Investors who buy delinquent mortgages routinely reduce principal to maximize value on these loans, according to William Dudley, president of the Federal Reserve Bank of New York. Therefore the government-sponsored enterprises should do so as well.

“It would make sense for Fannie and Freddie to do this as well in order to minimize loss of value on the delinquent loans they guarantee,” Dudley said in a speech at the New Jersey Bankers Association Economic Forum in Newark, N.J., on Friday.

The GSEs routinely resist calls for principal reduction. Michael Williams, CEO of Fannie Mae, told HousingWire in September that the company has no plans to ask mortgage servicers for principal reductions.

In May, Freddie Mac CEO Ed Haldeman, who recently announced his resignation, said principal write-downs do not make sense for Freddie Mac. Further, principal reduction may lead borrowers to default at higher rates to try to get their mortgage debt reduced.

Dudley said such a tactic would need to be avoided if Fannie and Freddie were to order mortgage servicers to reduce principal on the loans the GSEs securitize.

“I believe we should also develop a program for earned principal reduction for borrowers who are underwater but keep on making their mortgage payments,” he said. “Such a program would strengthen the incentives for mortgage holders who are underwater to continue to stay current on their loans, and reduce the likely number of defaults and REO sales.”

Dudley said analysis from the New York Fed suggests that without a significant turnaround in home prices and employment, a substantial proportion of negative-equity mortgages default, without an earned principal reduction program in place.

“One option developed by my staff is for Fannie Mae and Freddie Mac to give underwater borrowers on loans that they have guaranteed the right to pay off the loan at below par in the future under certain circumstances, including that the borrowers have continued to make timely payments,” he added.

“For instance, the borrower could be given an open-ended option to pay off the loan at a loan-to-value ratio of 125%, and the right to pay off the loan at an LTV of 95% after three years of timely payments,” according to Dudley.

He adds that this would protect borrowers against further declines in home prices who, in return, give up a portion of any upside from future capital gains on the home via a shared appreciation agreement.

“Note that under this arrangement some of the reduction in the loan amount would be paid by the borrower as the outstanding balance was amortized by continued monthly payments,” he said.

Write to Jacob Gaffney.

Follow him on Twitter @jacobgaffney.

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