Debt forgiveness for homeowners?
By Holden Lewis • Bankrate.com

Less than one in 50 mortgage modifications includes debt forgiveness, which is considered the surest way to prevent foreclosure.

For every troubled homeowner whose mortgage principal is reduced in a modification, 39 others end up with more housing debt as lenders tack on missed payments, late charges and even attorney fees to the loan balance.

Lenders are reluctant to reduce principal on delinquent mortgages, and the Obama administration's Home Affordable Modification plan, or HAMP, doesn't force them to. That needs to change, consumer advocates say.

"Ultimately, we believe in order to be effective, HAMP may need to mandate principal reductions," Diane Thompson, counsel for the National Consumer Law Center, told the Senate Banking Committee July 16. "With one out of five homeowners underwater, significant readjustments in principal balances are necessary for the economic stability of the country."

No one expects lenders to forgive mortgage debt as eagerly as they granted it to unqualified borrowers, so it probably would take political pressure to make them do it. Such pressure doesn't seem forthcoming.

In a recent letter, the secretaries of Housing and of the Treasury ordered mortgage servicers to hire more people to process modifications, mail more letters to borrowers, and appoint high-level liaisons to federal regulators. There was no mention of which types of modifications the servicers should offer.

Debt forgiveness equals success
A number of researchers have found that the most successful mortgage modifications involve debt forgiveness. Yet, according to the Comptroller of the Currency and the Office of Thrift Supervision, just 1.8 percent of modifications in the first quarter of 2009 forgave debt. That's about one in 50 modifications.

The other 49 modifications consisted of rate reductions or rate freezes, term extensions and "capitalization," which means that the missed payments and fees were added to the homeowner's debt burden. Some 70.2 percent of modifications included capitalization: That means that for every troubled borrower who got debt forgiveness, 39 ended up owing more.

The average amount added to mortgage balances: $10,800, according to Alan White, assistant professor of law for Valparaiso Law School, in his study, published in January, of 3.5 million privately securitized mortgages.

"It is apparent now that mortgage modifications will succeed in achieving sustainable repayment, and in reducing the aggregate debt overhang, only if they include reductions of principal to align debt with property values," White writes.

What prevents foreclosures?
White and other researchers have focused on the issue of what kinds of modifications result in fewer foreclosures. There are other issues, too: Is it fair to forgive the debt of feckless borrowers? How does a servicer figure out whether the optimal financial outcome is foreclosure or modification? But one thing is clear: Debt forgiveness is effective at preventing foreclosure.

There's an obvious reason and a not-as-obvious reason that principal reductions result in fewer foreclosures. The obvious reason is that less debt equals a smaller monthly payment. People get modifications because they have trouble making their mortgage payments, so smaller payments tend to help.