Freddie Mac will allow mortgage servicers to apply federal taxpayer dollars to reduce principal or pay past due balances for struggling borrowers in all states that have designed such programs.

"Effective immediately, (servicers) should participate in state (housing finance agency) modification assistance programs that permit (servicers) to apply funds as a partial principal curtailment for homeowners with Freddie Mac-owned or guaranteed mortgages," according to an alert sent to servicers late Monday.

State housing finance agencies in California, Nevada, Michigan, Arizona, Rhode Island and Ohio put money from the $7.6 billion Treasury Department Hardest Hit Fund toward eligible borrower principal. This reduces their loan-to-value ratio and could qualify them for various modification or refinancing programs.

A Freddie Mac spokesman said servicers are cleared to participate in all state Hardest Hit Fund states that do not require matching amounts by the servicer or investors. The modification structure the reduction is linked to must also conform with Freddie programs as well. The Michigan program, for example, grants up to $10,000 in reductions, but the program currently requires the servicer to match, which Freddie would not allow.

Just $217.4 million of the Hardest Hit Funds available were spent as of the end of last year, according to the latest data from the Special Inspector General of the Troubled Asset Relief Program.

Much of the delay is caused by a lack of participation by the government-sponsored enterprises. Before the guidance released Monday, both GSEs prohibited principal reductions on mortgages backing the bonds they issue and will continue to forbid write downs outside of these programs. Because the Hardest Hit Fund programs are voluntary, servicers did not participate when such large portions of their portfolios – those owned by the GSEs – could not be applied.

In July, the Federal Housing Finance Agency rejected an offer from the Treasury to pay for a portion of principal reduced under a Home Affordable Modication Program workout.

Some of the restrictions, though, began to thaw earlier in the year. Both GSEs allowed servicers to participate in a Hardest Hit Fund principal reduction program in California after the state HFA dropped the requirement for banks to match any taxpayer-funded write-downs. It also cleared participation in a similar Nevada program that provided up to $50,000 in reductions.

A Fannie Mae spokesman did not immediately say if it was expanding its servicer participation as well.

Going forward, Freddie servicers must recalculate monthly mortgage payments for borrowers who were still current on their loan when receiving the newly available assistance. Mortgage servicers are prohibited from adjusting the interest rate or loan term when recalculating the monthly payment after the principal is reduced.

If a borrower was delinquent or already received some principal forbearance, the Hardest Hit Fund money must first go toward paying off the past due monthly payments, with the remaining funds applied to curtail principal, according to Freddie.

When the write-down is done in tandem with a modification, Freddie said the borrower must first complete a three-month trial period before the taxpayer money can be applied to any arrears or fees. Remaining money can then be applied to reducing the principal.

After the HFA funds are applied, servicers can then recalculate final modification terms, Freddie said.