Forgiving mortgage principal invites greater risks

To err is human, to forgive is divine. That seems to be President Obama’s thinking when it comes to mortgages. He wants lenders to forgive significant amounts of principal owed by homeowners who are in over their heads.

The tactic hits political hot buttons because many voters who were cautious about taking on debt during the housing bubble loathe the idea of bailing people who weren’t. Yet Obama is pressing on.

His most recent expansion of his 2009 Home Affordable Modification Program relies heavily on principal reductions, not just tactics such as

Let the housing market heal itself

lowering interest rates or extending repayment schedules. He also wants to expand the program to the 60% of home loans owned or guaranteed by the government-controlled mortgage giants Fannie Mae and Freddie Mac, which could put these troubled institutions back in the business of inflating housing bubbles.

This would, without question, add a potent economic stimulus. Helping people who are behind on their mortgages would ease the foreclosure crisis, which drags down home values for everyone.

Even so, it is a misguided idea. It’s principal flaw is highlighted by Edward Demarco, acting director of the Federal Housing Finance Agency, which oversees Fannie and Freddie. Demarco, a technocrat first appointed by then-president George W. Bush, points out that it would reward bad behavior.

This is more than a simple value judgment. Demarco — whose resistance to the plan makes him a target for some liberal groups — foresees a strong chance that some people who are current on their payments would stop paying to qualify for the government’s generosity. That would undermine the very reason behind the plan.

It also amounts to an exceptionally sweet deal for banks. Much of the money spent under the much-reviled Troubled Asset Relief Program of 2008 was less a bailout than a shrewd investment. As of December, the Treasury had received a return of $258 billion on $245 billion put in bank stock. But the $75 billion in TARP money used to assist borrowers really is a bailout that taxpayers will never recoup.

The final problem with the administration’s plan deals with Fannie Mae and Freddie Mac. The pressure that Demarco is under to sign off on their participation in debt forgiveness is eerily similar to the pressure that Fannie’s and Freddie’s critics found themselves under in the years leading up to the financial crisis.

For decades, the two companies exposed taxpayers to vast risk in the name of promoting home ownership. Whenever critics raised questions, they were neutralized by Fannie’s and Freddie’s legions of lobbyists and friends on Capitol Hill.

Now, just a few short years after Fannie’s and Freddie’s collapse cost taxpayers $187 billion, something similar is happening.

This pressure undermines the effort to reform, downsize, or even eliminate Fannie and Freddie that most economists and government leaders say is necessary. They simply cannot be allowed to resume business as usual when the housing economy recovers. That would invite a recurrence of the recent crisis.

As for dealing with the immediate problems in housing, the government should focus on those borrowers who owe more than the value of their home but are still current on their payment. Most of them can’t even refinance to today’s lower rates for lack of equity despite their responsible behavior.

This would not have as big an impact on the housing market as Obama’s plan. But it wouldn’t do as much long-term damage to the economy, either. Forgiveness may be a virtue, but in this case it is not good policy. Better to step back and let the housing market heal than to create new risks by freeing people from obligations they voluntarily took on.