Widespread principal reduction for underwater homes has long been the Holy Grail for many observers of the housing market, as well as for those who believe the weak housing market is one of the heaviest burdens weighing on the broader economy. Supporters of writing down mortgages to reflect their current values say that it’s a win-win solution: Underwater homeowners would obviously benefit from having their liability reduced, but mortgage lenders would also, in theory, benefit because principal reduction is usually much less expensive than the foreclosure process — and severely underwater homeowners are much more likely to default on their loans than are those who have some equity.
Even if you’re not an underwater homeowner, this pertains to you because American taxpayers — through the government’s conservatorship of Fannie Mae and Freddie Mac — own or guarantee roughly 60% of the outstanding mortgages in America. So if proponents of principal reduction are correct, implementing such a plan through Fannie and Freddie would save taxpayers money, help out struggling homeowners, and stimulate the broader economy.
So why haven’t we implemented this? The man in charge of Fannie and Freddie, FHFA Acting Director Ed DeMarco, doesn’t see eye to eye with the principal reduction crowd. He has argued that existing programs put forward by the Treasury and FHFA are just as effective as principal reduction, and that a program of principal reduction would attract dishonest “strategic modifiers” who would abuse a program they don’t actually need. If enough people did this, DeMarco has argued, the program would no longer be cost effective for the taxpayer, and therefore counter to his Congressional mandate to limit taxpayer losses.
When DeMarco last spoke publicly about his efforts to help struggling homeowners, he said that his organization was still studying the issue, in light of new incentives offered by the Treasury Department to pursue principal reduction. Well, the study is now complete and information contained in it was leaked to The Wall Street Journal Monday by “people briefed on the findings.” According to the article, the study contradicts the claim that the FHFA made in April that principal reduction wouldn’t be cost effective:
“In April, the agency said that loan forgiveness would save about $1.7 billion for the companies, relative to other types of relief. At the time, the agency said that because the Treasury was paying to subsidize those write-downs, the relief would still cost taxpayers $2.1 billion, offsetting any savings to the companies.
But the latest analysis done by the agency found that such write-downs would generate $3.6 billion in savings for the companies, under certain assumptions, according to people familiar with the analysis. Even after subtracting the cost of the Treasury subsidies, the program would save $1 billion, these people said.”
But not so fast. In a letter sent yesterday to the Senate Banking Committee, DeMarco announced that he would not allow Fannie and Freddie to participate in a principal reduction program. Wrote DeMarco: “The potential benefit was too small and uncertain relative to known and unknown costs and risks.”
So were the Journal‘s sources lying? Perhaps not, but according to DeMarco’s letter they left out several factors that would increase costs to taxpayers including implementation costs, the diversion of labor from existing loss-mitigation programs, and the aforementioned “strategic modifiers,” who DeMarco believes would dishonestly come seeking taxpayer aid.
The decision stirred up the fresh ire of the Treasury Department, which has been increasingly vocal in its support for broad-based principal reduction. In a letter to DeMarco, also fired off yesterday, Treasury Secretary Tim Geithner criticized the decision, saying he was “concerned by [DeMarco's] continued opposition” to principal reduction.
By yesterday afternoon, criticism for DeMarco’s decision abounded. Jared Bernstein, former Chief Economist and Economic Adviser to Vice President Joe Biden thinks DeMarco is grossly overstating the costs required to implement principal reduction because he is philosophically opposed to such measures:
“One can only conclude that he’s got a deep aversion to reducing principal. This is something you often see among bankers and lenders who view any sort of write down as the unacceptable breaking of a contract.”
Because an the analysis conducted by the FHFA involves so many assumptions as to the costs of implementation, and most importantly how many “strategic modifiers” the program would engender, one could conceivably make the analysis say whatever one wanted it to say. Certainly DeMarco’s critics are accusing him of doing just that. So depending on your point of view, DeMarco is either a courageous public servant, standing up for taxpayers in the face of unwarranted criticism, or a clueless bureaucrat blinkered by his irrational reverence for the sanctity of contracts.