Ed DeMarco’s obstructionism

By Felix Salmon
November 16, 2011

Representative John Tierney of Massachusetts is one of those politicians whose questions tend to be substantially longer than the answers they elicit. But that doesn’t mean the questions, pared to their essence, aren’t good ones. Here he is grilling FHFA head Ed DeMarco, asking why he’s refusing to consider principal reductions on mortgages.

DeMarco’s answers come at 2:15 and 4:50. He starts off quite explicitly:

We have been through the analytics of the underwater borrowers at Fannie and Freddie, and looked at the foreclosure alternative programs that are available, and we have concluded that the use of principal reduction within the context of a loan modification is not going to be the least-cost approach for the taxpayer.

Later on, he agrees to furnish Congress with these analytics: I, for one, would love to see them. There are two ways that you can come to this conclusion, and I suspect that the analysis uses both. First, you can try to maximize the probability that underwater borrowers will continue to make payments after a loan modification, rather than simply strategically walking away; and secondly, you can maximize the probability that borrowers who are current on their mortgages will strategically default if they think they can get a principal reduction by doing so.

At heart, what any lender needs to do with regard to any given loan in default is make a choice. You can modify it in any number of different ways, some involving principal modification. Or, you can just foreclose. You know, pretty much, what the costs of foreclosure are — and they tend to be enormous. So there’s a good case for modifying the loan, if the present value of the modified loan payments is decent. But in order to calculate that present value, you need to have a handle on the probability of a redefault. The lower the redefault probability, the more attractive a modification is to the lender. The higher the probability of a redefault, the more likely it is that you’d be better off simply foreclosing now.

Now here’s Tierney’s point: redefault rates are significantly lower when you do a principal reduction than they are when you don’t. It stands to reason: if you have equity in your house, you’re going to want to keep that equity. If you have negative equity in your house, not so much. As a result, principal reductions reduce redefault rates, and are a good way of maximizing the value of a loan.

In order to demonstrate that Tierney is wrong, then, DeMarco is likely to attempt to show that redefault rates don’t drop very much if you do a principal reduction. I think that’s going to be hard, not least because we haven’t had much in the way of principal reductions, so the data on redefault rates is going to be pretty thin.

And then there’s the second leg of the argument DeMarco has to make, which is even harder to get good data on. It’s the moral hazard problem: if you start doing principal reductions, everybody’s going to want one — even people who are current on their mortgage right now. And you don’t want to do anything which will give people an incentive to default, just so that they can get their mortgage modified.

Again, however, the argument here is a relative one. Any kind of modification program, at the margin, is going to provide an incentive to default. So DeMarco is going to have to demonstrate that people are more likely to strategically default the minute a principal-reduction program gets implemented. And I can’t imagine where he could possibly find the data to support that conclusion.

It’s worth noting that DeMarco made neither of these arguments in his answers to Tierney. Instead, he started attacking straw men:

I do not believe that I’ve been appropriated taxpayer funds for the purpose of providing general support to the housing market…

I believe that the decisions that we’ve made with regard to principal forgiveness are consistent with our statutory mandate… I do not believe I’ve been authorized to use taxpayer money for a general program of principal forgiveness.

Tierney was not asking DeMarco to provide “general support to the housing market”. He was not saying that DeMarco’s actions to date were somehow illegal. And he certainly wasn’t suggesting that DeMarco use taxpayer money for a general program of principal forgiveness.

In fact, he wasn’t suggesting that DeMarco use taxpayer money for anything at all. He was suggesting, instead, that DeMarco would save taxpayer money if he did principal reductions on certain mortgages. And he rattled off a long list of private-sector lenders who are doing just that, which suggests that there’s definitely a profit motive in there somewhere.

Obviously, no one’s suggesting that the FHFA start doing principal reductions across the board for all mortgages: Tierney’s only suggesting that DeMarco allow such things where it makes financial sense to do so. That’s a no-brainer; what’s weird is DeMarco’s certainty that it never makes financial sense to do so. Fannie and Freddie own a lot of mortgages; surely a few of them, at least, are good candidates for principal reduction — especially ones where the home is worth half or less the amount of the mortgage.

