Debate Rages Over Principal Forgiveness at Fannie and Freddie

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The man at the center of the controversy over writing down mortgage principal on Fannie Mae and Freddie Mac loans isn’t wavering. He may be reconsidering previous loss formulas, factoring in new government subsidies for principal write-down, but his opinion seems largely unchanged.

After beginning a speech this morning about all the so-called “Enterprises” (Fannie and Freddie) have done to help millions of borrowers behind on their mortgage payments, and reminding listeners of his agency’s mandate to, “preserve and conserve the assets of the Enterprises,” FHFA Acting Director Ed DeMarco took a left turn.

“There is another human element in this story that does not seem to receive much attention,” DeMarco continued. “Clearly, many households got over-extended financially. Some accumulated debts they couldn’t afford when hours or wages were cut or jobs were lost. Others withdrew equity from their homes as house prices soared. Others bought houses at the peak of the market, often with little money down, perhaps in the belief house prices would continue to climb. Yet there are other Americans who did not do these thing.”

That last part really clinches what may eventually be his decision not to allow principal forgiveness, or to do it in an extremely narrow way. Yes, there are all kinds of formulas, and “net present value” analyses that have been and continue to be run. There will be Enterprise gains offset by taxpayer losses, and there will be estimates of operational costs to implement a wide-ranging and necessarily transparent program. But in the end, less than one million borrowers would be helped, and for DeMarco, as for many others, it will come down to fairness and cheating.

“One factor that needs to be considered is the borrower incentive effects. That means, will some percentage of borrowers who are current on their loans, be encouraged to either claim a hardship or actually go delinquent to capture the benefits of principal forgiveness?” asks DeMarco.

“This is a particular concern for the Enterprises because unlike other mortgage market participants that can pick and choose where principal forgiveness makes sense, the Enterprises must develop the program to be implemented by more than one thousand seller/servicers. In addition, the Enterprises will have to publicly announce this program and borrower awareness of the possibility of receiving a principal reduction modification will be heightened among Enterprise borrowers,” he explains.

In other words, this opens the flood gates to cheating. The fact is that there are 11 million borrowers who currently owe more on their mortgages than their homes are worth and yet the vast majority of them are still making monthly payments. Those who haven’t been paying have been delinquent, in some cases, for many years. The concern is that borrowers who are current on their loans might think it’s unfair that those who are not current are being rewarded and they are not. It would take a relatively small group of them strategically defaulting to offset the gains of any principal reduction program and turn it into a massive debacle.

“The far larger group of underwater borrowers who today have remained faithful to paying their mortgage obligations are the much greater contingent risk to housing markets and to taxpayers. Encouraging their continued success could have a greater impact on the ultimate recovery of housing markets and cost to the taxpayers than the debate over which modification approach offered to troubled borrowers is preferable,” concludes DeMarco.

He is expected to announce a decision on principal reduction this month, but the analysts are already out:

“We see this as a strong political attack against principal reduction,” says Jaret Seiberg of Guggenheim partners.

The Obama administration is clearly pushing for it, with Treasury Secretary Timothy Geithner recently telling a Senate panel that there is a, “very strong economic case” for principal write-down. He suggested DeMarco, “take another look at the math,” which DeMarco is obviously doing. The trouble is, when it comes to today’s housing market and today’s borrowers, paying your mortgage, whatever it’s worth, is not always a simple equation.

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