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Few topics have sparked more debate among housing market watchers than mortgage principal reduction. Its proponents tout debt forgiveness as one of the surest ways to counteract the housing slump. Its critics label it a handout that would cost taxpayers and spur further defaults.
The arguments for and against are only going to get hotter. In 2010, principal reduction was included in just 11 percent of those mortgage modifications without government guarantees. But by the fourth quarter of 2011, the number had jumped to 40 percent, according to a report by mortgage research firm Amherst Securities Group. And it's likely to rise still further: The "robo-signing" settlement reached in February requires the country's five major mortgage servicers to perform at least $10 billion in write-downs, mostly on loans that they own, to atone for illegal foreclosures.
Now principal reduction is nipping at the heels of Fannie Mae and Freddie Mac. Many consumer advocates and policymakers are calling for the twin mortgage guarantors to adopt the loss-mitigation tactic, but so far the mortgage giants' conservator, the Federal Housing Finance Agency, has resisted.
All forms of mortgage modification, not just principal reduction, carry some of the same risk, but critics say that principal reduction offers more of an incentive for a homeowner to strategically default. Calabria points out that principal reduction, unlike a break on an interest rate, offers a lasting reward in the form of increased home equity.
And, he added, debt forgiveness also puts a homeowner closer to having a home value that exceeds his or her loan, which makes it much easier for a borrower to sell.
The question of whether lenders should reduce principal on some distressed mortgages grows even more fraught in the case of write-downs performed under government-sponsored programs like the Home Affordable Modification Program.
Taxpayers fund HAMP, which subsidizes modifications on distressed mortgages. So when a lender performs a HAMP modification, taxpayers are footing some of the bill.