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.

Comments
14 comments so far

It would probably be a lot easier to cause inflation in the housing market than to get banks, homeowners, and the government to agree on a plan. Once there is housing inflation, the underwater problem goes away.

Posted by KenG_CA | Report as abusive

Ken –

Economy-wide inflation would significantly help. But if homes inflate and salaries (or employment) don’t, there won’t be enough demand to keep housing prices high, and you’d just be inflating a bubble that will pop.

Posted by AnonymousChef | Report as abusive

The devil is in the details. Say someone bought a home for $200,000 with 100% financing and the home is now worth $100,000. The lender writes off half the loan’s face value and the homeowner comes out whole. What about someone who purchased an identical home for the same amount but put down 50% — $100,000? In the second case, the loan doesn’t need to be written down because it’s not underwater. It’s the homeowner who takes the hit — a $100,000 unrealized loss. The first owner gets bailed out but the second doesn’t. The lesson: Don’t put your own money into a house. Let the bank keep the risk.

Posted by 2contango | Report as abusive

Anonymous Chef, maybe you’re right. But if interest rates are kept artificially low (like they were in 2003-05), then prices can rise a little without increasing monthly payments. The key would be to only gradually let interest rates (and monthly payments) rise once housing prices rose enough to get mortgages above water.

Not that easy to do, I know, but still easier than getting banks and politicians to do anything that benefits the public interest.

Posted by KenG_CA | Report as abusive

Ah the media lexicon of debt – borrow and can’t pay back then you deserve to have the debt written off, borrow and pay it back in full ahead of schedule and you have been “bailed out” and are evil.

Why exactly do these people deserve to have their loans paid off by people who didn’t buy at the top of the cycle?

Posted by Danny_Black | Report as abusive

I have come to seriously dislike all mortgage holders. They are a plague upon America just like the evil bankers. If someone has a mortgage, they will have all the equity they need when they make that last payment. Why are we in such a rush to forgive debt that isn’t due for 20+ years? Isn’t the whole point of buying a house to live in it for 30 years and own it free and clear when you are ready to retire? If that’s not the goal, then people shouldn’t buy houses. Rent. There is just no need to do this. If someone can’t afford the payment, and especially if they live in a non-recourse state, they should just move out. So sorry if that screws up their credit rating. That’s the price of mismanaging your finances.

Posted by silliness | Report as abusive

Danny, I don’t think the concern over defaulting mortgages is necessarily over the borrowers, but rather the impact it will have on other housing prices, banks, and the economy in general. It was rising defaults in 2007/08 that triggered the debt crisis, and another round of increasing foreclosures will not be a good thing for people not connected to the loans, like you.

Posted by KenG_CA | Report as abusive

Please, people, the problem is not that prices are falling. They have to fall, because they got way out of whack with incomes over the past two decades. Are incomes coming back? No? Then why should prices?

End the debt ponzi now. If people need to find new places to live so be it. At least they won’t be debt slaves.

Felix, you know as well as I do that principal reductions, even if they could be forced upon unwilling lenders, will not be deep enough to make a difference for those in serious trouble. They will only benefit the same people who have benefitted from low interest rates and refi options. GREAT! Not the target audience!

You might as well mandate wage increases and mandatory hiring programs as keep pressing for principal reductions. There is no pure villain and no pure victim in this story. And for every person “saved” by such a program there will be another who loses (an investor, a would-be buyer, a taxpayer).

Posted by LadyGodiva | Report as abusive

Why do taxpayers have to pay down principals of those who bought homes they could not afford. Everyone has had a decrease in property value the past few years.

Is Obama about to forgive billions in mortgage principal?

How about the responsible taxpayer/homeowner who is propping up the economy?

It’s interesting to see that individuals who are current on their loans and have mortgages that were funded with a set of standards are now asked for even higher credit standards to refinance.

Posted by FirstCapital | Report as abusive

Ok. Just be sure to hand me the average amount of money everyone in this plan gets. I spend money too, and my spending would also help the economy. The mere fact that I do not have an underwater house should be irrelevant. All it means is that I was not greedy. Time for a change! I want my money too.

Posted by txgadfly | Report as abusive

I can’t give Felix much for smarts, in spite of his heritage. Free rides to those underwater, including banks, are not part of natural economics. The key to investing in houses is RISK and REWARD.

If you are smart, you end up being with a reward of being a homeowner at the end of your mortgage term.

If you are stupid, and you get in way over your head due to slick salesmanship to you who did not do due diligence, then, admit it: YOU ARE NOT TOO BIG TO FAIL, no matter what they taught you in your elitist high school.

Suggest you go to college and take a course in economics; and, for starters, READ SAMUELSON and stay away from KEYNES and John Kenneth Galbraith, two fine examples of failed economic socialism.

Posted by deemerk | Report as abusive

I don’t know. This would have helped a bunch at the beginning. All the mortgages on the books at the time should have been reduced in principal by 20% and converted from ARMs (where necessary) to straight 30 year at 5%. Yes – yes, you would have had a slew of angry folks who played by the rules screaming foul. But many of those people watched their employers and jobs disappear and got sucked into the maelstrom anyway – and lost THEIR homes. And – the banks were perfectly willing to repossess property instead of looking to keep some cash flow going. Because they knew they would get help in the form of bailouts. Natural and true economics don’t work because we’ve allowed these corporate entities to get so big and hold sway over so many middle income jobs that they know they have us by the short hairs and can do pretty much anything they want.

Posted by SGinOR | Report as abusive

Principle reduction is a stupid idea. Bankruptcy is the only way forward for many people.

Posted by M.C.McBride | Report as abusive

Felix- this is totally wrong. Our principle is no principal reduction- it punishes the responsible (and the lucky, but mostly the responsible). Just because you signed a contract saying you would pay for the house someday gives you no special rights.

Some other ideas:
Payback the loan or become a renter. What about a plan to just give the house back to the bank and have the current resident pay rent? This could create a lot of jobs in property management companies.

Reduce the credit score impact of foreclosure. It was a one time national condition and a lot of people got caught out cold.

Ultimately, the banks are going to recognize the loss, why provide unfair benefits to housing gamblers?

Posted by mattmc | Report as abusive
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