While this would certainly involve outlays, these would be offset by reduced defaults. Whether there is a net cost or not depends on the reduction in the default rate that would come with principal reduction and how this reduction would affect the performance of the overall housing market and the economy. Based on recent data on borrower behavior,17 my staff calculates that the taxpayer (through the effect on Fannie Mae and Freddie Mac) would be better off with earned principal reduction under a base case of roughly flat house prices and persistent weakness in the jobs market. Under a scenario of modest house price increases, the combination of fewer defaults and shared appreciation also produces a net benefit. This result occurs before taking into account the positive externalities of nudging house prices onto a stronger path, which would reduce the magnitude of losses on loans that do default. On an expected value basis, such a program appears still more compelling, since  17  Lender Processing Services data. BIS central bankers’ speeches  9  Fannie Mae and Freddie Mac are currently exposed to the downside risk of further declines in home prices. Of course, just focusing on the impact on Fannie Mae and Freddie Mac is much too narrow even from a taxpayer perspective. If you believe as I do that improving the outlook for housing would materially strengthen the over economy, one must also include the fiscal benefits generated by stronger economic growth.
Earned principal reduction Investment firms that purchase delinquent mortgages routinely reduce principal in order to maximize value on these loans. It would make sense for Fannie and Freddie to do this as well in order to minimize loss of value on the delinquent loans they guarantee. However, I am uncomfortable with the notion that “underwater” borrowers who owe more on their mortgages than their homes are worth should have to go delinquent before they have a chance of securing a reduction in their mortgage debt. I believe we should also develop a program for earned principal reduction for borrowers who are underwater but keep on making their mortgage payments. Such a program would strengthen the incentives for mortgage holders who are underwater to continue to stay current on their loans, and reduce the likely number of defaults and REO sales. Negative equity is one of the most significant predictors of mortgage default across all types of mortgage products, including when you control for credit scores and level of income documentation. While recent underwater borrowers have not been defaulting at a rapid pace, they are also not prepaying, implying that underwater mortgages remain “at risk” for a prolonged period of time to any adverse shock to the borrower. It is admittedly challenging to predict how underwater borrowers will ultimately perform and this performance will be sensitive to the path of home prices.