See also: Give the Rehab-to-Rent Pilot Program in California a Chance by Alon Cohen; Latinos Bearing the Brunt of the Foreclosure Crisis by Jennifer Rokosa
The federal regulator overseeing mortgage giants Fannie Mae and Freddie Mac last week confirmed that principal reduction—writing off a portion of a mortgage in exchange for a higher likelihood of repayment—can save the two taxpayer-supported companies money. That’s a welcomed conclusion from an agency that has long obstructed the use of this critical foreclosure-mitigation tool.
Since the government placed Fannie and Freddie in conservatorship in 2008, the Federal Housing Finance Agency, or FHFA, has prohibited the two firms from reducing principal on the loans they own or guarantee—even though private banks routinely use write-downs in their mortgage modifications. This past Tuesday’s announcement was the first time the agency publicly acknowledged that principal reductions could bolster the books of Fannie and Freddie compared to alternative modifications.
Still, the acting director of the Federal Housing Finance Agency, Edward DeMarco, stopped short of announcing whether the agency will lift its ban, saying the final analysis is “not yet complete.” DeMarco peppered his remarks with caveats, hinting he may not yet be convinced that principal reductions would actually help Fannie, Freddie, and the taxpayers supporting them.
While the preliminary finding is an important step forward, more must be done to assess the true costs and benefits of principal reduction at Fannie and Freddie. Here we lay out what the new numbers say, what they don’t say, and what the Federal Housing Finance Agency should consider as they hone their position in the coming weeks.
Principal reductions can be good business practice
The agency’s new analysis focused on Fannie- or Freddie-backed borrowers that are expected to be eligible for the Home Affordable Modification Program, which was created in 2009 to help struggling homeowners avoid foreclosure. FHFA projected about 700,000 borrowers would be eligible, being both delinquent and deeply “underwater,” or owing significantly more on their mortgage than their home is worth.
Here are the basic findings: If Fannie and Freddie did nothing to avoid unnecessary foreclosures, they would expect to lose a combined $63.7 billion on these loans. If the companies defer a portion of principal and interest on those loans to avoid some foreclosures, known as principal forbearance, they expect to lose significantly less: $55.5 billion. But they can stave off even more foreclosures through principal reduction, resulting in just $53.7 billion in losses.
In other words, a federally supported principal-reduction program will save Fannie Mae and Freddie Mac about $10 billion compared to doing nothing, and $1.7 billion compared to alternative foreclosure-mitigation tools, according to the Federal Housing Finance Agency’s own analysis.
These findings should not come as a surprise. The Center for American Progress has long argued that a targeted principal-reduction initiative would be beneficial in the long term to Fannie, Freddie, and the taxpayers supporting them. Last month we proposed such a program, administered through the Home Affordable Modification Program, which focuses on troubled homeowners who are most likely to benefit from a reduction in their loan balance. Specifically, our proposed pilot targets delinquent or at-risk borrowers that are deeply underwater and facing a long-term economic hardship, such as a nontemporary decrease in income or a permanent increase in unavoidable spending.
Based on these new numbers, one would expect the Federal Housing Finance Agency to adopt a similar approach to principal reduction in the coming weeks. But according to DeMarco’s remarks last Tuesday, it’s unclear whether the agency will.
FHFA is still reluctant to embrace principal reduction
DeMarco offered three important caveats to the analysis, hinting that he may still not be ready to embrace principal reduction as a viable foreclosure-mitigation tool. Let’s examine each in turn.
First, DeMarco explained that the financial benefits of principal reduction rely heavily on taxpayer subsidies. That’s true to an extent. His agency’s analysis estimated that Fannie and Freddie would receive about $3.7 billion in payments from the U.S. Treasury through the Home Affordable Modification Program’s so-called Principal Reduction Alternative. The Obama administration recently made these funds available to Fannie and Freddie for the first time.
But it’s important to understand a key distinction here. Congress in 2009 instructed Treasury to set aside a portion of funds through the Troubled Asset Relief Program—enacted to protect our economy from complete meltdown at the height of the financial crises—for foreclosure prevention, resulting in $29.9 billion going to the Home Affordable Modification Program. Under the new rules Fannie, Freddie, and their mortgage service companies can now use those funds to keep more troubled borrowers in their homes through principal reduction, which is fully consistent with Congress’s initial intent.
As DeMarco pointed out in his remarks, the Federal Housing Finance Agency has a very different goal in mind: to protect taxpayers by preserving the assets of Fannie Mae and Freddie Mac. “Congress gave us a responsibility and a mandate. It gave the Treasury Department a different responsibility and mandate, and a different funding source,” he said. “Our responsibility is to that of conservator, so [the analysis reflects] how this affects the net present value to Fannie and Freddie.” In other words, both public goals can and should be met at the same time.
Missing from DeMarco’s remarks, however, is any mention of his agency’s second congressional mandate. FHFA is also tasked with fostering “liquid, efficient, competitive, and resilient national housing finance markets.” The agency’s true responsibility as conservator goes beyond the simple calculus of net costs and benefits. On top of the financial gains, a targeted principal-reduction program would lead to fewer foreclosures, which in turn means more stable neighborhoods and stronger local housing markets.
