The Federal Reserve picked up a major portfolio of home loans when it bailed out Bear Stearns and AIG. The Washington Post writes that they are now initiating a new home loan modification program for those loans that focuses on principal reduction - a tactic many (including me) feel is the best way to stem the tide of foreclosures.
The Fed is emphasizing reducing the amount of principal owed by people at risk of foreclosure, particularly those with a loan balance that is more than 125 percent of the estimated value of their property. Private lenders have been reluctant to renegotiate loans that way, as some of the institutions that own those loans, in the form of mortgage-backed securities, stand to lose money and therefore object.
This gets to the heart of the matter - banks (and investors in mortgage-backed securities) lose money if they write down principal and have to recognize that loss on their books - which further hurts their capital positions. So instead they try to do as little as possible in a modification and often only delay the inevitable foreclosure - costing the bank or investor even more money than if they had just written down the principal. Furthermore, as the article points out, investors in MBS typically need to approve principal write-downs, so mortgage servicers often are not allowed to modify loans in a way that would prevent foreclosure.
For example, the Federal Deposit Insurance Corp. has tried to use its control of California bank IndyMac, which it seized last summer, to do loan modifications, but has been frustrated by investors in those loans being unwilling to reduce the amount of principal owed.
To remedy this problem, bankruptcy cramdowns are now being considered in new legislation circulating in Congress. This would put principal write-downs in the hands of judges, not the banks - and the banks (and MBS investors) are generally not happy with that idea. The alternative, of course, is for banks and investors to undertake principal reductions voluntarily, which they do not yet seem willing to do. Perhaps the threat of bankruptcy cramdowns will incentivize them to do this.
Still, the amount of home loans owned by the Fed is only a small fraction of the amount of total loans outstanding and, according to the article, homeowners typically will not know whether their loan has been acquired by the Fed and is eligible for this new program. But the hope is that by initiating a true principal write-down strategy, it will provide some empirical evidence of whether principal write-downs will be effective and will serve as a model for other government programs and the private sector.
Update: More coverage and commentary from HousingWire, including the letter from Bernanke, can be found here.
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