Principal Reduction: Why Banks Don’t Do It More + What’s Wrong With It
There are quite a few people who advocate principal reduction as the best way to get out of the housing crisis. Their arguments were succinctly laid out and analyzed in an Atlanta Federal Reserve white paper.
Advocates of such a policy argue that it would be cheaper for banks to reduce the principal of a loan to the current value of a house because people who have positive equity in their homes are much less likely to default on their loans. The policy would also help homeowners because they would get to stay in their homes. It seems like a win-win situation, except it isn’t.
As a recent New York Times article illustrates the difficulty with large scale restructuring programs is that banks don’t know who really needs the help and who is trying to take advantage of the situation.
Ms. Rula Giosmas was not one of the people who needed help, yet she got it anyway. For her lender, the modification amounts to an avoidable loss. The lack of knowledge in who can pay and who can’t is the reason why banks are wary of initiating large scale modification programs: not all underwater borrowers will default on their mortgages.
It still remains economically advantageous to foreclose on the defaulters and continue to collect the full loan amounts from the people who can and will pay. The banks also worry that if they do initiate large scale modification programs, it will encourage people who can pay to miss payments simply to qualify for the principal reduction. Such a problem is called moral hazard, where there are incentives to perform badly. The last thing that banks want is to encourage people to default.
Oppenheim Law warns you: don’t bet on a principal reduction. Banks are very wary of them and the Federal Reserve white paper is going to scare them off even further.
There are, however, other foreclosure defense solutions so don’t become a deer in the headlights. You must be proactive!
Check out a recent post about ‘how to pay off second mortgages at a discounted rate’.