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.