DeMarco does have one other alternative — he could just come clean and be honest. In which case he’d say something like this:

“We’re keeping millions of underwater mortgages on our books at par. We know they’re not worth 100 cents on the dollar, and so do you. But our accounting conventions allow us to pretend that they are worth that much, and as a result we’re managing to kid ourselves that our assets are worth a lot more than they really are. If we modify the loans while keeping the principal amounts constant, we can continue to carry those loans on our books at par. But if we do principal reductions, the accounting conventions finally grow some teeth, and we’re forced to take a write-down. Since we don’t want to recognize reality and take that write-down, we’re simply going to avoid doing principal reductions instead.”

Since it seems to be impossible for anybody to remove DeMarco from his supposedly interim position, he might as well come out and say this. After all, no one seems to be capable of firing him, no matter what he says.

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Comments
20 comments so far

Very informative post and it throws light on Felix’s long-standing campaign on this blog in favor of principal reductions.

What I’d like to know, however, is why a borrower somehow deserves a principal reduction just because they and large numbers of people like them are underwater on their mortgage.

Congress, via The Mortgage Forgiveness Debt Relief Act, has already provided an out for underwater borrowers. If a borrower agrees to a short sale, the IRS won’t come after the borrower for taxes on the forgiven amount of debt.

Posted by Strych09 | Report as abusive

Strych, this has NOTHING to do with borrowers “deserving” a principal reduction. And everything to do with the US taxpayer maximizing the value of its mortgage portfolio — while helping homeowners at the same time.

Posted by FelixSalmon | Report as abusive

Actually, the Mortgage Foregiveness Debt Relief Act sunsetted and is no longer in effect.

Posted by AliceTJones | Report as abusive

Strych09, this is not (or at least not only) a matter of “deserving” the principal reduction. The point is that in many cases, a principle reduction is Pareto efficient. The homeowner is not sufficiently solvent to pay off the existing mortgage. The question is whether it will cost the owner of the debt more to simply foreclose, or do some kind of modification; and if they’re doing a modification, what kind. If a principal reduction leads to the best outcome for everyone involved — homeowner still in the home, and best fairly-valued NPV of the new debt for the mortgage holder — then that should be the choice. The fact that there are also probably some good macroeconomic externalities (accelerating the deleveraging process and freeing up household income for current consumption would both help pull us out of the liquidity trap), this seems like kind of a no-brainer.

Any time you start bringing “deserves” questions into economics, you really should remind yourself of one of Krugman’s favorite aphorisms: Economics is not a morality play. (Google the phrase for numerous examples of people succumbing to error and fallacy because they are too eager to see black-and-white where even the shades of gray are not terribly relevant. The story of the Recession of the DC Babysitting Coöp, and what it says abotu recessions in general, is a good illustration of how moral logic screws up economic policy. http://www.slate.com/articles/business/t he_dismal_science/1998/08/babysitting_th e_economy.html )

Posted by Auros | Report as abusive

What is very weird is that you don’t see forgiving mortgage debt has a cost.
Also it’s very weird that you don’t know Fannie and Freddie have to set aside a reserve for the entire loan when they modify a mortgage to help distressed borrowers, and that’s another cost, because the mortgage is deemed non performing loan regardless if it’s performing during the entire life of the mortgage. So FnF hold now reserves for performing loans, just because they’ve been modify.
You must pay the debt you owe.

