Mortgage Forgiveness Presents Challenges in Housing Recovery (Update 1)

Updated from 7:34 a.m ET to include Mel Watt's comments in an interview with the Wall Street Journal.

NEW YORK ( TheStreet) -- Deeply indebted homeowners with government-backed mortgages may have a fresh shot at receiving meaningful mortgage relief, but it will likely come with strings attached.

Earlier this week, President Obama nominated House Financial Services Committee member Mel Watt (D-N.C.) to head the Federal Housing Finance Agency, the regulator of Fannie Mae ( FNMA) and Freddie Mac ( FMCC).

If confirmed, Watt, as the regulator of the agencies that guarantee nearly 60% of the U.S. mortgage market and back nine out of ten new mortgage loans, would have a major say on various aspects of government housing policy, including the $180-billion dollar question of what to do with the bailed-out mortgage giants.

Dump DeMarco Campaign Wins

While his confirmation is by no means certain -- analysts expect stiff opposition from Senate Republicans -- Watt's nomination has been welcomed by consumer activists who have been calling for the removal of current FHFA acting director Edward DeMarco.

DeMarco has come under attack over the past year for opposing principal modifications, a contentious form of mortgage relief.

Proponents of principal reduction believe it is the most effective form of mortgage relief for deeply underwater borrowers -- those who owe more than their homes are worth.

Forgiving a portion of the principal not only cuts borrowers' monthly payments, but unlike other forms of modification, also helps borrowers regain some equity in their homes. This increases their willingness to continue making loan payments, lowering the probability of a default.

DeMarco, however, has resisted pressure from the Administration to reduce principal on mortgages under the Home Affordable Modification Program (HAMP), even after the FHFA's own analysis showed that principal reductions would result in $1.7 billion in savings to taxpayers.

On principle, he argued that principal reductions were unfair as it punished borrowers who continued to make their mortgage payments despite being underwater. As the conservator charged with minimizing losses to the taxpayer, he said the program would be too costly to administer and could encourage "strategic defaults" by borrowers hoping to take advantage of the program. The costs outweighed the benefits, he concluded.

While private-label investors have increasingly embraced principal forgiveness as a relief option, the housing giants' failure to participate has meant that fewer borrowers have been able to benefit from this form of relief.

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