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Time To Reduce Mortgage Principal Payments: Lockhart

James Lockhart, former head of the Federal Housing Agency, told CNBC Tuesday that he wants more generous mortgage modifications, including principal payment reductions.

“I know it’s very tough but now 25 percent of the people are now underwater in mortgages,” Lockhart told CNBC. “And if we want to keep them in their houses, we’re going to have to do more than just lower their payments.”

Although the latest Case-Shiller Index indicates the housing market has been improving for the last five months, there could be another spike in foreclosures, said Lockhart. While banks and investors have already marked down mortgages on their books, he said, that benefit has not yet been passed onto homeowners.

Lockhart, who stepped down in August, is now vice chairman of WL Ross & Co., the distressed investment firm run by billionaire Wilbur Ross. WL Ross makes big bets on the mortgage market.

“We still haven’t seen the falloff in foreclosures,” he said. “All the solutions have been on the income-side, and people’s balance sheets are suffering. It’s coming to the point where I think we really have to consider much more aggressive [loan modifications and] at looking at reducing principals.”

Lockhart also expects strategic defaults will start to occur more frequently. “You look at the bankruptcy numbers; the stigma is not there anymore,” he said.

This comes at a time when the federal program to support the mortgage backed securities market is set to end in spring.

“Since the housing market collapsed, Fannie and Freddie have become a public utility,” said Rep. Barney Frank, D-Mass told CNBC Tuesday in a separate interview. “They used to be that inappropriately private hybrid public stock company and public policy instrument.”

Now, Fannie Mae and Freddie Mac have become the “public utility that finance housing in America,” said Frank. Combined, they guarantee some 75 percent of the mortgages made today.

Meanwhile, Lockhart encouraged proposals to fix Fannie and Freddie and ultimately wean the public sector out of housing.

“We have to work our way out of that system,” said Lockhart. “The odd marriage isn’t working and we need a divorce. We need to separate the private sector and public sector and we need a real strong dividing line.”

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  • Diana Olick serves as CNBC's real estate correspondent as well as the editor of the Realty Check section on CNBC.com.