At least 7 million borrowers will lose their homes this year and next unless there is a broad increase in property values or lenders become much more willing to cut the principal on mortgage loans, an analyst with Amherst Securities Group told the U.S. House Financial Services Committee recently. And, a study from the Federal Reserve Bank of New York has shown that mortgage modifications that reduce the principal of a home loan are much more successful than those which just lower the payments.
 

        The paper finds that principal reductions are more successful at avoiding re-defaults because they reduce negative equity and give the borrower a greater incentive to keep current on the loan. A loan modification that only reduces the interest rate, meanwhile, "creates an in-place subsidy to the borrower leading to a lock-in effect. That is, the borrower receives the subsidy only if he or she does not move."
 
       This information has motivated Federal Deposit Insurance Corp. Chair Sheila Bair to consider incentives for lenders to cut principal on $45 billion in mortgages her agency has acquired from seized banks.  "We're looking now at whether we should provide some further loss-sharing for principal write downs," says Bair. "Now you're in a situation where even the good mortgages are going bad because people are losing their jobs."
 
        Mark Zandi, the chief economist for Moody's Economy.com, suggests that banks receive a federal match of $1 for every $2 in principal reductions they offer to homeowners.  "You're not going to wipe out all the borrowers' negative equity," he says. "This just gives them enough hope to get them committed again."
 
Source: Bloomberg, John Gittelsohn and Prashant Gopal (01/07/2010)