Posted by GJOA | Report as abusive

A principal reduction program would be a good thing, but the fact is that working through every defaulted mortgage to determine a principal reduction would take an enormous amount of time… maybe it would take less time then foreclosure, but if we really want to fix the housing market, we need to do something that is likely to work through the system faster.
Why not just pass a law that says if a home has a mortgage written before June 2008, then a short sale of the home must be aloud with no recourse on the borrower (so long as the short sale is an ‘arms length’ transaction at market prices)?
The idea is that an underwater homeowner could sell their house, and move on without having to worry about the mortgage. The house gets a new owner, and the bank gets a loss. No more massive portfolios of REO on the banks that represent decaying empty houses. Just a housing market quickly finding it’s equilibrium price, and getting back to business.
Sure the banks get a big loss, but they are getting one anyway, and at least this way we get the economy out from under the massive overhang of housing.
To Strych09′s point as to why homeowners deserve a break… The fact is that a failed loan has two responsible parties, the borrower AND the lender. The last housing boom would never have gone to the lengths it did if it were not for the crazy money coming from the banks. Don’t forget that the borrower is still loosing the down payment (as long as the bank was smart enough to take one) and any payments they ever made on the loan.
We bailed out the banks once, and we will likely have to do it again. Why shouldn’t we bail out the homeowners?

Posted by FinanceChicken | Report as abusive

FinanceChicken,
I have been proposing a similar plan for some time now. It would amount, if enacted, to a sort of House Swap on a grand scale. People in houses they cannot afford could trade down to cheaper ones; people whose families and incomes have grown could trade up. Nobody would get something for nothing and the RE backlog would vanish much more quickly.

But the losses to the banks and investors would be brutal over the short term and would have to be covered by the govt. Who would support that? I fear we are doomed to the slow bleed of extend and pretend, though what you propose would be infinitely better for everyone.

Posted by LadyGodiva | Report as abusive

Let’s see: I have a mortgage for $X. The market value of my house is currently $X/2.

I can be economically stupid and continue to make payments. If we were talking 0.9X or maybe even 0.8X, I might do that because between moving, storage, foreclosure/default, etc. (“transaction costs”), I might be inclined to stay where I am.

At 0.5X, Jingle Mail is BATNA, to coin the MBA term. Can there be a Negotiated Agreement?

On the bank side, when I tell them “it’s yours,” they can (1) go through the expense of foreclosing, (2) maintain the property until it sells, (3) and expect to get the new buyer to pay, oh, about $X/2. Or they can renegotiate.

So at $X/2, we’re both ahead on TCO. In fact (as noted above), I probably settle for slightly above market value (say, 0.55-0.60X) just to avoid hassle.

The above assumes I am reasonably certain there will be support for the current market price; otherwise, we reach an agreement closer to 0.50X–or even Very Slightly Lower, since it still cuts the bank’s costs. So a willingness of the FHFA (or FNMA or FHLMC or AOTA) to support the market at that level is required.

From their side, the above assumes that I am still of good enough credit (less than I had to be to get the mortgage, in theory) to cover the lower payments. But I have a history of paying the excessive mortgage at the higher interest rate (double whammy, that), so they’ve been booking at least 30% of my mortgage payment as profit compared to current levels anyway.

The lies of their accounting are a separate issue–one that has been lurking for the past five years, at least. But FHFA could at least argue–if it were done under a Federal program that is offered exclusively to homes where the market value is, say, at least 30% underwater–that those are isolated cases, and a full remarking of the mortgage portfolio is not required.

It won’t make them solvent, but they weren’t solvent in the first place. And it will stop the steady decline in mortgage values as more and more people realize that Jingle Mail is a good idea.

Posted by klhoughton | Report as abusive

There is a federal agency that has routinely been ordering write-downs of undersecured debts to the value of the collateral for decades, without bringing down the economy or the banking/lending sectors in the process. That would the bankruptcy courts in reorganizations under Chapters 11, 12, and 13. The only reason it hasn’t been doing so here is that 30 years ago home mortgages were excepted, because that market was so stable and conservative that it would never need such a thing. That cannot now be changed because President Wall Street has an absolute veto. But it would be a great idea.

Posted by kenjd | Report as abusive

My understanding is that there are recourse and non-recourse states as well as a few with a choice between getting the house versus other assets. From an economic analysis standpoint, the decisions the agencies should make would factor these legal options into account.

Principal reductions make a lot of sense in states where the houses are underwater and only the house can be accessed as collateral. They would probably make less sense where it appears that a strategic default is occurring and other collateral would be accessed.

