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22 December 2011 By Daniel Indiviglio

The idea of forgiving principal for underwater U.S. mortgage borrowers pops up regularly. Usually politicians like it and lenders don’t. Now, though, the regulator of Fannie Mae and Freddie Mac is humoring such a plan.

The proposal would allow borrowers in Chapter 13 bankruptcy, a sort of personal reorganization rather than liquidation, to pay no interest on their mortgages for five years. The effect would be the same as a principal reduction, potentially amounting to 17 percent for a typical borrower, plus short-term payment relief.

Advocates for stretched borrowers might embrace any such measure. But the plan’s impact would be minimal. The National Association of Consumer Bankruptcy Attorneys thinks it would help those who participate, but reckons just 880,000 Americans have active Chapter 13 cases that include mortgages. And only a subset may eventually qualify.

The sudden willingness of the Federal Housing Finance Agency to contemplate the notion might stem from the possibility it could work to Fannie and Freddie’s advantage. Though the program has the same effect as cutting loan balances, technically it is achieved by non-payment of interest, not write-offs of principal. The firms, which guarantee mortgages, would only have to cover losses on interest owed to the owners of the mortgages concerned. And since the affected borrowers are in bankruptcy, some losses are inevitable anyway.

The FHFA might also like the timing. The housing market seems at or near its nadir, and the U.S. economy has strengthened recently. Strategic – or intentional – defaults by homeowners are becoming less of a concern. Taking some potential foreclosures off the table might also help home prices to stabilize a bit faster.

Yet as with many mortgage relief programs, the benefits depend on the questionable assumption that few of the borrowers will default again. The proposed help is temporary: mortgage payments could more than double after five years. More bad loan problems could then ensue.

That would slow the enterprises’ near-term losses – and could possibly reduce how much taxpayers have to hand them to stay afloat – but only prolong their agony. It would also do little to heal the housing market as a whole. The FHFA would be better focused on shepherding Fannie and Freddie quickly toward obsolescence.


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