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.