by Calculated Risk on 3/09/2011 07:10:00 PM

From Chris Foote, Kris Gerardi and Paul Willen at the Atlanta Fed: The seductive but flawed logic of principal reduction (ht Dean).

The researchers point out that principal reduction seems to make sense if a borrower is going to default and the lender foreclose, but that it is hard to predict exactly who is going to default (and not cure). If lenders aggressively offered principal reductions to underwater homeowners who are delinquent, then borrowers who are current would have an incentive to stop paying their mortgages.

I noted this a couple of years ago:

If it became widely known that lenders routinely reduce the principal balance for delinquent borrowers with negative equity, this would be an incentive for a large number of additional homeowners to stop paying their mortgages.

And from another old post:

Some people point to Lewis Ranieri's apparent success with principal reductions, from Fortune: Lewis Ranieri wants to fix the mortgage mess

Now Ranieri is championing an inventive solution for fixing the mess he's accused of enabling in the first place. Ranieri has raised $825 million from 31 foundations and corporate and public pension funds, including the South Carolina Retirement Systems, to form the Selene Residential Mortgage Opportunity Fund.

Selene's mission is simple: to buy delinquent mortgages at a deep discount, work with homeowners to get them paying again, and resell the now stable loans for profit. To get homeowners to do their part, Ranieri is taking the radical step of substantially lowering their mortgage balances.

This only works because Ranieri bought the distressed mortgages at a deep discount, and his company has no reputation risk. Ranieri wants his borrowers to know that he will reduce their principal.

Imagine what would happen to Wells Fargo or Bank of America if their borrowers found out that the banks would substantially reduce their principal if they were 1) underwater (negative equity), and 2) stopped making their payments. The delinquency rate and losses would skyrocket

Here are some excerpts from the new research:

The idea of principal reduction starts with a correct premise: borrowers with positive equity—that is, houses worth more than the unpaid principal balance on their mortgages—rarely ever lose their homes to foreclosure.
...
With this idea in mind, it then follows that if we could somehow get everyone back into positive-equity territory, then we could end the foreclosure crisis. To do that, we either need to inflate house prices, which is difficult to do and probably a bad idea anyway, or reduce the principal mortgage balances for negative-equity borrowers. So we have a cure for the foreclosure crisis: if we can get lenders to write down principal to give all Americans positive equity in their homes, the housing crisis would be over.
...
The logic that principal reduction can prevent foreclosures at no cost is compelling and seductive, and proposals to encourage principal reduction were common early in the foreclosure crisis.
...
Ultimately the reason principal reduction doesn't work is what economists call asymmetric information: only the borrowers have all the information about whether they really can or want to repay their mortgages, information that lenders don’t have access to. If lenders weren't faced with this asymmetric information problem—if they really knew exactly who was going to default and who wasn't—all foreclosures could be profitably prevented using principal reduction.

I think that is the key reason lenders have been reluctant to offer principal reductions.