The Washington Post waded into the principal reduction battle yesterday, endorsing Federal Housing Finance Agency Acting Director Edward DeMarco’s refusal to allow Fannie Mae and Freddie Mac to write down principal balances on delinquent underwater mortgages. The Post editorial endorsed what is a fatally flawed assessment by FHFA of the large potential savings to taxpayers from a carefully crafted program to reduce principal balances for delinquent underwater borrowers.
FHFA’s “analysis” of the presumed risks and rewards of principal reduction appears to be aimed at justifying the hard line that DeMarco and Fannie and Freddie have drawn against granting principal forgiveness in any form other than through short sales. In fact, both Fannie and Freddie, with FHFA’s approval, have recently moved to ramp up their short sales volumes. In a short sale transaction, the homeowner sells her house for less than the amount owed on her mortgage and the lender accepts the net sales proceeds without requiring additional payment. This is a forgiveness of mortgage principal that is equal to the amount by which the mortgage loan balance exceeded the net sales proceeds. Why principal writedowns are allowed in the form of short sales, but not in any other form, simply is incomprehensible.
Here’s what FHFA gets wrong: It compares the costs and benefits of principal reduction to those of principal forbearance when modifying delinquent mortgage loans. In a principal forbearance loan modification, a portion of principal is not included in the calculation of monthly mortgage payments, but it remains an obligation of the borrower which must be repaid in the future. So if a delinquent borrower will accept a loan modification offer that involves principal forbearance, then, of course, this is more attractive to the mortgage lender than a principal reduction modification. But that is only true if—and this is a big if—the percentage of borrowers who re-default on their modified loans are the same or lower for the loans having principal forborne versus those receiving a principal reduction.
Fundamentally, however, FHFA has evaluated the wrong things. Rather than assess a principal reduction loan modification program for delinquent underwater borrowers against standard loan modification techniques, including forbearance, FHFA should analyze the potential savings from avoiding foreclosure and short sales for those who do not enter into loan modifications or default again after having received one. In many, many instances, foreclosure and short sales are much more expensive for Fannie and Freddie—and, of course, U.S. taxpayers—than would be granting principal reductions to existing homeowners. In other words, FHFA should not be evaluating principal reduction alternatives against standard loan modifications, but rather against the alternatives of foreclosure and short sales. Doing so would change the answer to the principal reduction question.
Let’s be clear: there’s no risk-free course here. But private sector experiences suggest that a carefully conceived principal reduction program could achieve significant cost savings for U.S. taxpayers by reducing losses at Fannie Mae and Freddie Mac. Such a program can be done responsibly and fairly without fueling moral hazard — the risk that borrowers who otherwise would make their mortgage payments go delinquent in an effort to get their principal balances reduced. I have previously outlined such a program in “Another Tool in the Toolkit: Short Sales to Existing Homeowners“.