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Will Banks Be Forced to Reduce Loan Principal?

I'm reporting today from a Wells Fargo two-day mortgage modification eventin Portland, OR. This is the 20th such event WFC has held since September of 2009, meeting face to face with over 19,000 borrowers.

Foreclosure
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Foreclosure

Some borrowers will walk into this convention center today and walk out with a mortgage modification, including payment reductions and possibly even a permanent reduction of mortgage principal.

That last part is particularly pertinent today, amid several reportsthat government regulators and state attorneys general are nearing a $20 billion settlement with the big banks that would force more loan principal reduction.

This in the wake of the so called "robo-signing" foreclosure paperwork scandal last fall. (Read more: A Primer On The Foreclosure Crisis)

The big banks aren't commenting on the potential settlement, which even government officials tell me is still "fluid," but industry insiders argue that banks can reach the same affordable monthly payment by deferring principal, rather than forgiving it. Deferring principal is when the bank lowers the principal temporarily, so borrowers are paying on a smaller amount, and then tacks it on toward the end of the loan, when the home would likely be sold or refinanced. This of course doesn't work if the home is deeply underwater, that is, when the home's value has fallen far below the value of the mortgage.

Part of the reported settlement would also place the financial burden entirely on the loan servicers (namely the big banks) and not on the investors, private and Fannie Mae and Freddie Mac alike. Fannie and Freddie won't participate in the FHA short refinance program, which requires principal reduction. Industry folks call that unfair, given that the investors supposedly knew what they were buying. Others say regardless of who takes the hit, it's just not enough.

"The proposed $20B for 7.5 million borrowers — $2600 per borrower — is far too low, as the Bank of America [$8.6B] settlement was far too low. An apples-to-apples Robo-Settlement based on the BAC settlement would be $161 BILLION. This will make no difference to anything occurring — and about to occur — in mortgage, housing or MBS. Further, new Notice-of-Defaults — the first stage of foreclosure — in CA in January alone totaled $9B," notes mortgage consultant Mark Hanson. He contends the real issue is home equity and gross debt to income ratios. Borrowers just don't want to pay so much of their income on a home that will never pay them back in any way and which they are unlikely to be able to sell without a significant loss.

Wells Fargo is one of the few banks really pursuing the principal reduction line, I won't say aggressively, but more than most.

They have reduced $3.8B in mortgage principal for 73,000 borrowers.

That comes to $52,000 per borrower.

That's out of 622,000 permanent and trial modifications, so again, it's not a lot.

Wells is the nation's number two mortgage servicer. Bank of America, which took over Countrywide, leads in servicing. Wells is now the number one mortgage originator in the nation, churning out one out of every four new loans today.

"From our perspective, principal reduction is an effective means to help creative affordability," says Joe Ohayon, Senior VP of Wells Fargo Home Mortgage Servicing. "It's a tool that we utilize when appropriate." Ohayon would not comment on the potential settlement nor on the moral hazard of reducing principal for some and not for others. The concern there is that people will simply stop paying in the hopes of getting a principal reduction, whether they can afford the payment or not.

Wells Fargo has been doing the reduction largely on its own loans and when investors allow it.

In the last two months they started putting some loans through the government's Home Affordable Modification Program.

Still only 14 percent of Wells Fargo's 622,000 permanent and trial modifications have gone through the government program. HAMP has been deemed to difficult to qualify for. It's no wonder the House Financial Services Committee has scheduled a vote next week on legislation that would end the HAMP program as well as government-funded principal reduction programs through the FHA.

No question, something more has to be done. Today's big drop in sales of newly built homes is a direct result of increasing competition from bargain-priced foreclosures. As banks ramp up the foreclosure process again and put those properties up for sale, inventories will rise yet again, and I'll say it again: That only puts more downward pressure on home prices, slowing the recovery indefinitely.

Questions? Comments? RealtyCheck@cnbc.comAnd follow me on Twitter @Diana_Olick