Foreclosure Hope, but No Cure-All

"Anecdotal evidence suggests that even in the best-case scenarios, borrowers given repayment plans re-default at a high rate," he said at a banking conference in Orlando.

This is because some homeowners, once they get back on track, will face the same steep payments that initially got them into trouble. Others will see their interest rates reset at higher levels once the freeze lapses or float higher as their variable rates rise with the market.

Though financial analysts and non-profit groups say principal reduction is the best way to avoid default, lenders say they avoid that option.

Reducing principal may help ordinary homeowners but would create massive losses for investors, said Tom Deutsch, deputy director of the American Securitization Forum, the largest association of debt investors and a member of Hope Now.

"If servicers wrote down principal, it would certainly reduce the foreclosure rate, but writing down principal creates a lot of difficulties," he said. A mortgage firm that modifies a "loan solely for the benefit of policymakers rather than [the investor], could find themselves in legal jeopardy."

Principal reductions are being considered more, but they still are rare, said Tom Kelly, a spokesman for J.P. Morgan Chase, which services about $20 billion of subprime home loans. "It's the investors who have to say go ahead or don't go ahead," he said.

In California, one of the few states to compile extensive data about loan workouts, fewer than 2 percent of homeowners who got help from their lenders in January saw their principal reduced. By contrast, about 22 percent were put into repayment plans, which allow borrowers to make up their missed payments over time, according to the California Department of Corporations.

A report by the Mortgage Bankers Association showed that nearly one-third of homeowners in foreclosure proceedings in the third quarter of last year had tried a repayment plan or loan modification. Those efforts failed to keep the borrowers out of default.

Treasury officials say solutions need to be tailored to individual homeowners. Some may need just a little bit of help to get through a short period of financial hardship, caused for instance by a divorce or temporary job loss, and a reduction in principal is not necessary.

"Treasury expects Hope Now members to continue working toward sustainable solutions to help borrowers keep their homes, which may mean any one of a variety of options," said Robert K. Steel, undersecretary for domestic finance. "Servicers have no incentive to modify someone into an unsustainable loan because foreclosure is a costly outcome for the investor and the borrower."

When Ocwen Financial, which services nearly $60 billion in subprime loans, offers to modify a mortgage, it needs to get permission from about 25 percent of the investors that hold the mortgages. Some don't allow it.

As a result, when Ocwen offers to modify a loan, it begins the discussion by proposing a reduction in borrowers' monthly payments by adjusting their interest rate, said William Rinehart, Ocwen vice president and chief risk officer. "If that is not enough and we determine that a customer has a loan balance well in excess of the value of a property we may consider adjusting the principal."

Falling home prices are forcing more lenders to consider reducing principal, Rinehart said. "We will lower the principal to make the payments affordable, but we're not necessarily going to lower it to get them equity," he said.

Investors who hold mortgage securities include mutual funds, retirement accounts, pension funds, hedge funds and big financial institutions. Steve Bartlett, chief executive of the Financial Services Roundtable lobbying group and Hope Now member, said these investors would suffer big losses if lenders reduced the principal of home loans on a large scale. That in turn could force up the cost of future borrowing since lenders would have to make up their losses by charging more for loans, Bartlett and Treasury officials said.

After receiving limited help from their lenders, some homeowners say they continue to struggle with their payments. Others question whether it is worth it to stay in their homes.

Vickie McCrary's lender threatened her with foreclosure after her mortgage payments jumped from $1,700 to $2,200 a month on her Chesterfield, Va., home. As a subprime borrower, McCrary, 24, could not refinance into a better loan without facing a prepayment penalty. After the value of her home fell, she couldn't refinance at all unless her loan principal was reduced. She soon fell behind on her mortgage.

Ultimately, after adding $5,000 to the loan amount for late charges and other fees, the lender agreed to restore McCrary's monthly payments to $1,700. She said she can make the payments for the time being.

"It has proven to me that homeownership is not for everyone," she said. "They call it the American Dream. For some people it becomes a nightmare."