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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US Treasury Forcing Mortgage Principal Forgiveness

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Late Friday the U.S. Treasury Department announced a major expansion of its Home Affordable Modification Program (HAMP).

The three-year-old program has been largely deemed unsuccessful, as it has provided just about 750,000 borrowers with permanent loan modifications. The initial expectation from government officials was that it would help three to four million borrowers.

“Clearly the initial program erred on the side of making sure taxpayers were protected, but it didn’t do enough to help the overall economy,” said Michael Barr, former Asst. Treasury Secretary for Financial Institutions and one of HAMP’s original architects.

Now taxpayers will pony up the cash, as Treasury is tripling the financial incentives to lenders and opening the program up to Fannie Mae, Freddie Mac and investors in rental properties. The money would come out of TARP funds, i.e. from the taxpayers. We still don’t know if Fannie and Freddie will participate, since their conservator, the FHFA’s Ed DeMarco, has been actively fighting principal write down for years. A week ago he sent a letter to members of congress explaining the math behind his argument. 

But the Treasury may be forcing DeMarco’s hand. He claimed that writing down mortgage principal would cost $4 billion more than the modifications that Fannie and Freddie are doing now. Those involve interest rate reduction and principal forbearance. The newly expanded HAMP, however, with its triple- sized cash incentives, would shore up that $4 billion hole. Funny how he mentioned that hole on Monday, and the Treasury announced the new plan Friday.

“If he [DeMarco] doesn’t get to yes, then he has no political leg to stand on,” says FBR’s Ed Mills, who estimates the enhanced program could add one million borrowers to its ranks. Mills says a ‘no’ from DeMarco would enable the Obama Administration to replace him, which it tried to do once before, only to be blocked by members of Congress.

“It would be an appropriate response for him to do it,” says Barr of DeMarco. “I do think they should participate.”

I asked Barr why the Treasury waited three years to use the TARP funds for principal reduction. The obvious answer is that this is presidential election year, and the housing market is still floundering, but Barr claims the Treasury was just being careful.

“It’s a use of taxpayer funds, and you want to make sure you’re not providing more of an incentive than is required,” he said. “One person’s successful program is another person’s bailout.”

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JPMorgan Fights Back on Forced Principal Forgiveness

It's not like we didn't already know the banks were opposed to forgiving principal on troubled loans, even though they claim they are doing a little of that now. But today CNBC's Melissa Francis got an earful from JPMorgan Chase's [JPM  Loading...      ()   ] Charlie Scharf, CEO of Retail Financial Services.

"We've got to be very careful that we don't create an environment where we encourage people not to pay, and that's the danger you have when you get into broad based principal forgiveness," said Scharf.

This is all in reaction to the big push on principal reduction by state attorneys general, meeting in Washington DC this week. While the head of the 50-state investigation into so-called "Robo-signing" foreclosure paperwork issues, Iowa Attorney General Tom Miller, did not put forth a fine or penalty fund in his first settlement proposal, the expectation is that banks will be subject to such a fine that would be used for banks to write down mortgage principal.

Already, Senate republicans are blasting any payment.

Sen. Richard Shelby, the top republican on the Senate Banking Committee, at a hearing today put the number to be "extracted" from banks at $30 billion.

"I question whether removing $30 billion in capital through a back-door bank tax is the best way to jump-start lending. The long-term consequences of this settlement could be even more serious. It would politicize our financial system," Shelby said in a statement, while calling for an investigation into what he deems a "regulatory shakedown...led by Elizabeth Warren."

I'm not really interested in the politics surrounding this 'settlement,' more in what it will mean for the housing recovery going forward.

Home prices are double-dipping, foreclosures are in a standing mess due to paperwork issues, and credit to worthy consumers is only getting harder to come by.

The state AGs put out a framework for new foreclosure practices, but they intentionally didn't put out the big bad penalty number because they knew it would ignite a firestorm.

My question is: When will the firestorm start, and who will put it out?

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