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Time to Make an Offer FHFA Can’t Refuse

Federal Housing Finance Agency Needs to Embrace Loan Principal Reduction

The agency stands in the way of principal reductions by mortgage financiers Fannie Mae and Freddie Mac, but the Treasury Department can fix that, writes John Griffith.

Federal Housing Finance Agency Acting Director Edward DeMarco, right, testifies on Capitol Hill in Washington before the Senate Banking Committee. (AP/Manuel Balce Ceneta)
Federal Housing Finance Agency Acting Director Edward DeMarco, right, testifies on Capitol Hill in Washington before the Senate Banking Committee. (AP/Manuel Balce Ceneta)

The federal regulator of mortgage finance giants Fannie Mae and Freddie Mac announced Tuesday that he would not allow them to reduce the loan balances of struggling borrowers, ending months of deliberation. That’s bad news for the 2.5 million Fannie- and Freddie-backed homeowners that are deeply “underwater,” meaning they owe significantly more than their homes are worth. This decision is bad for American taxpayers, too, who stand to save up to $1 billion from a well-designed principal reduction program at Fannie and Freddie, both of which are now under government conservatorship.

But it’s not time for the Obama administration and other proponents of principal reduction to throw in the towel quite yet. There’s still one way the administration can get its way: Instead of offering to pay for a portion of principal reductions using funds set aside for foreclosure prevention from the 2008 Wall Street bailout, they can offer to pay for all of it. By offering to cover up to 100 percent of the cost, the administration would overcome the regulatory agency’s main objection to loan principal reduction: the price.

Since 2011 the Federal Housing Finance Agency, or FHFA, has permitted Fannie Mae and Freddie Mac to participate in principal-reduction programs provided 100 percent of the cost of the write-down is covered by another source. Just this past spring, state housing agencies in Nevada and California took the federal agency up on this offer, using money from the Treasury Department’s Hardest Hit Fund to cover the cost of principal write-downs. “We think it’s great,” one FHFA official told The Wall Street Journal in June. “It’s what this money was distributed to these states for.”

From the agency’s perspective, the problem arises when Fannie and Freddie are asked to foot some of the bill. That’s where this week’s announcement comes in.

FHFA rejected Treasury’s offer to help pay for principal reductions

The Treasury Department in January offered to cover some of the cost of principal reductions at Fannie and Freddie through the Home Affordable Modification Program’s Principal Reduction Alternative, created in 2010 to help deeply underwater homeowners avoid unnecessary foreclosure. Treasury later offered to cover the administrative cost of implementing the program as well.

The Federal Housing Finance Agency’s much-anticipated analysis of that offer shows that Fannie and Freddie would save $3.6 billion by reducing principal for nearly half a million eligible borrowers who otherwise face foreclosure. As we’ve explained before, targeted principal reductions save money for investors by lowering monthly payments and improving the borrower’s equity position, increasing the likelihood of repayment.

Those savings were not large enough to sway regulators. In Tuesday’s statement from the acting director of the agency, Ed DeMarco, the agency “concluded that the anticipated benefits [of principal reduction] do not outweigh the costs and risks.”

The letter laid out two main reasons for its position. First, after accounting for government subsidies, implementation costs, reasonable take-up rates, and associated risks, there’s a chance the net benefit to taxpayers could be much smaller or even disappear. Second, the sudden availability of principal reductions for delinquent borrowers could encourage homeowners who don’t need financial help to purposely stop making their monthly payments, what many refer to as the “moral hazard” problem. Both of these objections are misguided.

FHFA needs to focus on its mandate, not fiscal policy

The Federal Housing Finance Agency’s analysis focuses heavily on the net cost to taxpayers. In other words, the analysis takes the expected savings to taxpayers due to limiting losses at Fannie and Freddie, and then subtracts the amount of money that would come from Treasury’s budget for the Home Affordable Modification Program, arguing that those funds also come from taxpayers. After accounting for those payments, the potential savings shrink from $3.6 billion to about $1 billion, according to the agency’s analysis, which DeMarco concluded was not worth the time, resources, and risks associated with implementing the program.

