Regulator Leaves Underwater Homeowners High and Dry

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By Deborah Solomon

After months of stalling, Edward DeMarco finally slammed the door on hundreds of thousands of beleaguered homeowners looking for relief.

DeMarco, acting director of the Federal Housing Finance Agency, said today that he won't allow Fannie Mae and Freddie Mac to engage in debt relief for borrowers who owe much more than their homes are worth.

In doing so, DeMarco clearly put ideology ahead of economics, hindering the housing market's recovery in the process.

Forget for a moment that DeMarco has been urged to do this by his boss, President Barack Obama, as well as by Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben S. Bernanke and that many banks are already engaging in so-called principal reduction for loans that aren't backed by Fannie and Freddie.

The most mind-boggling aspect is that FHFA's own analysis shows principal reduction would save the taxpayer-backed mortgage giants as much as $3.6 billion compared with other modification efforts. It would also prevent broader damage to the housing market by helping as many as 500,000 borrowers in danger of default.

The program is aimed at those hardest hit by the economic downturn and in need of relief: Only borrowers who can show financial hardship, such as a recent job loss, and demonstrate an ability to pay the modified loan amount qualify for principal reduction.

DeMarco has consistently objected to such a program. His arguments range from concern about the difficulty and expense of implementing principal reduction to worry that it could encourage "strategic default" by borrowers who stop making mortgage payments simply to qualify for debt forgiveness.

In a letter to lawmakers today, DeMarco said FHFA's analysis showed that such a program "would not make a meaningful improvement in reducing foreclosures in a cost effective way for taxpayers."

In drawing that conclusion, DeMarco is assuming both a low participation rate of just 50 percent and lower savings because of Treasury incentive payments, which are essentially financed by taxpayers. Still, FHFA's own numbers make a compelling case: Under "optimal" modifications (meaning those with the lowest losses to Fannie and Freddie and the biggest increase in cash flow after a modification), the companies save between $3.1 billion and $3.6 billion -- or as much as $500 million when deducting the incentive payments.

DeMarco concedes in his letter that principal forgiveness "may provide some financial benefit to Fannie Mae and Freddie Mac" but says it "presents operational challenges for them and their servicers as well as a risk of loss to the taxpayer. The program would be costly and time consuming to implement."

Those arguments fall flat. First, Treasury has offered various incentives to encourage principal reduction, including paying Fannie and Freddie as much as 63 cents for every dollar of principal they forgive. That makes the program not only affordable but lessens losses for the companies, which continue to be backed by U.S. taxpayers. Even after deducting Treasury's incentives, the FHFA analysis shows the program saves the mortgage financiers as much as $1 billion. As Treasury makes clear in a letter sent today to DeMarco, it has also offered to pay any administrative costs associated with implementing a debt relief program and help FHFA with staffing needs.

There's also a way to structure a program so that it's both cost-effective and punitive enough that it doesn't reward irresponsible behavior. View editors and others have advocated a shared-appreciation model, in which Fannie and Freddie agree to forgive as much as 50 percent of a borrower's debt in exchange for a share in any future home price appreciation. This allows the companies to participate in any upside and takes a bite out of most Americans' biggest asset -- their home -- making them unlikely to simply stop paying their mortgages in order to win debt relief.

Even absent shared appreciation, debt relief is unlikely to prompt a wave of structural defaults. First, the program requires eligibility tests, including demonstrated financial hardship. Second, anyone who deliberately defaults takes a huge risk in damaging their credit. Third, default doesn't guarantee debt forgiveness or any type of loan modification. Fannie and Freddie would have been required to use what's known as a Net Present Value model, which compares the financial benefit from a loan that's modified with one that's not. A loan that's NPV "positive" is considered a good candidate for modification, since it will improve cash flow for the investor in the loan. Such a test generally eliminates borrowers who aren't in danger of foreclosure or who have positive equity in their homes, since the lien-holder is unlikely to suffer losses if the loan isn't modified.

Perhaps this is why a recent report by Fitch Ratings, which looked at the principal reduction required by the national mortgage settlement, found "there does not appear to be any sign yet of a material change in the behavior of underwater borrowers attempting to strategically default to qualify for a reduction."

(Deborah Solomon is a member of the Bloomberg View editorial board. Follow her on Twitter.)

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-0- Jul/31/2012 19:34 GMT