To date, permanent modifications in this credit cycle episode, as in the past, have typically involved a reduction in the interest rate or an extension of the loan terms, while reductions of principal balance have been quite rare. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of situations known as negative equity positions in which the amount owed on the mortgage exceeds the current market value of the property. A distressed borrower with a negative equity position may have neither the means nor the incentive to remain in the home. In this environment, servicers and investors may well find principal reductions that restore some equity for at-risk homeowners to be an effective means of avoiding delinquency and foreclosure.
Although principal write-downs may be especially germane today given the prevalence of negative equity positions, they are not necessary or appropriate for all borrowers who have negative home equity or who become delinquent on their mortgage. On the contrary, a strategy of targeting write-downs to certain groups of borrowers may provide the best path forward. For example, one possibility would be to limit the availability of write-downs to those borrowers with high debt payment-to-income ratios and loan-to-value ratios significantly in excess of 100 percent before loan modification, but with the capacity to carry a written-down mortgage. In any event, it seems clear that principal reductions should be part of the tool kit that servicers and investors bring to bear as they deal with delinquent loans.