Arizona home values have fallen so much that almost half the people with mortgages owe more than their homes are worth. Despite a state offer to reimburse banks up to $50,000 of a $100,000 principal loan reduction to help homeowners stay afloat, most banks balked, including the nation’s two largest home loan guarantors, which flat out said no to any debt relief offer.

In fact, Fannie Mae and Freddie Mac opted out of the state-sponsored mortgage debt relief program, saying that the agency’s policies forbid them from participating. As a result, only three Arizona homeowners have been approved for a principal debt reduction since the program began in Sept. 2010.

Although many, including sate attorneys general who are negotiating a multibillion-dollar settlement with big banks over fraudulent mortgage practices, believe that mortgage loan principal reduction has become an indispensable tool for fixing the housing problem, Fannie Mae and Freddie Mac disagree. The taxpayer-owned agencies say debt relief for homeowners is bad for business and, as a result, bad for taxpayers.

Critics claim the response is another example of how banks and investors have benefitted from the government bailout after the housing collapse while borrowers have been left to drown.

“It’s sinful, is the word I would use, that they won’t do this,” said John Taylor, president of the National Community Reinvestment Corporation. “And the only reason they won’t is they don’t want to realize the red ink that’s already on their books.” Taylor and others claim that Fannie Mae, Freddie Mac, and other lenders that have opted out of debt relief programs in Arizona and elsewhere are only delaying inevitable losses on loans that were shaky to begin with (“Freddie and Fannie Reject Debt Relief,” The New York Times, Oct. 5, 2011).

Large Lenders: Debt Relief Involving Principal Reduction Invites “Moral Hazard”

Lenders claim that if they were to offer debt relief to borrowers, it would create a “moral hazard” and encourage borrowers to take out risky loans in the future because there would be less dangerous consequences or to purposefully default on their mortgage loans to get principal reductions.

Proponents of principal reductions say any mortgage debt relief, such as a mortgage loan modification, that fails to reduce the principal of the loan isn’t helping the continuing housing problem. At least one financial company, PMI Group, which shares the credit risk in many Fannie Mae and Freddie Mac loans, thinks that debt forgiveness makes financial sense because it gets loans down to realistic numbers that encourages the normal buying and selling of homes and shortens the pain involved in delaying a hit from bad loans. The company has found a way around Fannie Mae and Freddie Mac’s policy to deny principal reductions by paying some underwater homeowners if they make on-time payments for several years, a practice that amounts to a de facto principal reduction.

Steve Bailey, chief servicing officer at PennyMac, said that the failure to offer debt relief by cutting principal creates a moral hazard, not the other way around.

“A loan that is modified and left at 200 percent loan-to-value invites the moral hazard,” Bailey said. “You’re telling a person that they need to live in this house that’s severely underwater, paying more for housing than they need to, and looking around their neighborhood at homes that have gone through foreclosure and are available for much less.”

Nationwide, about one in five homeowners with a mortgage is underwater, with total negative equity between $700 billion and $800 billion.

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