New Business January 7, 2010, 5:00PM EST

Finding a Better Lifeline for Homeowners

With mortgages underwater by a record $745 billion, regulators may force lenders to cut principal

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Marcus Beckett's monthly payment dropped $1,100 after lenders deferred principal Ethan Pines

By John Gittelsohn and Prashant Gopal

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Despite encouragement from policymakers, many banks have moved slowly to aid distressed homeowners. When they do modify mortgages, the fixes—such as interest-rate cuts—often are temporary and only put off the day of reckoning.

With another wave of foreclosures looming as payments on risky loans rise and unemployment remains high, it looks as if banks may be forced to resort to a remedy they've been trying to avoid: principal reductions. Banks don't like principal reductions for obvious reasons. But many economists, policymakers, and homeowners see it another way. While interest-rate reductions or extending loan terms do reduce homeowners' monthly payments, they don't give much comfort to borrowers who owe more on their homes than their properties are worth. Borrowers who don't have a stake in their homes are more likely to hand over the keys when they run into trouble. "The evidence is irrefutable," Laurie Goodman, senior managing director of Amherst Securities Group in New York, testified before the U.S. House Financial Services Committee on Dec. 8. "Negative equity is the most important predictor of default."

The 25% plunge in residential real estate prices from their 2006 peak has left homeowners underwater by $745 billion, according to research firm First American CoreLogic—a number that tops the government's $700 billion bailout for banks. That's why Federal Deposit Insurance Corp. Chairman Sheila Bair is considering incentives for lenders to cut the principal on as much as $45 billion of mortgages acquired from seized banks. "We're looking now at whether we should provide some further loss-sharing for principal writedowns," says Bair.

The foreclosure crisis is likely to deepen this year in part because payments on many adjustable-rate mortgages are set to balloon. Unless there's a sharp recovery in property values or a change in lenders' willingness to cut principal, at least 7 million borrowers currently behind on their payments will lose their homes, estimates Goodman.

RIGHT-SIZING MORTGAGES

Some lenders may be coming around, grudgingly, to the idea of principal reduction. "If you can right-size the mortgage and return to an equity situation, the incentive is to stay," says Micah Green, an attorney at Patton Boggs in Washington, D.C., and a lobbyist for a coalition of mortgage bond investors. Banks can either forgive principal outright or defer it. In deferrals the borrower must pay back the full amount on the original mortgage when he sells the property; if the ultimate sales price doesn't cover the principal, the homeowner has to pay the difference, making it a less effective tool.

A principal deferral helped Marcus Beckett stave off foreclosure. The 42-year-old small-business owner couldn't afford his $2,413 monthly mortgage bill after his income dropped and his son, Riley, was born. In October, OneWest Bank agreed to defer $66,000 of the $423,000 debt on his two-bedroom condominium, which he'll have to pay back if he sells his Aliso Viejo (Calif.) home. The monthly tab on the house he bought in 2006 is now $1,314. "It's like I got a second chance on life," Beckett says. "I feel, mentally, I'm able to keep making payments."

While principal reductions remain rare, banks are doing them more often. In the third quarter of 2009, some 21,000 home loans—3% of the total modified mortgages—included a principal reduction or deferral, according to Mortgage Metrics, a government publication. That's up from 6,245 in the first quarter of 2009, the first time the U.S. reported the data.

Banks that negotiate principal reductions have seen positive results. Last year, Wells Fargo (WFC) cut $2 billion of principal on delinquent loans. After the modifications, the six-month re-default rate on those loans was roughly 15% to 20%. That's less than half the industry average. "We are very comfortable with what we've been doing," says Franklin Codel, chief financial officer of the bank's home-lending unit. "