OPINION: Reducing principal shouldn't be taboo

Neil Baron, a director of the bond insurer Assured Guaranty Ltd., represented the Reagan White House in drafting the enabling legislation for the secondary mortgage marketand was vice chairman and general counsel of Fitch Ratings until 1998.

It's ironic that President Barack Obama traveled to the Cleveland-area epicenter of the housing crisis last week to deliver his recovery plan speech, which includes infrastructure spending and business tax breaks. The irony is that the plan doesn't include any serious attempt to stop runaway foreclosures, which may be more responsible for weak consumer spending than unemployment.

Consumer spending constitutes 70 percent of gross domestic product, and one of the biggest engines of consumer spending is home purchases. When people buy homes they hire workers and spend on furnishings, appliances and the like. But people aren't buying because they don't see a bottom to home prices and won't invest in an asset that will lose value.

This week brings news that lenders repossessed more homes last month than in any month since the mortgage crisis began, and pending foreclosures on Long Island increased by more than 50 percent from July to August. We need to stem foreclosures to reduce the inventory of unsold homes. This will finally stabilize prices and bring buyers into the market.

Even though loan modifications are on the rise, there is evidence that the Obama administration's efforts on this front have been ineffective: The rate of redefault - defaulting on a mortgage that's already been modified because of borrower trouble - has exceeded 50 percent. Looking deeper, according to research by Amherst Securities, the redefault rate has been 70 percent when only the interest rate was reduced - but significantly lower when principal was reduced. The study concludes that negative equity is the largest driver of foreclosures.

Fannie Mae and Freddie Mac, which control about 80 percent of all residential mortgages, should require their mortgage servicers to reduce outstanding mortgage principal to or near the current home values - but only for homeowners who can pay the reduced payments.

This would, of course, be politically unpopular, since the administration would be seen as aiding irresponsible homeowners at the expense of responsible ones. Take the Smiths, who've paid down their original $300,000 mortgage to $200,000, while the Joneses next door have increased their original $300,000 mortgage to $450,000 to build a pool and buy an expensive car. Now the government wants to reduce the Joneses' mortgage back to its original amount. If the Smiths aren't already outraged, the Republicans will undoubtedly get them there.

But the Smiths need to understand that foreclosure of their neighbors' home will reduce the value of their own. Many foreclosures are managed by mortgage servicers with no financial interest in the mortgages. Prices realized in foreclosure sales are generally around 25 percent lower than in non-foreclosure sales - "comps" that can drive down the value of nearby homes.

A second concern is that homeowners who are current on their mortgages will default to get their loans reduced. This is a legitimate worry, but it could be addressed by denying relief to homeowners who can afford to pay their existing mortgages. Credit underwriting - that is, determining who is or isn't able to pay back a loan - is what mortgage services do (or were supposed to do). Given their track records, they should feel obligated to participate.

Another concern is that Freddie and Fannie and the banks that hold mortgage assets not guaranteed by them, will take more losses at taxpayers' expense, because the government would have to recapitalize them. But this could be mitigated by converting existing mortgages to "participating mortgages," whereby the proceeds from the sale of the home above the reduced principal amounts are shared. The mortgage holders could value their participations and minimize losses accordingly. This would also give homeowners a share of any increase in the value of their homes - providing an incentive to keep paying their mortgages.

Given the distressed prices realized from foreclosure sales, lenders would benefit more through the lower defaults that would result from reducing principal than they would by foreclosing. This would actually save taxpayers money (always politically popular). And unlike Obama's proposed tax breaks, reducing mortgage principal would slow foreclosures and stimulate consumer spending quickly - before the recovery comes to a complete halt.