Since the financial crisis, American taxpayers have collectively made all sorts of investments that would have been unthinkable ten years ago. We bought stakes in the auto and insurance industries and, perhaps most significantly, the residential housing market. Fannie Mae and Freddie Mac, the Government Sponsored Entities (GSEs) that the American government has taken under conservatorship, own or guarantee 60% of the outstanding mortgages in America. That’s right, we are financially exposed to over 48 million mortgages. If a given home owner pays back his loan, plus interest, we’ll make a nice return on the investment. But if that homeowner defaults, we’re all on the hook for the loss.
Ed DeMarco, the man in charge of these two GSEs, therefore has a lot riding on his shoulders. When Congress passed the law allowing the federal government to take over Fannie and Freddie at the height of the financial crisis, it gave DeMarco’s Federal Housing Finance Agency (FHFA) two mandates: to prevent further loses on mortgages that the taxpayers now owned, and to continue to promote the stability of and liquidity in the U.S. housing market.
DeMarco’s problem is just how to go about achieving these goals. The housing market has entered uncharted territory. Between 2005 and 2011, according to the Federal Reserve, the total decline in housing wealth has been over $7 trillion. The total amount of “negative equity” (that is, the amount owed on American homes that are “underwater” minus their combined market value) is over $700 billion. Simply put, the taxpaying public owns a whole bunch of questionable loans that will probably continue to cost us money.
DeMarco spoke last week at the Brookings Institute about this problem, and made clear that he believes the best strategy going forward is something called “principal forbearance,” under which Fannie and Freddie will temporarily reduce the amount owed on a mortgage until the mortgage matures or the homeowner sells his house.
To illustrate how this program might work, let’s look at the fictional case of Joe from Nevada. In 2004, Joe bought a $250,000 home for his family, putting 20% down and taking out a 30-year mortgage to cover the remaining $200,000. Then the financial crisis struck. Home prices across the nation, and especially in Nevada, collapsed. Joe’s wife was laid off from her job, cutting the family’s income in half. Today, Joe’s house is worth only $125,000.
To this you might say, “Tough luck Joe; you shouldn’t have bought an overvalued house.” But the collapse in the value of Joe’s house isn’t only Joe’s problem; it’s also the problem of whomever loaned him that $200,000. Because Joe might decide to walk away from his house, which can only be resold for $125,000, and walk away from the commitment to pay the remaining $75,000 on the mortgage. And, via Fannie and Freddie, taxpayers are on the hook for that $75,000.
Principal forbearance is meant to prevent that outcome. In Joe’s case, Fannie and Freddie would temporarily set aside the $75,000, interest free, and allow Joe to pay back his mortgage as if he owed only what his house is currently worth. He will eventually have to pay back the entire amount loan, but in the meantime he lowers his monthly housing costs, in some cases for decades. That will theoretically give his wife time to find another job, and in the best-case scenario, time for the market price of his home to appreciate to its previous value.
This strategy obviously helps homeowners. But it also can benefit taxpayers because of a feature called “shared appreciation”: In exchange for the forbearance, the lender gets part of the upside if the home appreciates. If Fannie and Freddie were instead to write down the value of the loan altogether — this is the “principle reduction” strategy that many critics of DeMarco are advocating — taxpayers would take a loss even if the home regains its value over the next several years.
So forbearance sounds like a win-win, right? In theory, yes — but some experts think there’s a big flaw in the theory. Namely, they believe that loan forbearance will not be as effective as loan forgiveness at convincing homeowners to continue paying off their loans. Andrew Jakabovics, for example, a senior director at Enterprise Community Partners, says that there are powerful psychological incentives associated with principal forgiveness: “Borrowers feel reinvested in their homes.” Indeed, the evidence shows that when lenders write down the value of a loan, mortgagors are much less likely to default again down the road.
That expains why, Jakabovics argues, private sector lenders are moving towards principal forgiveness as opposed to forbearance. “It’s the private guys that are doing next-generation modifications, whereas the GSEs had been leading earlier in the process.” In fact, he says that private banks are allowing principal reductions for roughly 18% of the loans on their books, while Fannie and Freddie are sticking solely with principal forbearance.
So why isn’t DeMarco as open to forgiveness as private lenders ? Ted Gayer, a housing economist with the Brookings Institute who moderated last week’s discussion, thinks it’s partially a product of considerations other than profit and loss. A truly effective principal forgiveness program entails giving a handout worth tens of thousands of dollars to those some would consider the least responsible homeowners — i.e. those who are willing to walk away from their mortgage obligations — and that’s not politically palatable. In practice, principal forgiveness would probably have to be made available to so many homeowners that it wouldn’t save taxpayer money. “I think DeMarco would say, ‘Yeah, in certain cases principal reduction would make sense, but I can’t pick and choose.’ Fannie and Freddie have 3 million underwater homes and it’s hard to design a policy that is that selective.”
Ultimately, Gayer says, “If it’s going to be an all or nothing, then maybe forbearance is the way to go.”