Do Principal Reductions Subsidize Consumer Debt at Investors’ Expense?

Principal reductions have been approached with some reluctance and much debate throughout the industry, but as part of the recent $25 billion settlement with the state attorneys general, the nation's largest servicers have agreed to administer the loss mitigation tactic.

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California Attorney General Kamala Harris insists ""principal reduction programs are the most helpful form of loss mitigation for homeowners and the most cost effective for investors when compared to foreclosures,"" and she is pushing for the GSEs to write down principal for struggling homeowners as well.

In fact, she ""recently requested"":http://dsnews.comarticles/california-ag-requests-good-faith-pause-on-gse-foreclosures-2012-02-28 a ""good-faith pause"" on Fannie and Freddie foreclosures while their conservator, the Federal Housing Finance Agency conducts further analysis on the pros and cons of the loss mitigation strategy.

Meanwhile, ""Fitch Ratings"":http://www.fitchratings.com/web/en/dynamic/fitch-home.jsp has released its own ""analysis"":http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=672858&cm_sp=homepage-_-FeaturedContentLink-_-View%20report of the strategy and its effects on investors. Fitch suggests

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principal reductions can have a positive impact on the market by preventing some foreclosures.

However, Fitch maintains the issue of principal reductions is not a simple ""yes"" or ""no"" question, and ""if not implemented carefully, a wide-ranging principal reduction program could potentially increase defaults among borrowers who would otherwise remain current.""

Furthermore, without reviewing each borrower's entire financial situation, principal reductions have the potential to be ineffective or disproportionately impact investors.

For example, allowing a substantial reduction in principal on a mortgage loan may allow a borrower to fulfill his or her debt obligations but may in effect be ""using mortgage debt (and, therefore, mortgage investors) to subsidize other consumer debt and expenditures,"" according to Fitch.

Fitch advises approaching principal reductions with caution, writing mortgage debt down to ""a reasonable housing payment-to-income ratio"" or setting a ""predetermined LTV"" to apply to all principal reduction scenarios.

While Fitch observes that borrowers with positive equity are more likely to stay current on their loans than borrowers with negative equity, Fitch says even negative equity homeowners ""show a willingness to repay.""

The ratings agency cites a Fannie Mae survey indicating that just 10 percent of respondents condone strategic default for underwater homeowners.

However, a widespread principal reduction strategy may sway some homeowners' opinions, Fitch suggests.