The notion of widespread principal reduction for underwater borrowers has gained new currency since the beginning of the year. In addition to articles in the popular financial press, the Federal Reserve's recent white paper on housing devoted a section to discussing the concept of "Loan Modifications with Principal Reduction." Nonetheless, the concept of aiding middle-class homeowners through principal reduction is politically tempting, and political pressure to "do something" (evidenced by another mass refinancing plan proposed in President Obama's State of the Union address) is intensifying. However, the experience of HAMP and other initiatives suggests that a broad program to reduce the loan balances of underwater borrowers held or guaranteed by the GSEs would be extremely expensive, ultimately ineffective and potentially counterproductive.

The problem of widespread negative home equity is, unfortunately, not amenable to sweeping solutions. Designing and implementing a GSE-run principal-reduction program raises a host of difficult questions. Which borrowers would have their balances reduced? How much should loan balances be reduced? What happens if borrowers experience further declines in their homes' prices? And how can outright speculators be identified and excluded from the program? These considerations are critical in light of the enormous costs of such a program. The Fed's white paper estimated that a total of 8.6 million borrowers are underwater, with negative equity totaling approximately $425 billion. (This may be conservative; I've seen the amount of negative equity estimated to be as much as $800 billion.)

More importantly, it's unclear that a principal-reduction initiative will do much to fix the housing market. According to the most recent LPS data, there are just under 4 million loans either seriously delinquent or in foreclosure in the U.S.; the average loan in foreclosure hasn't made a payment in 631 days. These statistics suggest that the housing downturn is well beyond the stage at which a principal-forgiveness program can meaningfully impact housing's primary challenge, which is the crush of long-delinquent properties in the foreclosure pipeline.

Additional factors weighing against a principal-reduction program are the complexities and subtleties involved in managing a comprehensive initiative. The problems encountered in implementing HAMP, HARP, HAFA, etc., have been well-documented. A major obstacle has been that the people implementing the programs do not understand the workings of the mortgage industry, and their dictates often conflict with the realities of the MBS markets. These problems will be compounded if complex initiatives such as "shared appreciation mortgage" modifications (where lenders and homeowners would share housing appreciation in exchange for immediate principal reduction) are attempted on a widespread basis. The importance of execution in carrying out complex and multifaceted campaigns brings to mind the old military maxim: amateur generals talk strategy, while professionals talk logistics. The history of well-intentioned but disappointing housing initiatives casts doubt on whether the government is fundamentally capable of managing the minutiae involved with a broad principal-forgiveness program.

MBS investors should also contemplate the implications of such a program on their holdings. It's likely that loans for which principal is reduced must be bought out of pools, resulting in a potentially large uptick in prepayments. With the MBS markets trading at historically high premiums (e.g., the weighted average price for 30-year Fannies is over 107), already-pressed financial institutions could suffer losses from a principal-reduction program even if it is limited to GSE-backed pools.

The only form of principal reduction that would be equitable and effective would be one run by the courts and/or court-appointed arbitrators. Any attempt to impose a politically motivated program on the GSEs would, I believe, be disastrous for the country's fiscal health while doing little to remedy the housing market's woes.


Bill Berliner is Executive Vice President of Manhattan Capital Markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of the recently-released second edition of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. His email address is

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