The Principle of Principal Reduction

January 24th, 2012 at 5:42 pm

I don’t know if the President will say much about housing tonight, but there are some important and potential helpful policy choices percolating in the background.

I’ve long held that of all the stuff on the White House’s “we-can’t-wait” list—things they can do to help the economy and jobs without going through that legislative death trap formerly known as Congress—housing policy is the one with the greatest potential to actually move the needle.

And the most helpful policy in housing is the reduction of mortgage principal for underwater homeowners.   Research has clearly revealed that owing more than the value on your home is the strongest predictor of foreclosure, and housing finance analysts widely agree that principal reduction is the best medicine to avoid this outcome.

But what does any of this have to do with stuff we could actually do right now?  Good question.  The answer is that the Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, could quickly reduce the principal on millions of home loans they own or insure, without going through Congress.

So, why haven’t they done so?  Another fine question.   First, you need to recall that Fan and Fred are 80% owned by the US gov’t right now, and FHFA, as conservator, wants to protect the taxpayer.  That’s fine—we thank you, FHFA. 

But—and news accounts have been getting this quite wrong—FHFA believes that loan forgiveness (principal reduction) would only save the taxpayers $20 billion while loan forbearance would save $24 billion (the latter modifies the loan, it does not reduce it).  

In other words, the FHFA agrees that both types of loan adjustments would reduce defaults and thus reduce losses to taxpayers, with a slight advantage to forbearance, which, as I’ll argue in a moment, is very likely incorrect.  I think if you did the analysis right, forgiveness would trump forbearance by a long shot.  But given the fact that reduction would clean this mess up a whole lot faster and more reliably than just changing the terms of the loans, and that taxpayers save either way, the path ahead—toward forgiveness, not forbearance—should be clear.

Unfortunately, the FHFA is placing landmines in that path.  Based on a letter reviewing all this by FHFA acting director Ed DeMarco, news accounts like this or this are reporting that if Fan and Fred were to reduce the principal on a subset of the mortgages they own or insure, it would cost taxpayers $100 billion.

This $100 billion (it’s actually $102bn), however, is a gross number—it is the losses to the agencies, and the taxpayers, from all the mortgage defaults that FHFA expects to occur if they neither forbear nor reduce principal.  The relevant numbers, however, are the difference between the losses under a forbearance program ($78 billion), or a reduction program ($82 billion) and the cost of doing nothing.

The punch line, then, is that by their estimates, forgiveness saves the taxpayer $20 billion; forbearance, $24 billion.

But for a number of reasons, FHFA’s methods make forbearance look better than it really is.  This is some weedy stuff, but it matters:

–they use a state level price index rather than a localized price level.  This approach averages across cities with huge price drops and those with normal price declines, and thus reduces the number of the deeply underwater borrowers.*   That in turn understates the impact of the policy most helpful to those borrowers: principal reduction.

–they use FICO credit scores and debt-to-income ratios at the time of loan origination rather than where those measures are today.  Obviously, they’re worse today, so this makes the agencies’ book look better than it really is, and again, understates the benefits to principal reduction.  In other words, the way they do it artificially lowers their expected default rate, and so the policy that’s most effective against defaults for those with lower FICOs and higher DTIs gets less credit than it should.

–they assume that all of their debt forgiven in their forbearance programs is repaid…100% of it.   That’s not realistic and it significantly reduces the cost of this option.   Simply building in a realistic default rate for debt that’s been pushed back to the end of the loan would raise the cost of forbearance relative to principal reduction.

Any one of these changes will sop up the $4 billion difference in an NY minute, showing forgiveness to dominate forbearance.  But even if the FHFA wants to stick with their numbers, reductions will go to work much more quickly and effectively to prevent defaults. 

If they keep coming up with reasons not to do the right thing, the White House should do the right thing and replace DeMarco—a perfectly good guy who believes he’s doing the right thing here but isn’t—with someone who gets the urgency of the situation.

*Imagine a) that anyone with a home price decline of 30% is underwater and needs a loan mod, and b) a state has two homeowners in two different cities.  Homeowner A’s price went up 30%, homeowner B’s price went down 30%. Average them together across the state and no one needs a mod; use the local price index, and B should get one.

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5 comments in reply to "The Principle of Principal Reduction"

  1. Jean says:

    Good article. Thanks.

  2. The Raven says:

    I think in a forbearance situation, a large number of people are simply going to walk away. There’s no good reason to stick with a mortgage that’s been extended to 40 or 50 years of repayment, especially in this economy.

    There’s also a wild card: the 100 million or so titles in question, thanks to MERS. There’s an awful lot of homeowners who can, if they choose, successfully just stop paying and squat in their homes and, in many states, chances are the courts will uphold their right to do so.

    Without forgiveness, a lot of those loans are just garbage.

  3. Don says:

    We’re not underwater (thanks to my wife, the Good Citizen, putting down a substantial down), and our Nevada home has declined 35% from its 2003 price. Why shouldn’t all principals be adjusted? I think there’s a fairness issue at play here that isn’t being addressed.

    • Enderprise says:

      I’ve been arguing for three years, now, that the only way to turn around the U.S. housing market is for ALL outstanding mortgages — both underwater and not — to be reset to Fair Market Value (FMV). There *is* an equitable way to do this so that ALL homeowners benefit — and the quants at the banks KNOW THIS! But the key to making this politically salable is to make the banks themselves pay for it — not the taxpayers. And the way to do that is to allow the banks to write off their resulting losses as depreciable assets — over a 3-to-5-year period rather than as short-term losses. By viewing the mortgage write-downs as contributions to their Net Operating Losses — which can be used to offset actual income — the banks actually could gain a significant tax deduction. In the end, doing wholesale principal reductions across the entire U.S. mortgage portfolio also could provide a viable incentive for the big banks and brokers to bring some of their income sheltered offshore back into the U.S. — because they would be able to leverage their increased NOLs against the additional income to save in corporate taxes.

  4. clarence swinney says:

    clarence achmed swinney olduglymeanhonest
    political historian Lifeaholics of America