Its just business, folks.

Posted by ErnieD | Report as abusive

Two points:

First… if we are going to write down principal by $10,000… $20,000… $50,000 plus… well then a very large number of people are going to “sell” their credit rating for that price by intentionally falling behind on their payments to get a loan mod. Suzy Orman will be doing specials on CNBC on just how to do it.

Second… if we are going to change terms greatly benifiting a few at the expence of the many than should we not share in the upside if the house is ever sold above the newly lowerd principal balance. That would at least placate the tea-party cround at some minimal level.

Posted by y2kurtus | Report as abusive

Quick question…

When we talk about “fixing” the housing market, are we looking for ways to sustain ridiculously unaffordable prices that have your average household perpetually teetering on the bring of bankruptcy, or are we looking for ways to bring prices down another 20%-30% as rapidly as possible without shocking the system so that those presently forced to rent might finally afford to buy?

You have to pump very hard to keep a bubble inflated. Letting it collapse is certainly the easier solution.

Posted by TFF | Report as abusive

“It stands to reason: if you have equity in your house, you’re going to want to keep that equity. If you have negative equity in your house, not so much.”

OK – if this is correct and defaults correlate with negative equity… then defaulting is a rational and reasonable choice made by the debtor. Good for them! Default. Please, just default and move on.

Posted by silliness | Report as abusive

@klhoughton: all of that is correct of course, but putting the accounting lies “aside” is a mistake. To borrow from Steve Randy Waldman, for banks, “accounting is destiny”. For so long as accounting rules permit banks to carry mortgages at par, they will not pro-actively do mortgage modifications, with the exception of those cases where they’ve acquired a portfolio of loans at less than par. If we could force them to take a writedown to market value, their incentive structure would suddently change.

So to solve a problem that Felix is pointing we need one thing and one thing only: force FHFA/Fannie/Freddie to mark every loan portfolio to market. That’s a legislative step, most likely. If that’s done, however, there would no longer be any “losses” to the taxpayer from doing principal modifications all the way down to the mark.

2. @TFF: what you’re looking to do is to bring incomes and housing prices into balance. You could do this by having another housing price crash. Or you could do this by inflating nominial incomes. In the former case, you are left with the problem that debts are nominal and won’t go down automatically just because collateral has gone down. Inflating incomes, on the other hand, is a strategy that suffers from no such flaws and, moreover, spreads the costs and benefits as equitably as possible.

Posted by Y.Alekseyev | Report as abusive

A key consideration is that principal reductions sponsored by the FHFA are never going to be confidential. So a guaranteed result is going to be to motivate borrowers who have no thought of default demanding equal treatment – after all if the it is the US Treasury funding this why should there be any criteria to pick winners and losers in the underwater mortgages based on ability to pay? Immediately thereafter the non-GSE-guaranteed borrowers are going to start screaming “where’s mine?” Why should a consideration that is mostly arbitrary relative to the borrower – i.e. what arrangement did the lender have with a GSE – make or break getting government dough? Next everybody who lost equity is going to start screaming: why are you shovelling money at those guys simply because they got in with no/low downpayments? WTF? Then renters are going to point out “what the heck is so darn special about owning homes anyway that I’m not getting my $40,000?” You have to be an idiot at this late date not to understand that the political obstacle hasn’t been overcome because such a program will anger many more people than it delights. Well life is not fair, I know, but Pres. Obama understands you can’t help 4 million people and get 80 million people thinking about how they have been shafted and come out ahead politically. This is not a spreadsheet exercise here – it is going to be raw outrage and bitter anger.

Posted by Eric377 | Report as abusive

“@TFF: what you’re looking to do is to bring incomes and housing prices into balance. You could do this by having another housing price crash. Or you could do this by inflating nominial incomes.”

Exactly. Still, we’ll need one or the other before the housing market can truly be considered “repaired”. Stabilizing prices at an unaffordable level isn’t sufficient to bring life back to the real estate market and our economy.

