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

Finding a Better Lifeline for Homeowners

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We offer a principal reduction if that makes sense for that individual borrower's situation."

Many banks don't want word to get around that they reduce principal. They fear that homeowners who can afford their payments will demand better deals. John Lashley, a 44-year-old salesman in Huntersville, N.C., is making his payments. But he is thinking about walking away from his four-bedroom home unless his lender, Sun Trust Mortgage, agrees to cut the principal on his $345,000 loan. The house next door recently sold for $260,000, and Lashley doesn't see the point of pouring money into his house when he may never recoup the investment he made in 2007. "Why should I stay in my house?" he says. "It's not a moral decision. It's a financial decision."

The conflicting interests of mortgage lenders and home-equity lenders is a big roadblock to doing principal reductions. Banks, credit unions, and thrifts held $951.6 billion in home-equity loans as of Sept. 30, according to Federal Reserve data. Mortgage lenders don't want to cut principal unless the home-equity lenders agree to take a hit. Typically, though, the home-equity lenders are reluctant; much of the value of their loans would be wiped out. That could drive more banks into insolvency, says Joshua Rosner, an analyst at investment research firm Graham Fisher in New York.

The threat of lawsuits is also hampering principal reductions. In December 2008 money manager Greenwich Financial Services sued lender Countrywide Financial in New York State Supreme Court. Greenwich, which owns mortgage-backed securities, demanded 100 cents on the dollar for some Countrywide investments. The securities included loans on which Countrywide had agreed to cut $8.4 billion in principal and interest to settle allegations of predatory lending. Greenwich Financial's case is pending. Bank of America (BAC), which bought Countrywide in 2008, says: "We are confident any attempt to stop this program will be legally unsupportable." Greenwich says it's willing to accept loan changes that benefit borrowers.

So far the feds haven't put pressure on banks to forgive debt. President Barack Obama's $75 billion program to spur banks to alter loan terms doesn't require them to do so. But the FDIC and other regulators are looking at measures to promote the writedowns. Mark Zandi, chief economist for Moody's Economy.com (MCO) (who has testified before Congress on housing issues), proposes that banks receive a federal match of $1 for every $2 in principal reductions they offer to homeowners who were victims of predatory lending practices. "You're not going to wipe out all the borrowers' negative equity," he says. "This just gives them enough hope to get them committed again."

With Jody Shenn

Gittlesohn is a reporter for Bloomberg News. Gopal writes about real estate for BusinessWeek in New York.