Geithner’s Math Puzzle Beyond Numbers for DeMarco: Mortgages

Timothy F. Geithner is giving Edward J. DeMarco, Fannie Mae and Freddie Mac’s overseer, some math homework. For DeMarco, it’s more of a psychology question.

Geithner, the U.S. Treasury secretary, is offering new incentive payments to the two government-supported mortgage financiers if DeMarco drops his opposition to principal reductions for homeowners whose loans are backed by the companies. Geithner told Congress yesterday he was sure the economics would work in favor of debt reductions “in some circumstances.” The Treasury would pay a maximum of 63 cents for each dollar of loan forgiveness as part of its expanded Home Affordable Modification Program.

It’s not just a question of whether the numbers add up, DeMarco said in an interview at Bloomberg’s headquarters in New York yesterday. The Federal Housing Finance Agency also is examining for the first time whether forgiveness would encourage defaults among borrowers who have kept making payments on mortgages that exceed the values of their homes, he said. The analysis may be finished by mid-April.

“The principal forgiveness debate for FHFA is not a question of should we forgive principal versus should we be foreclosing on borrowers that stop making mortgage payments,” DeMarco said. “We’ve got to consider all of the ramifications of principal forgiveness relative to other tools.”

DeMarco faces mounting pressure as President Barack Obama’s administration, Congress and the Federal Reserve seek to turn around a housing market that’s lost 34 percent since the 2006 peak, and wiped out $7 trillion of household wealth. Proponents from Martin Feldstein, a chief economic adviser to the late President Ronald Reagan, to activist groups such as have called on DeMarco to allow writedowns. Congressional Democrats including Rep. Elijah Cummings of Maryland have accused him of blocking a recovery and called on him to resign.

FHFA Unconvinced

Last month, the five largest U.S. banks agreed to offer mortgage forgiveness as part of a $25 billion accord with federal regulators and state attorneys general that settled charges of abusive foreclosure practices by lenders.

FHFA is not yet convinced principal reductions are the best answer, DeMarco said, in part because the agency still must examine how offering loan writedowns would affect the behavior of underwater borrowers who are still making their payments on time. Until now, the agency hasn’t specifically focused on the issue of whether loan forgiveness would create a moral hazard by providing an incentive for borrowers to default. That’s because without the extra incentives offered by the government this year, debt forgiveness was more costly than forbearance as most underwater borrowers would stay in their homes if given a low enough payment, according to its analysis.

Negative Equity

About 12 million borrowers are weighed down by $700 billion in aggregate negative equity, according to a report the Federal Reserve sent to Congress on Jan. 4.

Fannie Mae and Freddie Mac guarantee almost 3 million mortgages that are underwater. Of those, most are not delinquent, DeMarco said.

“Three out of every four underwater homeowners with mortgages by Fannie and Freddie are current,” DeMarco said in an interview on Bloomberg Television’s “Street Smart” with Trish Regan. “These borrowers are making their monthly mortgage payments by honoring their obligations.”

In a January analysis sent to Congress, FHFA said it would cost Fannie Mae and Freddie Mac an additional $100 billion to write down all 3 million loans to the value of the homes securing them.

Violating Legal Responsibility

The U.S. government has spent $190 billion to shore up the companies since they were taken into federal conservatorship in 2008 after their investments in risky loans soured. DeMarco said adding to the firms’ costs would be a violation of his legal responsibility to restore them to financial health.

Using principal forbearance instead of forgiveness so far has been better for taxpayers, DeMarco said. Forbearance reduces monthly payments while requiring borrowers to pay back the full amount of the loan when they sell the house.

“If the borrower is successful on the modification, allows them to stay in their house and they stay in their house and start making mortgage payments, the taxpayer gets to share in the upside of that borrower’s success,” DeMarco said in the Bloomberg Television interview. “If we forgive the principal up front and the borrower is successful, that upside all goes to the borrower and is not shared with the taxpayer.”

No Slam Dunk

Paul Willen, senior economist at the Federal Reserve Bank of Boston, offered evidence in a 2008 study that suggests DeMarco’s concerns about principal reductions may be right.

