Photo by epicharmusTreasury Department is taking hits from all sectors, private, academic and government, for its handling of the housing crisis. The latest report produced by the Congressional Oversight Panel said Treasury’s response continued to lag behind the pace of the crisis.

Treasury has responded in two ways.  1) By pointing out the successes they feel the Making Home Affordable Loan Modification has achieved; namely, an increase in 35% of permanent loan modifications in March. This placed the total number of permanent loan modifications to 230,000 homeowners enjoying reduced mortgage payments and fixed interest rates. 2) By announcing it is still implementing new programs which should be more aggressive with the housing crisis. The problem is that big banks like JPMorgan Chase and Wells Fargo are not buying the new deals Treasury is proposing.

A centerpiece of the new loan modification program is the plan to increase the reducing of mortgage principals as a loan modification measure. Up to now the main methods banks and lenders have used to reduce mortgage payments have been increasing the term of the loan, reducing the interest rate of the mortgage, and changing variable and ARM interest rates to fixed interest rates. Clearly, this is not producing the results hoped for, so Treasury is suggesting lenders get more aggressive and is asking lenders and servicers to reduce the mortgage balance of underwater mortgages.

What does this mean?

Reducing the principal balance of a mortgage means forgiving a chunk of the money owed to the bank. For instance, if you have a mortgage of $100,000 for a house that is only worth $80,000, your mortgage is $20,000 underwater. This is also called negative equity, owing more than the value of the home. Treasury is suggesting that lenders consider reducing the mortgage balance for troubled homeowners who own underwater mortgages. Using our previous example a lender could decide to forgive the lender $20,000, bringing the mortgage out of negative equity. The theory is this would create a win-win situation. First it would allow banks to avoid stockpiling unsellable foreclosed homes. Second it would give borrowers a strong incentive not re-default on their mortgages.

A more radical version of this program is to apply principal balance reduction to mortgages that are not delinquent, that is, not behind on their payments, but have a large negative equity. This is the proposed modification that banks and lenders have more of an issue with. The worry is that reducing the mortgage balance of borrowers would give the wrong message to borrowers, which would receive compensation for borrowing irresponsibly. It would also undermine the chances of lenders taking the risk of providing new mortgages if they know the principal balance could be cut at any moment.

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