A study by the New York Federal Reserve Bank has confirmed what the man on the street has known all along: loan modifications would have a better chance of working if the principle was lowered.  Current programs, which just lower the interest and extend the terms, are likely to fail.

Specifically, the researchers found that if a payment is lowered by 25% because the interest rate was cut, the homeowner is 11% less likely to default.  If the 25% deduction is due to reducing the principle while cutting the interest a little, the homeowner is 27% less likely to default within one year.  Reducing the principle doubles the potential rate of success.

Lenders and the investors who bought the loans are reluctant to lower the principle, even though the dollars and cents of foreclosure are clear: it costs more to foreclose and then maintain a bank-owned home until sold than to cut their losses by making a deal with the home owner.

Homeowners are acutely aware that the value of their home has dropped in comparison to the loan value.  Nationwide, at least 23% of homeowners had negative equity in their homes by the third quarter of 2009.  The Fed Study found that the more “underwater” a borrower is, the more likely he is to default.  When their loan–to-value (LTV) is 115%, homeowners owe 15% more than the home is worth and are 51% more likely to default on a modified loan.  When they have positive equity, they are more likely to keep the terms of the modification.

It comes down to incentive.  If people are paying on a deeply underwater home, they have less financial stake in paying on the loan than those who would lose their own money if they defaulted.  No one wants a foreclosure, but those with positive LTV would lose their equity along with the home in case of default and ultimate foreclosure.

Some analysts think the study could result in a rethinking of federal housing rescue plans.  Currently, the Home Affordable Modification Program (HAMP) stresses lowering interest and lengthening the mortgage but does not push for principle reduction.  If lessening the principle to get the home more in line with current market values is the key to successful mortgage modification, existing programs are doomed to failure or at least will have minimal long term effectiveness.  The program must encourage people to make the choice to pay rather than default.  Hopefully, future modifications of HAMP will tackle the thorny issue of underwater mortgage head on.

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