He found only 5.2 percent of borrowers underwater by 20 percent or more during the 1990s in Massachusetts lost their homes. Two-thirds of those still in homes in 1994 would have had positive equity if they avoided foreclosure until 2000.

“The idea that there’s a slam-dunk case for principal reductions isn’t true,” Willen said in an interview.

That hasn’t stopped forgiveness from becoming increasingly popular among banks and servicers of securities without government backing, according to new data released yesterday by the Office of the Comptroller of the Currency.

Principal reductions were granted in 8.5 percent of the 116,153 delinquent mortgages that received permanent modifications in the fourth quarter, according to a report by the regulator. That’s up from 8.1 percent in the prior three-month period. Debt forgiveness was included in 16 percent of loans held by private investors and 25 percent of loans held in bank portfolios.

PIMCO, Lippmann Support

Pacific Investment Management Co., manager of the world’s biggest bond fund, hedge-fund manager Greg Lippmann and analyst Laurie Goodman at Amherst Securities Group LP also have voiced support for the idea of loan forgiveness.

“We’ve been behind responsible, intelligent principal modifications for two-plus years,” Scott Simon, managing director at Newport Beach, California-based Pimco, said in a telephone interview. Banks and bondholders can be best served by balance reductions that allow borrowers to refinance into new government-backed loans, he said. At the same time, Simon said that DeMarco must follow his congressional mandate to make sure Fannie Mae and Freddie Mac are sound.

DeMarco said he hasn’t seen evidence that homeowners re-default much less after getting principal reductions, so long as they’re offered an affordable payment. Analysts such as those at Credit Suisse Group AG agree with DeMarco’s assessment, while Amherst comes to the opposite conclusion.

Taxpayer Risk

Michael Barr, assistant Treasury secretary for financial institutions from 2009 to 2010, said that homeowners with “significantly high levels” of negative equity have been shown to stop paying their mortgages more frequently than those with lower levels of negative equity. Reducing defaults among them will help the real-estate market, and hence Fannie Mae and Freddie Mac, he said.

“If you’re not able to stabilize the housing market, taxpayers are further at risk,” said Barr, now a professor at the University of Michigan’s law school in Ann Arbor. “So, there are benefits to taxpayers in the medium-term in taking steps that in the short-term may cost taxpayers some funds.”

Homeowners who said they knew someone who strategically defaulted were 51 percent more likely to say they would in surveys done for a June 2011 paper by Luigi Guiso of the European University Institute, Northwestern University’s Paola Sapienza, and Luigi Zingales of the University of Chicago.

‘Social Contagion’

That underscores the risk of “social contagion” as the stigma of walking away from properties decreases or borrower understanding of the often minimal consequences grows, the researchers wrote.

Many homeowners don’t even realize they are underwater, according to the paper. The 2009 surveys found that between 9 percent and 16 percent of respondents estimated they have negative equity, compared with national rates calculated by CoreLogic Inc. during the period between 21 percent and 35 percent. Adjusting borrowers’ views of their home prices downward by 20 percent brought the ratios more in line.

Data that Credit Suisse analysts led by Dale Westhoff examined show essentially no difference in re-default rates among delinquent borrowers given only payment reductions and those also offered smaller mortgages.

Based on loans in mortgage bonds without government backing, about 40 percent of borrowers whose payments were cut between 20 percent and 40 percent defaulted again after 12 months, regardless of whether they were more than 60 percent underwater or had home equity between zero and 20 percent, according to Credit Suisse.

‘Unprecedented Times’

A December report by Goodman’s team at Amherst shows that among subprime borrowers who received payment reductions of more than 40 percent in 2010, 19 percent defaulted after 12 months if their reworked loans included a lower balance, while 27 percent fell behind again if they only received a lower rate.

How borrowers will react over time is difficult to know.

“The fact of the matter is we’re in unprecedented times,” said Scott Theobald, the chief risk officer for Philadelphia-based Radian Group Inc., the top U.S. mortgage insurer by new business. “If I had the numbers for that, I’d be a wealthy man.”

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