A lifeline for underwater homeowners

For hundreds of thousands of homeowners who are
underwater on their mortgages, it’s been a tantalizing question: Is there
any way that our lender might agree to lower the amount we owe — not just
the monthly payments but the principal debt itself?

But the outlook for principal reductions has changed dramatically. On
March 24, Bank of America unveiled the mortgage industry’s first
large-scale principal forgiveness program, potentially involving up to
45,000 underwater borrowers and $3 billion in debt write-offs.

On March 26, Treasury Department officials announced that the Obama
administration’s Home Affordable Modification Program will now encourage
lenders to consider principal reductions for underwater borrowers whose
mortgage balances exceed their home values by 15 percent. The program
changes — which will be phased in during coming weeks — could ultimately
affect loan modifications offered by substantial numbers of banks and
mortgage companies.

Bank of America’s new program targets borrowers who are deeply
underwater — those with loan-to-value (LTV) ratios of 120 percent or more.
This means they owe at least 20 percent more on their mortgage balances
than the current market worth of their homes. There is no upper limit on
how far underwater borrowers can be, but the program has a 30 percent
maximum reduction of any principal balance.

Barbara Desoer, president of Bank of America Home Loans, said the
program attempts to address the problems of the most “severely underwater
mortgages with some of the highest rates of delinquency,” and could “become
an industry model for principal reductions” on a far broader scale.

The program targets three mortgage products that were wildly popular
during the housing boom: subprime loans; payment-option mortgages with
negative-amortization features; and “2-1” adjustables that offered teaser
interest rates for the first two years, then converted into loans whose
rates adjust once a year.

As part of its ongoing loan modification efforts, the bank will look
to “earned” or phased-in principal forgiveness as the first step toward
keeping an underwater borrower out of foreclosure. Previously the bank —
along with the rest of the lending industry — looked first to lowering a
homeowner’s interest rate and monthly payments. Under the new program, by
contrast, severely underwater borrowers will be evaluated for principal
reduction as the first step in a modification.

Here’s how it will work, according to Bank of America officials: Say
you’re deeply underwater on a subprime mortgage you took out from
Countrywide Home Loans, which was acquired by Bank of America in 2008. Say
your mortgage balance today is $250,000, but your house is worth only
$200,000.

If you meet certain eligibility requirements, the new program could
reduce your balance by $50,000 and your new payments would be based on the
lowered principal debt and possibly a lower note rate. This would be
accomplished by the creation of an interest-free forbearance account
covering a five-year period. Assuming you made regular payments at the
modified, lower amount during the first year, $10,000 would be forgiven by
the bank.

The same would be true for the second and third years. By that point,
$30,000 of your principal debt would have been extinguished. During the
fourth and fifth years, the bank would appraise your property. If its value
had appreciated in either year to the point where your LTV had dropped
below 100 percent — you were no longer underwater but still benefiting
from the lowered payments — there would be no forgiveness for that year.
On the other hand, if you remained underwater, you would receive the
scheduled $10,000 per year principal reductions, extinguishing the full
$50,000 during a five-year span.

For certain payment-option loan borrowers who are underwater in part
because of the negative amortization features of the mortgage itself, the
bank will forgive the negative amortization amount down to a 95 percent LTV
level. Officials said the phased-in forgiveness will include issuance of
IRS 1099-C forms each year that principal is written off. This should
assist homeowners in applying for federal income tax exemption for the
forgiven mortgage amount.

Without fanfare, Wells Fargo, the country’s largest volume lender, has
also moved to selectively offer principal reductions for certain underwater
payment-option loans. Now that the Obama administration has signaled that
it is moving ahead with the concept, principal forgiveness might well
become a lifeline for a much wider group of homeowners who are now drowning
in mortgage debt.

Ken Harney is a real estate columnist with the Washington Post.