It's time for Fannie Mae, Freddie Mac, and their regulator to embrace principal reduction
There's a growing consensus among economists, investors, academics, and consumer advocates that more "principal reduction" -- writing off a portion of a mortgage that exceeds a home's value in exchange for a higher likelihood of repayment -- can help avoid another wave of costly and economy-crushing foreclosures. That's good for homeowners and lenders, and because millions of underwater mortgages are controlled by the government, it's also good public policy.
But the country's two biggest mortgage companies are not convinced, according to Edward DeMarco, acting director of the Federal Housing Finance Agency -- which oversees the government-controlled mortgage giants Fannie Mae and Freddie Mac.
"Both [Fannie and Freddie] have been reviewing principal forgiveness alternatives and both have advised me that they do not believe it is in the best interest of the companies to do so," DeMarco told Congress last week. He added that principal reduction is inconsistent with his mandate to protect taxpayers, who have invested more than $150 billion in the companies since 2008.
This stance makes FHFA the "big boulder in the path to principal reduction," according to former Obama economic advisor Jared Bernstein.
To be sure, FHFA's position may make some sense if the only goal is to protect the short-term interests of Fannie and Freddie. Principal reductions require the lender to recognize a write-down on their books today in order to save more money tomorrow. In the case of Fannie and Freddie, that may mean billions in temporary support from taxpayers - not to mention another unflattering headline.
But more than three years into the conservatorship -- with no clear path forward for winding down Fannie and Freddie and home values still weakening -- FHFA should be thinking long term. Here are three reasons why the agency should give its stance on principal reduction another thought.
First, analysis from FHFA itself shows that principal reduction helps the books of Fannie and Freddie. A large-scale effort to revalue underwater mortgages - so that the loans reflect the huge drop in home values over the past 5 years - would actually save Fannie and Freddie about $20 billion over the life of those loans compared to doing nothing, the study found.
And that was before the Obama administration announced new incentives for Fannie and Freddie to write down principal through the Home Affordable Modification Program, or HAMP. For the first time Fannie, Freddie, and their servicers could get as much as 63 cents on every dollar written off. So those savings should be even greater today.
Second, reams of economic evidence support principal reduction as the most effective way to stave off unnecessary foreclosure. Recent research from Amherst Securities found that severely underwater loans - where much more is owed than a house is worth - default at a much higher rate than loans at or below the home value. This is true across all mortgage types (prime, subprime, Alt-A, etc.), even after accounting for borrower characteristics like credit scores and debt-to-income ratios, according to the report.
This should not be a surprise. Families that are hopelessly underwater often cannot see the long-term upside from making expensive monthly payments into a bad investment. On the other hand, borrowers with more equity are naturally more likely to stick it out in tough economic times by making deep cuts to savings or other areas of spending.
That's why principal reduction, which rebuilds equity by writing down what is actually owed, is such an effective foreclosure mitigation tool. Recent studies from the UNC Center for Community Capital, the New York Fed, and Santa Clara University's Sanjiv R. Das confirm that principal reductions are often the best value to lenders compared to other loan modifications - such as capitalization or interest-rate modifications - because they prevent more foreclosures. Indeed, even the model FHFA used in their analysis assumed that principal forgiveness avoids more re-defaults than alternative modifications.
Fewer foreclosures mean a stronger, more stable housing market, which undoubtedly benefits Fannie and Freddie in the long run.
Third, the private sector has shown that principal reduction is good business practice. About 15 percent of private loan modifications in the third quarter of 2011 involved some sort of principal reduction. And that number was even higher for modifications done on loans that banks hold on their own books.
Many private firms have worked out ways to reduce principal responsibly without creating skewed incentives for borrowers. The subprime servicer Ocwen has one particularly promising approach: a so-called "shared appreciation" program for certain underwater borrowers. In exchange for a principal write-down that restores 5-percent equity in the home, the borrower agrees to make timely payments and shares 25 percent of any future home price appreciation when they eventually sell. As of this summer - one year after the pilot began - Ocwen reported that its principal modifications were experiencing re-default rates of less than 3 percent, far below what's seen in typical loan modifications.
Despite this and other field-tested ways to write down mortgage debt responsibly, Fannie and Freddie refuse to embraced principal reduction as a viable foreclosure mitigation tool. And their regulator, FHFA -- with full authority to plot a different course -- has yet to urge them to do so. So instead of recognizing the losses we all have already sustained, the taxpayer-supported mortgage giants continue to put off until tomorrow the bad news of today.
It's time they rethought that position. Only then can we start mending a housing sector that remains one of the biggest drags on our economic recovery.><