FHFA chief blocks Fannie Mae & Freddie Mac from granting principal reductions
Fannie Mae and Freddie Mac will not be allowed to grant principal reductions to help ‘underwater’ homeowners avoid foreclosure, the Federal Housing Finance Agency announced yesterday.
Stressing the agency’s statutory mandate to minimize taxpayer losses, acting FHFA Director Edward DeMarco rejected the Treasury Department’s offer to triple incentives for investors who agree to reduce principals for distressed borrowers.
“I have concluded that Fannie Mae and Freddie Mac’s adoption of [mortgage principal reduction] would not make a meaningful improvement in reducing foreclosures in a cost effective way for taxpayers,” DeMarco wrote in a letter addressed to Senate Banking Committee Chairman Tim Johnson (D-S.D.).
The formal decision was reached after months of debates on whether the two government-sponsored enterprises should participate in the Treasury Department’s Home Affordable Modification Program Principal Reduction Alternative (HAMP PRA) program. Under the program, the Treasury Department would use some of the Trouble Asset Relief Program (TARP) – or Wall Street bailout – funds to compensate investors who agree to reduce principal of loans that exceed the homes’ market value.
Granting principal reductions would lower the borrowers’ monthly payment to avoid default and foreclosure. However, DeMarco pointed out that standard loan modifications – including interest rate reductions, term extension, and forbearance – can achieve the same goal but without investors having to incur permanent losses.
DeMarco’s rejection drew a swift rebuke from Treasury Secretary Timothy Geithner.
“I do not believe it is the best decision for the country, because, as we have discussed many times, the use of targeted principal reduction by [Fannie Mae and Freddie Mac] would provide much needed help to a significant number of troubled homeowners, help repair the nation’s housing market, and result in a net benefit to taxpayers,” Geithner wrote to DeMarco.
Treasury disputes FHFA’s “selective numbers”
DeMarco claimed that the Treasury’s principal reduction program would only provide relief for 74,000 to 248,000 borrowers without Fannie Mae and Freddie Mac incurring losses but at a cost to taxpayers of $188 billion. He said that under the best case scenario taxpayers would receive a net benefit of only $500 million.
However, Geithner pointed out that FHFA’s prior analysis showed that the principal reduction program would help as many as 500,000 distressed homeowners, save Fannie Mae and Freddie Mac $3.6 billion more compared to standard loan modifications, and give taxpayers a net benefit of up to $1 billion. The FHFA’s analysis, Geithner stressed, also found that the re-default rates are lower for loan modifications with principal reductions compared to standard loan modifications, indicating that principal forgiveness is more effective in helping homeowners avoid foreclosure.
“We believe that implementation of the principal reduction alternative under Treasury’s mortgage modification program is not only consistent with FHFA’s statutory responsibilities but is also the most prudent way for FHFA to meet its obligation,” Geithner stated.
“Moral hazard” of “strategic default”
DeMarco also argued that allowing principal forgiveness would set a dangerous precedence for “strategic default” where borrowers who are current on their loans would purposely stop making payments to claim hardship in the hopes of reducing their mortgage principals.
“This could give borrowers who are current on their mortgages a message that the government endorses forgiving a portion of mortgage debt if hardship can be demonstrated, creating a broad incentive for underwater borrowers to seek ways to become eligible,” DeMarco explained.
The Treasury rebutted the so-called “moral hazard” argument, maintaining that the HAMP PRA program was designed to prevent “strategic default”. To be considered for the HAMP PRA, a borrower must first sign an affidavit demonstrating financial hardship and at risk of imminent default. Second, Fannie Mae and Freddie Mac are required to assess whether granting a principal reduction would result in fewer losses than a standard loan modification. And finally, the borrower’s modified mortgage payment must meet the program’s debt-to-income criteria.
“A borrower would take a substantial risk by deliberately defaulting: they would have to choose to damage their credit for years to come and perjure themselves on the chance that they would be found eligible for the program,” according to the Treasury’s analysis. “In essence, a borrower who defaults cannot be certain that he or she will obtain a HAMP modification, much less a HAMP modification with principal reduction.”
Uncertainty for investors
Finally, DeMarco cited the potential adverse long-term impact on the stability and liquidity in mortgage markets if investors can’t be certain that mortgage contracts won’t be changed down the road.
“Forgiving debt owed pursuant to a lawful, valid contract risks creating a longer-term view by investors that the mortgage contract is less secure than ever before. Longer-term, this view could lead to higher mortgage rates, a constriction in mortgage credit lending or both, outcomes that would be inconsistent with FHFA’s mandate to promote stability and liquidity in mortgage markets and access to mortgage credit,” DeMarco stated.
The Treasury noted that the HAMP PRA program is supposed to be applied on a loan-by-loan basis and used only when “the modified loan has a positive net present value (NPV) that is greater than any other modification.” To put it another way, Fannie Mae and Freddie Mac could choose to grant principal reductions only in cases where they would save their investors – namely, taxpayers – money.
Geithner urges DeMarco to reconsider
Given that more than half of the outstanding mortgages in the U.S. are held by Fannie Mae and Freddie Mac, the FHFA’s decision would deal a substantial blow to the Obama administration’s housing recovery efforts.
Geithner urged DeMarco to reconsider his stance, writing that “five years into the housing crisis, millions of homeowners are still struggling to stay in their homes. You have the power to help more struggling homeowners and help heal the remaining damage from the housing crisis.”
- FHFA.gov: Letter from Edward DeMarco to Senate Banking Committee Chairman Tim Johnson – July 31, 2012 (PDF)
- Treasury.gov: Letter from Treasury Secretary Timothy Geithner to FHFA Acting Director Edward DeMarco – July 31, 2012 (PDF)
- WhatTheFolly.com: Fannie Mae & Freddie Mac considering mortgage principal reductions
- WhatTheFolly.com: 3 reasons why the FHFA opposes mortgage principal reduction
- WhatTheFolly.com: Transcript: FHFA Director Edward DeMarco on mortgage principal forgiveness