Second, DeMarco expressed concern that the sudden availability of principal reductions could inspire some underwater borrowers to stop making payments just to qualify for assistance, what he calls “strategic modifiers.” About three-fourths of underwater borrowers with Fannie- or Freddie-backed loans are current on their mortgage, and the last thing the Federal Housing Finance Agency wants to do is push those borrowers to miss payments unnecessarily. Indeed, the agency’s analysis shows that any financial gains from principal reduction could be wiped out if the program were to cause 90,000 borrowers to become strategic modifiers.
But this problem should not be overstated. As we point out in our recent report, there are simple ways Fannie and Freddie can structure a principal-reduction program without creating skewed incentives for borrowers. One solution would be to make this a one-time program open to borrowers that are already delinquent when the program begins. Such a rule limits a borrower’s ability to default intentionally just to be eligible.
Another solution is to impose some additional cost on borrowers that receive a reduction on top of the consequences of default on the borrower’s credit score. This would make principal reduction unattractive to those who don’t truly need it. We adopted one such approach for our proposed pilot: a “shared appreciation” model in which Fannie or Freddie agrees to write down some principal in exchange for a portion of the future appreciation on the home. The borrower improves their equity position but gives something up in the process, while Fannie or Freddie benefits when home prices eventually stabilize and rebound.
As a third caveat DeMarco warned that principal reductions could impose a significant administrative burden on Fannie, Freddie, and his own agency, which could further reduce the bottom-line benefit for the two mortgage giants. This burden includes costly technological upgrades to better track loans and guidance and training for servicers to ensure “consistent, quick, and efficient program delivery,” DeMarco said.
This is a serious concern, but hardly a deal breaker for principal reduction. Fannie and Freddie are responsible for more than $5 trillion in mortgage assets and remain one of the biggest and most influential financial institutions in the world. There’s no excuse for their systems and internal processes to be so far behind private banks, many of which are currently doing principal reductions. And while upgrades and training may cost money today, such an investment will likely save much more money tomorrow.
What FHFA should consider in the agency’s next round of analysis
When the Federal Housing Finance Agency released its initial analysis on principal reduction in January, industry experts including Laurie Goodman of Amherst Securities noticed “serious technical issues” with the study. To their credit the agency corrected many of these issues in this round of analysis, but many concerns remain that continue to skew the results.
First, the revised calculation was done on a portfolio level, assessing the relative impact on all 700,000 Fannie- and Freddie- backed loans that are eligible for principal reductions through the Home Affordable Modification Program. As we point out in our report, this ignores the fact that principal reductions might be the best option on certain underwater loans, while principal deferral and other alternatives might be best for other loans. That’s why the agency should assess this impact on a loan-by-loan basis.
To be fair, DeMarco did give one explanation why targeted principal reductions may be difficult for Fannie and Freddie. “Unlike other mortgage market participants that can pick and choose where principal forgiveness makes sense, [Fannie and Freddie] must develop the program to be implemented by more than one thousand seller/servicers,” DeMarco said. This concern may make targeted principal reductions difficult, but it’s far from impossible. Fannie, Freddie, and its conservator will have to be clear about what borrowers are best suited for a reduction, and which are better off with principal forbearance or other modifications.
Second, the new analysis does not adequately differentiate between uninsured loans and those with private mortgage insurance. When a loan with mortgage insurance defaults, the insurance company usually bears most or all of the loss. Thus, on an individual loan it is the insurer—not Fannie or Freddie—who has the most to gain from avoiding foreclosure through principal reduction, so it’s partly up to the insurer to negotiate and contribute to the modification.
There’s reason to believe that Fannie and Freddie are most likely to see the benefits from targeted reductions on uninsured mortgages, which account for 68 percent of their seriously delinquent loans. DeMarco last week mentioned that “whether or not loans had mortgage insurance made no difference in the results,” but offered no data to defend this claim. When assessed on a loan-by-loan basis, the revised report should at least lay out these findings.
Third, the revised analysis was limited to traditional principal write-downs, as opposed to alternative approaches to principal reductions than could spread risk and save Fannie and Freddie even more money. The shared appreciation model described above is one such model.
But the analysis ignores any possible upside of shared appreciation, using a model that “assumes home prices stay flat,” according to DeMarco. If his agency were to work off of more reasonable market expectation—even annual price appreciation of just 1 or 2 percent in the long run—then the shared-appreciation model would make principal reductions even more attractive to Fannie and Freddie. Alternately, the agency could present a series of scenarios, ranging from recovery to further price falls, and assess how the balance sheets of Fannie and Freddie would fare under each scenario.
If nothing else, the new numbers make it much more difficult for the Federal Housing Finance Agency to maintain an across-the-board ban on principal reductions. The preliminary analysis shows that principal reductions, by giving deeply underwater homeowners a fighting chance to regain equity and stay in their home, can be good business practice for Fannie and Freddie. It’s about time we tested that finding in the real world.
John Griffith is a Policy Analyst with the housing team at the Center for American Progress. Daniel Molitor is an intern with CAP’s economic policy team.
- Give the Rehab-to-Rent Pilot Program in California a Chance by Alon Cohen
- Latinos Bearing the Brunt of the Foreclosure Crisis by Jennifer Rokosa