Now that the government's Home Affordable Modification Program (HAMP) has adopted a principal reduction option, the performance of loan modifications should improve "substantially," according to Laurie Goodman of the Amherst Securities Group (ASG) .

"If you want successful modifications, you have to do principal reductions," the ASG senior managing director said during a presentation on the outlook for the residential MBS market.

Treasury's new Principal Reduction Alternative (PRA) option requires Home Affordable Modification Program servicers to consider a write down to reduce the loan-to-value ratio to 115% before employing the standard HAMP modification options.

If principal is reduced on the first mortgage, the servicer is obligated to make a proportional reduction on the second lien.

Principal reduction is still voluntary but most of the HAMP servicers have submitted "plans" to Treasury on how they will implement the PRA program.

It is not uncommon for banks to employ principal reductions when it comes to loans in their own portfolios.

In 4Q09, nearly 28% of bank modifications included principal reductions and the "results are very convincing," Goodman said. The re-default rate on portfolio loans is 19% six months after modification versus 35% to 46% for other types of loans.

"I am actually very very pleased that the HAMP program has implemented principal reduction," she said.

Participating HAMP servicers were supposed to implement the principal reduction option by Oct. 1. Treasury will begin reporting on the results early next year.

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