Fannie, Freddie’s mortgage dilemma
They say Demarco is taking his job — preserving Fannie and Freddie assets — too zealously and is single-handedly blocking a recovery in the housing market.
Rep. Zoe Lofgren, D-san Jose, has called Demarco an idiot for not reducing principal. “The private sector is doing more principal reductions than the brain-dead government,” she says.
Peter Goodman, business editor at the Huffington Post, labeled him “America’s most dangerous man.”
Van Jones, co-founder of Rebuild the Dream, called Demarco an “ideologue” in an interview on KQED radio this month.
There are at least 11 million borrowers who owe more than their homes are worth. Jones and others would like to see lenders reduce all of these underwater loans to market value.
Many not theirs
But only about 4.5 million of those are owned or guaranteed by Fannie and Freddie, and only a subset of them would be eligible for partial principal forgiveness if Demarco allows it.
“This particular fight is about adding one more option to the modification menu for about 700,000 loans,” says Jed Kolko, chief economist with Trulia.
It would affect only homeowners with a Fannie or Freddie loan on their primary residence who are underwater and behind on their payments and qualify for the government’s Home Affordable Modification Program.
Under Hamp, servicers follow a sequence of steps to reduce the borrower’s payment to 31 percent of gross income. They include reducing the interest rate, extending the term and, finally, reducing some principal. The reduction can be permanent (forgiveness) or temporary (forbearance).
For loans held by banks or investors, servicers use both types.
But Fannie and Freddie only allow forbearance.
Under forbearance, a portion of the principal is set aside. The homeowner does not make payments on the setaside portion, nor does it accrue interest. It only becomes due when the homeowner sells the home or refinances or pays off the loan. It’s similar to a “sleeping second” mortgage.
Forbearance accomplishes the same goal as forgiveness — lowering the payment — but gives Fannie and Freddie (and by extension taxpayers) the chance to recoup some or all of the sleeping principal if property values improve.
If the principal is forgiven, any increase in value above the reduced loan balance goes to the homeowner.
The crux of the issue is, “who gets the upside,” Demarco said in a speech at the Brookings Institution April 10.
The argument in favor of principal forgiveness: Some studies show that borrowers who receive a permanent reduction are less likely to walk away from their homes than those who get forbearance. The question for Demarco’s agency is whether the savings from fewer defaults offset the cost of permanent principal reductions.
In January, the agency released an analysis that said they do not. But that study did not factor in the incentives the Treasury Department is offering for permanent reductions.
In late 2010, the Treasury began offering payments to mortgage holders when they permanently reduce principal under Hamp on mortgages with a loan-tovalue ratio higher than 115 percent. The uptake was small, and earlier this year, the Treasury tripled the incentives. They are now 18 to 63 cents for every dollar of principal reduction.
When Demarco’s agency revised its earlier study and added the tripled incentives, it concluded that Fannie and Freddie losses would be reduced by $1.7 billion if they allowed permanent principal reductions. But that includes $3.8 billion in incentive payments from the Treasury, “which would imply a net cost to the taxpayer overall of $2.1 billion,” Demarco said.
This calculation does not include two factors that are difficult to quantify.
One is the benefit to communities and housing market stability if debt forgiveness reduces foreclosures.
The other is moral hazard. About threefourths of Fannie’s and Freddie’s deeply underwater borrowers are current on their loans. If they can get principal forgiveness under Hamp, how many will stop paying their mortgage to get the reduction?
At some point, these so-called strategic modifiers would wipe out the $1.7 billion in savings.
On private-sector loans, servicers can pick and choose where forgiveness makes sense, but Fannie and Freddie have to develop one program for all of their loans.
Developing a one-sizefits-all principal forgiveness program also raises other thorny issues.
For example, is it fair to forgive principal for borrowers who are underwater because they did a cash-out refi at the peak of the market and spent the money on trips or cars?
Second loans
And if the homeowner has a second loan or mortgage insurance, any modification of the first mortgage — including principal reduction — that reduces the risk of foreclosure benefits the mortgage insurance company or second-lien holder. Should taxpayers subsidize them?
Demarco says “well over half” of seriously delinquent, underwater Fannie and Freddie mortgages have a second loan or mortgage insurance.
“Some proponents of principal forgiveness would limit eligibility in various ways such as precluding it for cash-out refinance loans or loans with mortgage insurance,” Demarco says.
Others have proposed “shared appreciation” modifications where principal would be written down but if the home was sold for a profit, the homeowner and the mortgage holder would share the appreciation.
In 2009, Congress authorized a modification program for loans backed by the Federal Housing Administration that included shared appreciation, but the program flopped for a variety of reasons.
“The shared appreciation feature was problematic, with no cap on the amount of shared appreciation, either in terms of dollars or time,” FHA spokesman Lemar Wooley says.
In his speech, Demarco cautioned that his decision “is not about some huge differencemaking program that will rescue the housing market. It is a debate about which tools, at the margin, better balance two goals: maximizing assistance to several hundred thousand homeowners while minimizing further cost to all other homeowners and taxpayers.”