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.)