Publication

Overview

Edward DeMarco, acting director of the Federal Housing Finance Agency (FHFA), is drawing fire from congressional Democrats for preventing Fannie Mae and Freddie Mac from writing down the principal on home mortgages held by underwater borrowers. With U.S. taxpayers already on the hook for nearly $200 billion in losses incurred by Fannie and Freddie since September 2008, DeMarco understandably doesn’t want to make a bad situation worse.

The lawmakers, however, have a point. The housing slump may be the most significant brake on America’s economic recovery. That’s why it’s worth experimenting with creative ways to help delinquent underwater homeowners dig out from under a mountain of “negative equity.”

Private sector experiences suggest that a carefully conceived principal reduction program could achieve significant savings for U.S. taxpayers by reducing losses at Fannie Mae and Freddie Mac. Such a program could be enacted 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.

In effect, Fannie and Freddie can offer “short sales” back to the existing homeowners in return for a share of their home equity. Unlike foreclosure and traditional short sales, which are to third parties and usually at a discount to true market value, this approach would help support home prices, lower future default risk, and save taxpayers billions of dollars.

I propose that FHFA direct Fannie Mae and/or Freddie Mac to conduct a pilot program to test the technique’s viability and that Congress ask the Congressional Budget Office (CBO) to independently assess the potential savings for U.S. taxpayers should such a program be implemented on a full-scale basis.

The Principal Matter

Foreclosures are very expensive for lenders. In addition to the large costs of carrying, maintaining, and oftentimes improving homes they have foreclosed upon, disposing of the properties in foreclosure sales typically nets less than their fair market value. Similarly, short sales to third parties also usually suffer “distressed sale” discounts to the homes’ fair values. According to the latest LPS Home Price Index data, in today’s depressed real estate markets, foreclosed homes sell at an average discount of 29 percent and short sales at an average discount of 23 percent. And, of course, having on ongoing supply of such properties for sale adds pressure on home prices.

To avoid foreclosures, and thereby minimize their losses, many banks have already reduced principal balances on mortgage loans that they own. They have done this in two ways: by reducing the balances of outstanding mortgages through loan modifications, and by agreeing to short sales of homes which result in the borrowers’ loan obligations going away. In a short sale transaction, the bank lets the borrower sell her home for less than the mortgage loan balance without requiring her to repay the difference. This is a principal writedown for the borrower—it is equal to the amount by which the mortgage loan balance exceeded the sale price of the home in the short sale transaction.

Fannie Mae and Freddie Mac already provide underwater borrowers with relief on mortgage principal by allowing short sales of homes. In fact, both of the government-sponsored enterprises (GSEs) recently announced plans to streamline their short sales processes in order to stimulate the use of the technique. If they and FHFA are comfortable with granting principal reduction through short sales, then they must believe that doing so minimizes losses.

So the debate should not be about whether principal reduction per se can help minimize losses. It does. Rather, we should determine whether there is a better way to implement principal writedowns in order to reduce losses further for the GSEs without also creating meaningful additional moral hazard. Doing short sales of their homes to delinquent underwater homeowners, with them sacrificing some home equity as a cost, has the potential to save the GSEs (and, consequently, U.S. taxpayers) billions of dollars without stimulating moral hazard.

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