Principle reduction is a tricky business. A bank can estimate how much money it will lose by foreclosing on a delinquent borrower. It can then choose to split the difference with the borrower. This is motivated by bank’s own self-interest. The catch is that if the bank is too loose with its screening process for a principle reduction program, then it encourages people to become delinquent. But, if people become delinquent who would not previously have done so, the bank can lose more money as a result of such a program. As a consequence, it probably makes sense for a bank to avoid advertising such programs too much. What is nice is that the consequences of the decision impact the bank, the entity responsible for making the decision.
If the government subsidizes principle reduction, the bank now has more motivation to engage in such behavior. This is obviously a benefit to the bank, who has a cushion to absorb some of the losses provided to them by the taxpayer. The formula for reduction remains the same, though. The bank wants to avoid losing as much money as a resulting foreclosure. However, because of the subsidy, the target price may be less than the resulting foreclosure price. This benefits the delinquent borrower at the expense of the person in the market for a new home. What isn’t nice is that the consequences of the decision impact someone other than the entity responsible for making the decision.
Obama’s housing relief plan includes subsidies for principle reductions. Some, like Hilker, will take issue with this. Should renters subsidize the housing payments (and housing prices) of previous buyers? The benefit to people who bought houses they could afford is dubious as well. If you live in a house that you can make payments on, does it matter if the price is dropping? This was a situation that occurred in the 80s for nearly all buyers in California.
I find principle reduction to be an interesting strategy. An alternative approach might be to reduce principle in exchange for a warrant for the difference when the house is sold. To discourage borrowers from becoming delinquent, this warrant could even be more than the difference. I wonder why things didn’t evolve this way.
