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The Senate is considering legislation that would encourage lenders to reduce the principal balance on underwater loans, by giving them a share of any appreciation borrowers realize when the home is sold.

The legislation, sponsored by Sen. Bob Menendez (D-NJ) would establish two pilot programs to test the efficacy of this strategy, one under the Federal Housing Administration, involving FHA-insured loans and the other under the Federal Home and the other under the Federal Housing Finance Administration, targeting loans securitized by Fannie Mae and Freddie Mac.

Lenders would reduce the principal balance of the loan to 95 percent of the home’s current appraised value in stages, by one-third every year for three years, as long as the borrower remains current on the loan. The lender’s equity share at sale would depend on the amount of the principal reduction, capped at 50 percent of the appreciation.

"When you owe more than your house is worth through no fault of your own, relief can be hard to come by," Menendez said in a news release announcing his legislation. "My bill aims to break this cycle by giving homeowners the relief they are looking for by working with banks to find acceptable solutions for everyone."

His legislation falls squarely in the middle of an intensifying debate over whether principal reduction offers the best hope of clearing the logjam that is impeding the housing market’s recovery, or will exacerbate existing problems by encouraging borrowers who are able to repay their loans to default intentionally in order to obtain principal reduction relief.

Warning about the “moral hazard” involved in a principal reduction plan, Dale Westhoff, head of structured products research for Credit Suisse contends that this approach could push defaults “much, much higher.”

“We’ve never done this before; we don’t know what the risk is,” Westhoff, told reporters recently. In addition to encouraging more strategic defaults, he said, the strategy could also increase borrowing costs across-the-board, as lenders build “price protection” into their mortgage rates.

A Credit Suisse study of loan modifications found essentially no difference in the re-default rates of borrowers who received principal reductions and those who did not.

“You’ve got to base policy on something that’s factual,” Chandrajit Bhattacharya, an analyst at the bank, told reporters at a briefing. “You can’t base policy on something that you expect that hasn’t happened yet,” he added.

A slew of other economists and legislators have taken the opposite view, urging the Fannie Mae and Freddie Mac to embrace principal reductions on a broad scale – a move that Edward DeMarco, acting head of the FHFA and the GSEs’ primary regulator, has thus far resisted, arguing that writing down principal would increase the losses for the GSEs which are operating under federal conservatorship and have already received a combined total of more than $150 billion in federal aid.

“More and more economists across the political spectrum are recognizing [principal reduction] is a critical step,” Shaun Donovan, secretary of the U.S. Department of Housing and Urban Development (HUD), told the Wall Street Journal in a recent interview. “If a family is in their home for 10, 15 years and has no hope of being able to build equity again, they’re going to give up at some point,” he added.

Federal Reserve President William Dudley agreed, citing a study by Fed economists concluding that “a large proportion of those loans that are deeply underwater will ultimately default -- absent an earned principal reduction program.”

A study by Amherst Securities Group LP estimated that principal reductions would prevent up to 10 million distressed property sales over the next year. “We have shown that, even controlling for all other factors, principal reductions are more effective,” Laurie Goodman, an analyst for Amherst, said in an e-mail to Bloomberg News. “Realize also that banks are doing it on their own portfolios and have been for years. Why would they continue if it was not more effective?”


Here’s a switch. Housing industry officials say forecasts calling for a significant jump in new residential construction are “overly optimistic.” It’s usually analysts who are accusing industry executives of basing their forecasts more on wishful thinking than economic reality.

The forecasts at issue came from economists at Moody’s Analytics and Bank of America who are predicting that multi-family builders will begin work on 310,000 units and 260,000 units, respectively, this year – increases of between 70 percent and 75 percent over last year.

“We would love it if [Moody’s forecast] was right, but developers still need capital to start projects,” Sharon Dworkin Bell, senior vice president in charge of multifamily for the National Association of Home Builders (NAHB) told Multifamily Executive News. But the trade group is predicting that multifamily totals ― a forecast based, Bell said, on both current market conditions and historical trends.

That is much closer to the consensus view, that capital constraints and sluggish economic growth will restrain new construction activity for at least the next year.

“The combination of cautious equity and still-stringent construction loan underwriting by commercial banks should keep 2012 starts of rental apartments near 200,000 units,” Ronald Witten, president of Witten Advisors, LLC, told Bloomberg. That’s better than the 2011 performance, but well below Moody’s more upbeat forecast.

But Chen is betting heavily that stronger employment growth, reflected in recent labor market statistics, will boost household formation rates, increasing rental housing demand. As the job market rebounds, young adults who moved in with their parents when they couldn’t find jobs will be able to afford apartments of their own, Chen predicts. At the same time, tight lending standards and credit histories impaired by the downturn will continue to limit the number of consumers able to qualify for mortgages, pushing them into the rental market or keeping them there.

The rental market is already reflecting that pressure. Rental vacancy rates have been falling for the past year and are now “close to their historical averages,” Chen says, and she thinks trends will continue to favor the multifamily sector as the economy improves.

“Economic growth will strengthen even more in 2013 and 2014,” she predicts, “[creating] even greater demand for rental housing.”


Predictions that rental housing demand will surge (see above) seem to challenge conventional wisdom – and the findings of consumer surveys – indicating that the desire for home ownership remains strong, despite the battering the housing market has taken during the economic downturn.

But some analysts are suggesting that the calculations favoring ownership over renting have always been based more on emotions than on numbers.

