The Federal Housing Administration on June 8 announced plans to expand a pilot program that helps homeowners with government-backed mortgages modify their home loans and avoid foreclosure, potentially saving American taxpayers millions of dollars. For certain borrowers this could include lowering the amount owed on the loan to improve the likelihood of repayment—so-called mortgage principal reduction.
The Federal Housing Administration—the government-run mortgage insurer that backed about 40 percent of all homebuyers who needed mortgages in 2011—does not have the authority to directly reduce principal on the loans it insures, according to agency officials. So when an administration-backed borrower falls behind on their monthly payments, the agency can only take certain steps to minimize taxpayer losses by preventing unnecessary foreclosure such as deferring payments or extending the term of the loan. If those efforts fail to get the borrower back on track, a costly foreclosure process is typically the only remaining option.
That’s where the soon-to-be expanded pilot program comes in. After trying all other options, the housing agency will offer to sell the seriously delinquent loan—on the brink of foreclosure—to private investors, who have greater flexibility to restructure mortgages. Since the loan is at high likelihood of loss, it will fetch less than the total amount owed but more than the agency would expect to recoup through the foreclosure process, meaning taxpayers will likely save money. In exchange, the buyer agrees to delay foreclosure for at least six months and negotiates a new deal with the delinquent borrower. The buyer also agrees to hold at least half of the loans it purchases for a minimum of three years.
As a result, the Federal Housing Administration likely loses less than it would with a foreclosure, the borrower is given a fighting chance of staying in his or her home, and the private investor stands to profit if the borrower starts making payments again. Call it a win-win-win.
In many cases, the deal offered by the private investor will likely include a reduction in principal, according to U.S. Department of Housing and Urban Development Secretary Shaun Donovan. “[A borrower] might get a call to say, ‘Hey, we’re willing to … cut the balance on your loan dramatically,’ … which we couldn’t do based on the legislative options we have for FHA,” Donovan said at a Friday press conference. “This will be another chance, another lifeline for many of these families,” he said.
Donovan added that the initiative is “part of a broader set of efforts” to reduce principal amounts for borrowers who are underwater—those who owe more on their mortgage than their home is worth. That effort includes a $10 billion set-aside in a recent settlement with the nation’s largest banks. Billions more are available through the Obama administration’s Home Affordable Modification Program, along with other funds made available to underwater borrowers in hard-hit states.
But not every major player in the mortgage market is on board. The government-controlled mortgage financiers Fannie Mae and Freddie Mac still refuse to offer principal write-downs on loans they issue or guarantee, with a few small exceptions.
In fact, the two companies are generally barred from writing down principal by their federal regulator, the Federal Housing Finance Agency. That’s the case despite the regulator’s own analysis showing that targeted principal reductions would save Fannie and Freddie billions of dollars compared to other foreclosure prevention efforts. Such savings are one reason why write-downs are routinely used in the private sector.
The Federal Housing Administration’s announcement this past week supporting principal reduction should put added pressure on Fannie, Freddie, and their regulator to rethink their position. When the companies are ready to embrace principal reduction as a viable foreclosure-prevention and loss-mitigation tool, we have just the plan for them. We recently proposed a “shared appreciation” pilot where Fannie and Freddie agree to write down some principal in exchange for a portion of the future appreciation on the home. The pilot program would include special rules to maximize returns to Fannie, Freddie, and the American taxpayers supporting them without creating skewed incentives for borrowers. A bipartisan bill mandating a similar program for Fannie and Freddie was introduced this past week in the U.S. House of Representatives.
When it comes to principal reduction, Fannie and Freddie are quickly becoming the lone holdouts in the industry. It’s time they took a cue from the Federal Housing Administration and their private counterparts.
John Griffith is a Policy Analyst with the Housing team at the Center for American Progress.
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