To read the full report, click here.
Washington, D.C. — Today the Center for American Progress released a new report making the case for why the government-controlled mortgage giants Fannie Mae and Freddie Mac should embrace a targeted principal reduction strategy for deeply underwater borrowers. The report outlines how this is sound business practice and can improve the books of Fannie Mae and Freddie Mac—and the taxpayers supporting them—in the long run.
With nearly one in four homeowners “underwater,” meaning they owe more on their mortgage than their home is worth, and more than 7 million homes still in the foreclosure pipeline, the big question before lenders, investors, and policymakers today is how to avoid another wave of costly and economy-crushing foreclosures. There are several ways to lower an at-risk borrower’s monthly payments and increase the chance of repayment, including: refinancing to today’s historically low interest rates; extending the loan’s terms; modifying the interest rate; deferring payments; or lowering the amount the borrower actually owes on the loan, also known as “principal reduction.”
There is a growing consensus among economists, investors, academics, and consumer advocates that principal reduction is often the most cost-effective way to avoid unnecessary foreclosure for certain groups of borrowers. Principal reductions are particularly effective for deeply underwater borrowers that are facing long-term economic hardships, such as a permanent reduction in wages or long-term increases in unavoidable spending. These families are at high risk of default and often cannot see the long-term upside from making expensive monthly payments into a bad investment. With more equity in their home, these borrowers would be more likely to stick it out in tough economic times by making deep cuts to savings or other areas of spending.
While many lenders and mortgage investors in the private sector have embraced principal reduction, America’s two biggest mortgage finance companies, Fannie Mae and Freddie Mac, have not. In fact the two mortgage giants, which own or guarantee more than 3 million underwater mortgages, are forbidden from lowering principal on their loans by their regulator, the Federal Housing Finance Agency, or FHFA. The report released today, “Sharing the Pain and Gain in the Housing Market,” explains why Fannie, Freddie, and FHFA should give their stance on principal reduction another thought.
The report proposes a principal reduction pilot program at Fannie and Freddie that uses so-called “shared appreciation” modifications, through which Fannie or Freddie agrees to write down principal on deeply underwater loans in exchange for a portion of the future appreciation on the home. The borrower has a reason to keep paying, while the lender benefits when home prices eventually stabilize and rebound. The proposed plan includes program rules that deter borrowers from defaulting on their loan just to get a reduction in principal, what some critics call the “moral hazard” problem.
The report explains principal reductions should not be available to everyone, and that consideration must be done on a loan-by-loan basis. At this point, there is not enough data available to determine when exactly principal reduction is the best option compared to other modifications such as interest rate modifications or principal deferral. Indeed, that is precisely the reason for a launching a targeted pilot program. To test the model, the report recommends Fannie and Freddie focus first on borrowers that are most likely to benefit from a reduction, specifically borrowers that:
- Have a mortgage that’s worth at least 115 percent of the home’s current value
- Are either delinquent on their mortgage payments or at imminent risk of default
- Face a long-term economic hardship, such as a nontemporary decrease in income or permanent increase in unavoidable spending
- Do not have private mortgage insurance or a second lien, such as a home equity loan
To be sure, principal reduction could be the best modification option for Fannie- or Freddie-backed borrowers that do not meet all of these criteria. But the report recommends that the pilot focus on this core group to test the model.
“While principal reduction will give more struggling homeowners a fighting chance at staying in their homes, this is not a matter of charity,” said John Griffith, co-author of the report and Policy Analyst at the Center for American Progress. “At its core, principal reduction is good business. A carefully designed principal-reduction program—one that limits long-term risks born by Fannie and Freddie and focuses on borrowers that actually need a reduction—would save the government-sponsored enterprises and the taxpayers supporting them billions of dollars over the life of those loans relative to not doing anything.”
To read the full report, click here.
To speak with a CAP housing expert, please contact Katie Peters at 202.741.6285 or firstname.lastname@example.org.