswoman, responded to this story as follows:
Over 850,000 families are now paying reduced monthly mortgage payments under the modification program; over three million Americans have refinanced; we have increased resources to state and local finance agencies; we have provided $6 billion in Neighborhood Stabilization Program Grants through the Recovery Act, supporting restoration of vacant and foreclosed properties; and interest rates have been kept at record lows. By any measure, these are the most ambitious housing relief efforts ever undertaken by a presidential administration.
Seth makes pretty clear in the quotes you used that principal reduction is included in the program incentives, that we acknowledge it's [a] challenge among many, and that we are always discussing ways to tweak the program. He also stressed that servicers have both an economic interest in using principal reductions appropriately when they own the loan and a contractual responsibility to do so when they service on behalf of others.
The "tab" for all bank bailouts is actually projected to be a profit of several billion dollars. Most of it has already been repaid. It's true that TARP is expected to have about $90 billion in losses - largely because of housing programs - but the just-announced Financial Crisis Responsibility Fee will cover those losses in full.
There is an intelligent discussion to be had about the merits and risks of principal reduction - one that we are actively engaged in - but this type of coverage does not advance that discussion.