Posted by TFF | Report as abusive

“Then renters are going to point out ‘what the heck is so darn special about owning homes anyway that I’m not getting my $40,000?’ ”

Amen.

The tech bubble’s collapse wiped out ~$5 trillion. The real estate market’s collapse has (so far) wiped out ~$6 trillion.

What is so special about residential real estate that its increasing affordability should provoke the government — in the words of Jim Grant — to “nationalize the yield curve” — to do everything in its power to prevent further price decline & greater affordability? Why is the govt siding with the longs instead of merely refereeing the market?

We should enforce the current rules & generously disburse welfare to those in need. But the govt should cease trying to manipulate asset prices. Renters like myself listen to leftwing do-gooders and think:

“I wish you’d stop bein’ so good to me.”

Posted by dedalus | Report as abusive

“We should enforce the current rules & generously disburse welfare to those in need.”

Absolutely! And my apologies to those struggling to make payments on a $500k house, but in my experience “those in need” are not worrying about whether their mortgage is or isn’t underwater. Like the mortgage interest deduction, the benefits from “homeowner rescue” programs flow primarily to the upper middle class.

P.S. My top student is trying to find a way to purchase a $100 TI graphing calculator (the high school standard these days) for math class.

Posted by TFF | Report as abusive

I believe that reducing the principal balances on all mortgages would be beneficial to the economy as a whole. Of course everyone who is upside-down is going to want this deal, as they should. But just imagine the positive chain reaction this could initiate! The market would be more liquid – homeowners could sell their homes once again. Demand would increase not only in the real estate market, but all markets. Houses will sell, and thus the demand for housing alone will increase leading to construction, realtor, and broker jobs – just to name a few.

Of course we would need to share the appreciation of our assets with the modifiers. If a homeowner sells the property for a profit in regards to the new principal balance, then the seller should repay the modifier. If the house miraculously sells for a profit that exceeds the forgiven amount, then the seller would be entitled to the difference, only paying the modifier back the amount that was forgiven keeping the remainder of the profit for his or herself. With the increased liquidity in the housing market, more buyers will enter the market increasing mortgages on the books, in turn, more profit opportunities for lenders. As the demand increases, jobs are created. What better way to prevent default than to make sure we are all employed?

DeMarco has been stressing that it is not in the best interest to the tax payers to modify loans in this way. I do not understand how he can say that with the money that this would free up in our economy. If people have that money, they will spend it. The tax payers want to spend money. To spend money, we need jobs. To create jobs, we need demand. To create demand, we need expendable income. Equity in our assets creates confidence and morale. Those with confidence and morale will be more willing to spend money. As we spend money, we create jobs. I know that I’m going in circles with this; maybe I’m missing something. But any way that I look at it, it seems that principal reductions are the best way to go.
The average American did not create the problem we face today. The banking industry has made beaucoup profits at our demise. It is time that the banks correct the problem they created and give us back realistic debt to asset ratios.

Posted by StephanieRenee | Report as abusive

StephanieRenee, what you are proposing is much like a “short sale”. The borrowers are able to sell (if they wish) but any profit over the reduced principal goes to the lender. The difference is that your proposal would also reduce the loan payments *without* the borrower needing to move out.

Any government spending program would stimulate the economy, but they might not all do so equally. Your proposal involves a large immediate writedown (e.g. $100k) to provide reduced mortgage payments (e.g. $5k/year lower) over a 30-year period of time. The stimulus would be greater if that $100k were spent over a shorter period of time. This program would benefit a small number of households at a high cost with only a slight increase in expendable income. Simply not effective stimulus.

“The average American did not create the problem we face today.”

Nonsense. The average American happily joined in the game, believing that this was the easy path to wealth. (After all, real estate always rises, right?) The average American was clearly duped — but nonetheless played a critical role in creating the problem. Prices do not shoot through the roof without average American’s borrowing and buying at inflated prices!!!

P.S. Can’t really call them “homeowners” when they have no equity in the property.

Posted by TFF | Report as abusive
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