Saving taxpayers $1 billion in today’s fiscal environment certainly seems worthwhile, but regardless of the net outcome, subtracting the Treasury contribution from the total savings is inconsistent with agency’s mandate. The agency is charged with preserving and conserving the assets of Fannie Mae and Freddie Mac, promoting a stable and liquid mortgage market, and maximizing assistance to homeowners. Their analysis should focus on the program’s impact on Fannie, Freddie, and the broader housing market, not its effect on the federal deficit.

The housing finance agency has no business telling another agency how to spend its own money on foreclosure prevention. Indeed, if another agency can legally contribute funds to conserving Fannie and Freddie assets, then FHFA likely overstepped its statutory authority by declining that offer. Congress and the Obama administration in 2009 allocated $29.9 billion to the Treasury Department for the Home Affordable Modification Program for the express purpose of keeping troubled borrowers in their homes, and only about 10 percent has been spent so far.

Back in April, the FHFA seemed to understand this distinction. “Congress gave us a responsibility and a mandate,” DeMarco said in a speech at the Brookings Institution. “It gave the Treasury Department a different responsibility and mandate, and a different funding source. Our responsibility is to that of conservator.”

This week, that view appears to have changed.

Fannie and Freddie can easily mitigate the “moral hazard” problem

Borrower incentives have always been a key consideration in the debate over principal reduction. In his letter to lawmakers, DeMarco said that such a program “could give borrowers who are current on their mortgages a message that the government endorses forgiving a portion of mortgage debt if hardship can be demonstrated.” In fact, according to his agency’s analysis, if only a small number of current by underwater borrowers decided to default just to be eligible for a principal reduction then the initiative could result in a net loss to taxpayers.

While this concern is legitimate, it’s easily mitigated. As we explained in an op-ed this week in American Banker, Fannie and Freddie can structure a principal reduction program without creating skewed incentives for borrowers. The simplest solution is to make this a one-time program open to borrowers that are already delinquent when the program begins. No borrower would then be able to default intentionally just to be eligible.

Another solution is to impose some sort of fee on program participation, ensuring the borrower has to give up something valuable before receiving a principal reduction. In exchange for a write-down now, the borrower can give up a meaningful portion of any future price appreciation on the home, known as “shared appreciation.” Deeply underwater homeowners have reason to keep paying, while the modification is not particularly attractive to borrowers that don’t need it.

The Center for American Progress in March laid out how the shared appreciation model could work at Fannie and Freddie.

Treasury should make an offer FHFA cannot refuse

The decision this week by DeMarco and his agency is shortsighted. Wall Street analysts, economists, consumer advocates, and housing policy experts widely agree that homeowners who are underwater pose a continuing threat to the health of the housing market. Prices are not likely to hit 2006 heights again for quite some time; the losses are real, and they need to be accounted for in order for the market to remain stable over the long term.

Notwithstanding all the good reasons for the agency to reconsider its position, that’s unlikely to happen any time soon. Thus, the Treasury Department should bite the bullet and pay the full cost of principal reductions at Fannie and Freddie through the Home Affordable Modification Program.

There are two ways Treasury can accomplish this. Based on current program rules, Treasury covers between 18 cents and 63 cents on each dollar of forgiven through the program’s Principal Reduction Alternative. If the Federal Housing Finance Agency were to ratchet that number up to 100 cents on the dollar for certain Fannie- and Freddie-backed loans, then its cost concerns would no longer be an issue.

Alternatively, Treasury could just use funds from the standard Home Affordable Modification Program to pay off in full any amount that would otherwise be set aside as forbearance in Fannie and Freddie’s existing standard for this program. While borrowers would receive less forgiveness overall than through the Principal Reduction Alternative, it would place a much smaller operational burden on Fannie and Freddie. And since it works through an existing program, this approach would not require any changes to the servicing policies in place at Fannie and Freddie.

To put it bluntly, we’re quickly running out of options. If Treasury does not spend the Home Affordable Modification Program funds, the Obama administration cannot repurpose them to other housing assistance programs. And without the participation of Fannie and Freddie, which own or guarantee more than half of the mortgages in our country and traditionally set the industry standard for acceptable servicing practices, any principal reduction effort is unlikely to make a meaningful dent in the ongoing housing crisis.

This theoretical debate has gone on long enough. The longer it continues, the more American homeowners suffer. It’s time to bring the standoff to an end.

John Griffith is a Policy Analyst with the Housing Team at the Center for American Progress.

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John Griffith

Policy Analyst