Gretchen Morgenson’s bizarre defense of Ed DeMarco

By Felix Salmon
March 25, 2012
myself included, who would love him to allow Frannie to do principal reductions where it makes sense. But now he's managed to find a defender. In Gretchen Morgenson, of all people.

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Ed DeMarco, the regulator in charge of Fannie Mae and Freddie Mac, has many critics, myself included, who would love him to allow Frannie to do principal reductions where it makes sense. But now he’s managed to find a defender. In Gretchen Morgenson, of all people.

Morgenson’s column today is utterly bizarre. She starts off by painting DeMarco as a “career public servant”, “under fire” in a “thankless job”. This is a phrase she seems to reserve for DeMarco alone: she made sure to describe him as a “career public servant” in 2010, as well as in her book. And as far as I can tell, she’s described no one else that way. And there are many career public servants, up to and including Tim Geithner, who can’t stand DeMarco* and who think he is being deliberately obstructionist here.

Morgenson then defends DeMarco from critics like Barney Frank and Elijah Cummings:

What the proponents of principal reductions at Fannie and Freddie don’t talk about is what a transfer of wealth from taxpayers (again) to large banks such a program would represent.

Morgenson is actually serious about this: the headline on her column is “A Bailout by Another Name”. And when she says bailout, she doesn’t mean a bailout of deadbeat homeowners, who would see their net worth jump overnight as a bunch of their obligations were written off at a stroke. No, she means a bailout of banks.

On the face of it, this makes no sense. How can reducing homeowners’ principal end up as a bailout of banks? And not just any bailout, either: Morgenson goes on to tell us that such a program “would constitute a direct and sizable gift from taxpayers to the largest banks”, “another backdoor bailout for the banks that brought you the mortgage crisis”, and “another stealth bank bailout, courtesy of taxpayers”.

Don’t worry, Morgenson does actually spell out her thesis here. In her 1,170-word column, she spends a full 65 words explaining exactly how principal writedowns are in fact a “direct and sizable gift” to banks. So I may as well quote those words in full:

Many banks hold second liens on the same properties for which Fannie and Freddie either own the first mortgage or have guaranteed. If principal amounts on these first mortgages are reduced while leaving the second liens intact, those seconds become much more likely to be paid off over time. With no principal reduction, the banks would have to write off many of those second liens.

That’s it. I don’t know what your idea of a “direct gift” is, but I’m pretty sure it’s not this. Even if Morgenson’s argument here made sense, which it doesn’t, the gift would at best be indirect. And there’s nothing here at all indicating that it’s sizable.

More to the point, Morgenson’s whole argument, such as it is, is based on a classic straw man — that the holder of the first lien would be perfectly happy to write down a large chunk of what they were owed without any kind of write-down whatsoever on the part of second-lien holders. As far as I know, nobody advocating principal reductions is proposing this.*

It’s worth remembering here, that the whole point of principal reductions is that when people are underwater on their homes, they’re much more likely to default than when they have equity in their homes. If you reduce principal to the point at which the homeowner has positive equity again, then you’re more likely to get repaid, and you can end up with a more valuable loan than one with a higher face value.

But if there’s a second lien on the house in question, then even if the first lien is reduced to less than the value of the property, the homeowner would still be underwater, thanks to that second lien. Which would quite literally defeat the purpose of reducing the principal on the first lien.

Banks holding first mortgages negotiate with banks holding second mortgages all the time. If the homeowner is in default, then the owner of the first lien is in a strong negotiating position: they can foreclose on the home, sell it, and take all the proceeds, leaving nothing at all for the holder of the second lien. And because the second-lien holder is well aware that the first-lien holder has that nuclear option, they’re normally well disposed to negotiate: they’ll accept $5,000, say, to write off their debt.

