Principal forgiveness may soon become the newest addition to FHFA’s quiver in the fight against foreclosures, thanks to a new incentive from the Treasury Department, which has tripled the amount it will offer Fannie and Freddie to up to 63 cents for every dollar the enterprises write down on qualified mortgages.
Edward DeMarco, acting director of the Federal Housing Finance Agency (FHFA), which took over conservatorship of Fannie and Freddie after the enterprises were bailed out in 2008, has resisted calls from the Obama Administration and Democrats to allow such write-downs. But a new study conducted by FHFA has found that, with the Treasury incentive, principal reduction would cut losses to the GSEs by $1.7 billion. Given FHFA’s mandate to minimize the amount of taxpayer money lost through Fannie and Freddie, DeMarco may be legally obligated to implement the policy.
"FHFA’s job is to preserve and conserve the assets of the enterprises," DeMarco said in a presentation delivered at the Brookings Institution on Tuesday. However, he is far from enthusiastic about the prospect of principal forgiveness. Instead, he prefers principal forbearance, in which lenders set aside the underwater portion of a loan’s principal, do not charge interest or take payments on it, but then ask that the amount be repaid should the borrower sell the home for a profit down the road. "That gives the taxpayer the opportunity to share in that upside," DeMarco says.
But according to the report, the GSEs are expected to lose $63.7 billion from the 690,000 loans that would qualify for the program if no modifications are made. To be eligible, a borrower would need to have a loan-to-value ratio of more than 115% and be "in default or in imminent risk of default."
While a principal forbearance program could be expected to bring losses down to $55.5 billion, a principal forgiveness program would reduce expected losses to $53.7 billion, the study found. (That number includes an estimated $3.8 billion in payments from the Treasury in principal forgiveness incentives, with a net cost of $2.1 billion for taxpayers. An average write-down is expected to amount to $51,000 per mortgage.)
Still, DeMarco expressed a number of mitigating factors that could negate any potential benefits, including net value impacts, operational costs to implement the program, and most importantly the effect a principal forgiveness program might have on those borrowers who hold underwater mortgages but have thus far managed to keep up with payments.
Among deeply underwater mortgages held by the GSEs, three out of four are still current—a far larger pool than that of delinquent borrowers, and one that could potentially cause far more damage should those owners decide there was a strong enough incentive to stop making their payments.
"Will some percentage of borrowers who today are deeply underwater but current on their mortgage be encouraged to either claim a hardship or actually go delinquent in an attempt to capture the benefits of principal forgiveness?" he asked on Tuesday. Nationwide, an estimated 11 million mortgage holders are underwater, of which between 2.5 million and 2.6 million have loans backed by Fannie and Freddie. "It’s that 2 million we’re particularly concerned about," DeMarco said.
HUD Secretary Shaun Donovan dismissed the possibility as a major threat during a C-SPAN interview last week, saying, "The vast majority of homeowners don’t operate that way."
But while many private mortgage companies have already begun principal forgiveness, a program under the enterprises would be more difficult to guard against strategic defaulters, DeMarco says, due to the transparency necessary in government programs. While private institutions can pick and choose where they offer write-downs, FHFA would have to come up with criteria that could be "implemented the same way by more than a thousand seller servicers." There would also be greater public awareness that such forgiveness was an option, should it be offered through the enterprises, he says.
But while abuse of the system is a risk, such abuses would have to be quite widespread to negate the benefits. If all 691,000 eligible borrowers receive a principal reduction, it would take another 90,000 "strategic modifiers" to cancel out the program’s financial benefits, and "that’s unlikely," DeMarco said.
But additional strategic default is certainly possible. "There’s another human element in this story that does not seem to receive much attention," he said, while outlining some of the circumstances in which families overextended themselves. "There are families that did not move up to that larger house because they weren’t comfortable taking the risk. … And there are people working multiple jobs or cutting back on the family budget in many ways to continue making their mortgage payments through these tough times. Many of these families are themselves underwater on their mortgage, even though they may have made a sizeable down payment."
There are plenty of unknowns as well. The study didn’t take into account, for example, the potential impact on neighborhoods and surrounding home values should write-offs prevent foreclosures. And while those potential benefits are difficult to calculate, "there’s no doubt that defaults cause property values to deteriorate, and the default itself leads to property values falling," says Richard Green, director of the USC Lusk Center for Real Estate, in an interview with Builder. "It’s almost certainly a good thing to reduce defaults if possible."
As for the impact on home prices in real estate markets at large, Green doesn’t believe a GSE write-down program would have a large impact, and the impact it did have "could work in two ways," he says. Should the program reduce the number of distressed properties on the market it would serve to prop prices up. On the other hand, should reduced principal give people who were previously pinned beneath an upside down loan the freedom to move, that might flood markets with sales.
What he would prefer to see would be a program where buyers are selectively chosen for principal write-downs, with the caveat that they use proceeds from a successful sale to repay at least some of the forgiven debt. "A program that focused on places with unemployment rates of more than 10% where house prices have fallen more than 30%, I would absolutely support," he says. "There’s no moral hazard there."
Of course, not everyone is so enthusiastic. "The taxpayers’ cost for principal reduction generally exceeds the benefit created," said Frank Keating, president of the American Bankers Association, in a released statement. "Modifying loans in ways other than reducing principal has proven to be more effective for troubled borrowers."
For Anthony Sanders, a Mercatus Center Scholar at George Mason University and one of the panelists who discussed the proposed policy change at Brookings, there’s simply not enough data to justify the change. "Other than anecdotal tales of how principal reductions help avoid foreclosures, there is very limited data available in order to make a sensible policy decision," he wrote on his blog after the event. "When it doubt, don’t do it!"
Claire Easley is a senior editor at Builder.
Learn more about markets featured in this article: Greenville, SC.