Last week's announcement by the Federal Housing Finance Agency regarding its economic assessment of a proposed principal reduction program set off another round of debate over the merits of such programs. Whether a policy of forgiving principal can address problems in the housing market appears to be lost in the rhetoric from both sides of the issue. Answers to four key questions on principal reductions can clarify many misconceptions. 

The first question is: How much impact can this program have?  The latest figures from CoreLogic suggest that there are more than 11 million borrowers who are underwater on their mortgages.  Moreover, FHFA states that 4.6 million of these are Fannie Mae- or Freddie Mac-backed loans with 2.5 million of these having current loan-to-value ratios above 115%. 

Remember that the agency had specifically considered extending the Principal Reduction Alternative – a subset of the federal Home Affordable Modification Program – to loans guaranteed by Fannie and Freddie. As a best-case scenario after other program exclusions, the potential number of loans of about 500,000 would make up less than 5% of the total number of underwater mortgages in the country.  Factoring other restrictions such as the percentage of borrowers likely to participate in the program, the proportion falls to just 2% of all underwater borrowers.  These numbers suggest that the proposed HAMP PRA program is unlikely to be an effective public policy solution to the underwater mortgage problem on its own.

The second question is whether principal reductions are economically viable policy tools, and from whose perspective? 

In testimony to Congress, Laurie Goodman of Amherst Securities provided a comparison of costs associated with foreclosure versus principal reduction. In her example, taking into consideration the haircut to property value for a foreclosure and associated costs, on a current loan balance of approximately $280,000 an investor would stand to lose about $96,000 more with a foreclosure than with a principal reduction to 100% of the current property value. Fannie Mae's assessment of principal reductions found such a program to yield a positive net present value under a range of alternative scenarios.  From this perspective, principal reductions can provide a meaningful benefit over other default remedies on an individual loan basis.

One of the more debated issues surrounding principal reduction programs relates to the potential for moral hazard. The theory is that a borrower current on the mortgage may have an incentive to go delinquent in order to take advantage of a principal reduction program. Proponents of principal reduction programs tend to believe this is an immaterial issue, but some recent estimates from actual experience suggest otherwise. A recent study by Chris Mayer and others of a modification program introduced as part of a legal settlement on Countrywide Financial mortgages found that controlling for other factors, the percentage of borrowers rolling from current to 60 days delinquent rose 13% following the modification program announcement. (Full disclosure: I worked at Countrywide from 2004 to 2006.) Moreover, Goodman in her testimony acknowledges the potential for moral hazard showing that the incidence of defaults by owner-occupants eligible for HAMP was significantly higher around the announcement of the program than that of investor-occupants.

These findings suggest that strategic default is a substantial problem for modification programs in general, although the prospect for principal reduction may intensify the borrower incentive for strategic default.

Finally, if moral hazard is a real concern for principal reduction programs, are there mechanisms to mitigate this problem? Certainly it is possible to impose conditions on borrower delinquency at the time of the announcement, as Goodman and others have said. But other solutions, such as adding a shared appreciation component to the principal reduction, could mitigate some of the incentive to strategically default.  The shared appreciation concept is more than an abstract idea.  Servicers such as Ocwen have used such structures as part of their principal reduction efforts with apparent success. Some form of shared appreciation mortgage should be featured in principal reduction programs to limit moral hazard. Requiring these borrowers to sacrifice some portion of future gains would also be fairer to homeowners who continued to make payments even though they were upside-down on their mortgages.

The FHFA's conclusion regarding principal reduction modifications was based in part on the cost that would be borne by taxpayers, including the Treasury subsidy for the program and the potential for moral hazard.  Putting those issues aside, the HAMP principal forgiveness program, if implemented, would not appreciably help improve the housing market (The Bad). Principal reductions generally could be more useful if applied across the full spectrum of underwater borrowers with some form of shared appreciation (The Good) in order to reduce the potential for moral hazard (The Ugly).

 Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.