Don't Wait for a Principal Reduction on Your Home

NEW YORK (MainStreet) -- For underwater homeowners and many who want to help them, there is a Holy Grail: principal reduction.

But now, four years after the housing market started to collapse it may be time for a reality check. For most troubled borrowers, principal reduction is a remedy that may never happen.

Underwater homeowners have been pushing the government to explore principal reduction, but some doubt the proposal will become a reality.

Edward J. DeMarco, acting director of the Federal Housing Finance Agency that oversees Fannie Mae and Freddie Mac, said in a speech Tuesday that principal reduction could make some economic sense. The agency is expected to make a decision on the matter within a few weeks.

But DeMarco's comments were lukewarm and accompanied by several reservations. Despite heavy pressure from the Obama administration and many Congressional Democrats, DeMarco seems unlikely to embrace principal reduction for large numbers of borrowers. His sentiments are widely shared among lenders and mortgage securities investors.

What's the problem?

Advocates argue that reducing the homeowner's debt balance is a win-win solution. Reducing the debt to the home's current value, which in many cases is far less than the homeowner originally paid, can encourage the homeowner to keep making payments rather than to fall into foreclosure or walk away.

Lenders would win, too, because they'd lose less through principal reduction than foreclosure. Many foreclosed homes are resold for less than half of their pre-crisis value, while the debt reduction might be only 20% or 30%, perhaps less.

But if it were that easy, lenders would be jumping at the opportunity. They haven't, in part, because it is very difficult to get the owners of mortgage-backed securities to go along. And there are tricky issues involving private equity loans that may use the same property as collateral.