"It's the American Dream to own a home, but whoever said that didn't do the analysis on it," Rich Arzaga. As the founder and CEO of Cornerstone Wealth Management, and adjunct professor in personal finance at Berkeley,

Arzaga analyzed more than 250 properties in markets all over the country and concluded that renting would have been better than owning “100 percent of the time.” The killer, Arzaga says, is the cost of owning and maintaining a home over time – costs that are born by landlords rather than the tenants who rent from them. Owning a home, Arzaga contends, diverts financial resources that could be invested more profitably elsewhere.

"I don't have the emotions a lot of people do surrounding real estate," Arzaga says in a recent investor note. "I have steely eyes for how investing in real estate works, and I'd better be a prudent investor for my clients." Investors who own homes “aren’t going to meet their financial goals,” Arzaga warns. “They are going to fail.”

Some analysts say Arzaga’s analysis oversimplifies the ownership calculation, ignoring differences in financial conditions, investment opportunities and individual circumstances over time.

"Our lifetimes are a long time, and when we look over the long term, real estate and other investments tend to have a positive return," Jed Kolko, chief economist at, told

But more analysts than you might expect come down closer to Arzaga’s position. Among them is Greg McBride, senior analyst at Home ownership can be a good investment over time, he says, but not for owners who neglect other financial priorities – saving for the education of their children, creating an emergency fund, and saving for their retirement, for example. "There's no sense in buying a home if it's going to deplete your emergency or retirement savings," he told

For many owners, although not all of them, McBride agrees with Arzaga, "Homeownership may not [turn out to be] the moneymaker you think it is."


Opposition to regulations that would increase down payment requirements for home buyers continues to build, and it is coming increasingly from consumer advocacy groups, not just from lenders.

In the latest broadside against the “Qualified Residential Mortgage” (QRM) standards regulators have proposed, the Center for Responsible Lending has warned that the 20 percent minimum down payment required to qualify for “qualified” loans that would be exempt from reserve requirements would push at least 60 percent of borrowers who currently qualify for the lowest-cost mortgages into higher rate loans, and would force many of them out of the market entirely.

The study, "Balancing Risk and Access: Underwriting Standards for Qualified Residential Mortgages," acknowledges that higher down payment requirements reduce delinquencies and defaults. But those gains are more than offset, the study contends, by the large number of otherwise credit-worthy borrowers who would not be eligible for the “qualified” loans that most lenders will want to originate.

Minorities would be particularly hard-hit, according to the study which estimates that the new rules would exclude 70 percent of Latino borrowers and 75 percent of African-American borrowers who would currently qualify for “fairly priced” mortgage loans.

The more stringent requirements are unnecessary as well as counterproductive, the CRL study contends, because other underwriting changes mandated by the Dodd-Frank Financial reform legislation – specifically bans on no-documentation loans and prepayment addressed the major underwriting deficiencies that contributed to the subprime mortgage crisis.

Those changes alone “would curtail the risky lending that occurred during the subprime boom and lead to substantially lower foreclosure rates without overly restricting access to credit," the study concludes. The QRM standards, on the other hand, would do much to undermine the housing recovery and very little to reduce defaults, the study concludes.


Litigation challenging the application of ‘disparate impact’ claims to fair housing laws has ended in an out-of-court settlement, avoiding the Supreme Court decision that, housing industry executives hoped would resolve the question in the industry’s favor.

Disparate impact claims usually involve allegations by consumer advocacy groups that lending policies, even if non-discriminatory in intent, have a disproportionately negative impact on minorities. In this case (Magner v. Gallagher), it was rental property owners in Minnesota who claimed that the aggressive enforcement of building code requirements my municipal authorities was forcing the owners to raise rents, creating a disproportionate impact on low-income and primarily minority tenants.

Housing industry trade groups were hoping the Supreme Court would rule that disparate impact claims cannot be brought under the Fair Housing Act. Financial industry trade groups, who were also watching the case closely, were hoping the court would apply the same reasoning to the Equal Credit Opportunity Act (ECOA), barring disparate impact claims under that statute as well.

Both sides are arguing that if the underlying process – loan originations or rental housing policies – is not discriminatory, there should be no claim of discrimination, even if the outcome has a disproportionately negative impact on a protected class. To rule otherwise, industry groups contend, would open the door to a torrent of essentially merit-less discrimination claims. Disparate impacts, they argue, can result because of logistics – the sheer number of individuals in a protected class.

That is a particular concern for lenders as regulators begin to enforce the new “qualified mortgage” standards. A “friend of the court” brief filed on behalf of the Independent Community Bankers of America, The Consumer Mortgage Coalition and the American Financial Services Association notes that in order to verify a borrower’s ability to repay, as those standards require, lenders will have to apply more conservative underwriting standards, which will necessarily have a disproportionate impact on lower income and minority borrowers.

"Such differentials may prompt disparate-impact lawsuits," the associations wrote. "Even though lenders can defend such suits on the basis that their practices are undertaken in accordance with federal regulation, lenders will still face the reputational and monetary costs incurred in doing so."

Industry trade groups generally view the dismissal of the case as a missed opportunity to win a more favorable interpretation (for then) of the fair housing and fair lending laws. Consumer advocacy groups, who also thought the High Court would move in that direction, view the dismissal as a dodged bullet.

“Whenever [the court] has a chance to whittle down, if not obliterate, disparate impact, they will,” an attorney who represents plaintiffs in fair lending cases, told American Banker. “And that’s no secret,” he added.