Why does Morgenson think that wouldn’t happen here? She doesn’t say — after all, her entire argument is just 65 words. But she does go on at some length about the loan modifications which we are seeing from Frannie — more than 1.1 million, to date, with an impressively low redefault rate. She writes:

This suggests that the types of loan modifications provided by Fannie and Freddie — reducing borrowers’ monthly payments — are working fairly well. Addressing borrowers’ ability to repay loans has been the focus, Mr. DeMarco said. At the same time, these changes in loan terms do not encourage people to default in spite of being able to pay.

What Morgenson doesn’t seem to realize, here, is that exactly the same argument that she’s marshaling against principal reductions could be used against loan modifications as well. If you reduce borrowers’ monthly payments, and increase their ability to repay their loans, then quite obviously you’re also increasing their ability to repay second liens as well. And if you do a loan modification rather than foreclose on the delinquent borrower, then the second lien holder isn’t wiped out and the homeowner can continue to pay off their second lien over time.

So how is it that principal reductions are a giveaway to banks, but loan modifications aren’t? Morgenson even says that loan modifications don’t encourage people to default on their original loans, which would seem to be an argument for principal reduction: the moral-hazard argument, that such things only serve to give people an incentive to default, seems already to have been disproven with the loan-modification program.

Remember, too, that Morgenson said in her 65-word argument that “with no principal reduction, the banks would have to write off many of those second liens”. Something doesn’t add up here. After all, banks will never voluntarily write off a second lien if the homeowner gets a loan modification which increases their ability to repay their debts. So if Frannie is great at loan mods, then they must also be great at forcing second-lien holders to write off their loans at the same time. But if they can do that with a loan mod, they should be able to do it with a principal reduction, too. And if they don’t do that with loan mods, then the banks wouldn’t otherwise be forced to write off those second liens.

And we haven’t even touched, yet, on the most obvious and silliest part of Morgenson’s case — which is that most of Frannie’s delinquent mortgages don’t have second liens attached. DeMarco doesn’t like the idea of doing principal reductions on homes with second liens? Fine, don’t do it, then. But that’s no reason not to do principal reductions on loans without second liens.

More generally, DeMarco is just the regulator, here — he’s not actually running Fannie and Freddie. If he lifted his injunction on principal reductions, then we wouldn’t suddenly see a huge influx of the things overnight. These agencies move slowly and deliberately, and they’d almost certainly start small, and only on homes where there weren’t second liens. If that program worked, then they’d expand it, taking just as much care in doing so.

Morgenson’s argument implies that were it not for DeMarco holding back the floodgates, Fannie and Freddie would be doing principal reductions on a massive and reckless scale, without even trying to involve banks holding second liens. She has no reason to believe this, because it isn’t true. The agencies might be philosophically inclined — for good reason — to do principal reductions, but only when and because they make financial sense. DeMarco, on the other hand, seems to have some kind of quasi-religious belief that principal reductions never make financial sense. And his arguments to that effect are extremely weak.

But not as weak, it must be said, as Morgenson’s effort today. If principal reductions really would be “a direct and sizable gift from taxpayers to the largest banks”, then the largest banks would surely be pushing loudly for their implementation. But they’re not. Because the principle beneficiaries of principal reductions are not banks, but rather homeowners — the people whom Gretchen Morgenson wants to see continuing to suffer under the weight of mortgages worth far more than their homes. And all because of some inchoate and irrational animus she has towards Fannie and Freddie.

*Update: Anthony Coley at Treasury emails to say that Geithner “has tremendous respect for Mr. DeMarco”, even as he thinks “there’s a pretty strong economic case for principal reduction as part of a strategy to limit the future losses of the GSEs. What Treasury is trying to do is encourage Mr. DeMarco, who is fully independent, to take another look at the evidence because we think there’s a place to do more in a way that is consistent with the mandate that Congress gave him.”

And Shahien Nasiripour, who’s been getting the same line from DeMarco, points out that there is at least one person who thinks that principal reductions should be done absent write-downs on second liens: NY Fed president William Dudley.

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