Why won’t Frannie do principal reductions?

By Felix Salmon
October 6, 2011


Negative equity has reached epidemic status across the united states — and especially in the sand states of Arizona and Nevada, where more than half of all homes with mortgages are  underwater. But give the state of Arizona, at least, a lot of credit for biting the bullet and trying to do what needs to be done:

If banks would forgive some of a homeowners’ mortgage debt, the state said it would pay half, up to $50,000 of a $100,000 loan reduction.

But you know where this story is going to go, don’t you. Since the program was launched in September 2010, it has helped three homeowners. Three. And a big reason is Frannie’s blanket refusal to even think about participating.

The two largest mortgage guarantors, Fannie Mae and Freddie Mac, will not participate — in Arizona or elsewhere. No loans are eligible for the state’s program if they were bought and held or securitized by the two companies, which are now under government control and guarantee more than 70 percent of the country’s home loans.

Seems to me like it’s time for Frannie’s regulator, the Federal Housing Finance Agency, to step in and bash a few heads together. Or, not so much:

Edward J. DeMarco, as acting director of the Federal Housing Finance Agency, oversees Fannie and Freddie. Even though he recently signaled that he might make it easier for homeowners to refinance into more favorable loans, he has held his ground on debt relief. Fannie and Freddie say reducing the principal is bad for business, and as a result bad for taxpayers.

OK, if the FHFA doesn’t want to cooperate, let’s make them cooperate! Principal reduction is part of the US government’s stated policy tools, after all. Let’s just tell DeMarco that he has to play ball! No? No.

White House officials say that although taxpayers essentially own Fannie and Freddie, the administration lacks authority to require Mr. DeMarco to comply with its policies, which encourage principal reduction through a handful of programs. The Federal Housing Administration and the Veterans Administration do not allow principal reduction on their loans either.

This despite the fact that the private sector, which has no control over Frannie at all, has managed to implement de facto principal reductions on Frannie-backed loans:

In the latest sign that debt forgiveness might make financial sense to some on the lender side, the nation’s second-largest mortgage insurance company, PMI Group, has found a way around Fannie and Freddie’s policy. PMI, which shares the credit risk in many Fannie and Freddie loans, will pay some underwater homeowners, those who owe more than their home is worth, if they make prompt payments for several years, a de facto principal reduction.

While the company would not disclose what percentage of the principal was covered, a spokesman for the Loan Value Group, which administers the program for PMI, said that on average it was 5 to 7 percent of the loan amount but could be as much as 30 percent.

Does it matter whether you get your principal reduction up-front, or whether you get it five years down the line, in the form of  a check from PMI? Yes, at the margin — but the principle is the same, that people are much more likely to continue to make payments on their mortgage if they have a good chance of owning equity in their homes at the end of it. And if Frannie is OK with the PMI program, then it should be fine with Arizona’s program too.

Of course the big difference between the PMI program and the Arizona program is that the PMI program is paid for by PMI: Frannie needs to take no write-down. While the Arizona program involves Frannie taking pain now to avoid bigger pain further down the road.

It’s worth remembering that it’s not just insurers like PMI — even banks like Chase are doing principal reductions. But they only ever do so when they don’t need to take any up-front charges. If you bought the mortgage at a discount, then it’s fine to do a principal reduction, since it doesn’t reduce the value of the mortgage on your books. Accounting is destiny.

Maybe the thing for the US government to do, then, is not to force Frannie to accept principal reductions outright — but rather just to force Frannie to mark their current underwater mortgages to some semblance of sanity, rather than doing their see-no-evil act and insisting on holding them at par. If Frannie has to take writedowns anyway, then maybe they’ll do so in a homeowner-friendly way.

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