Counterparties: DeMarco’s principal principle

By Ben Walsh
April 11, 2012

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The most hotly debated cure for America’s gigantic and protracted foreclosure crisis is all about principal – or rather, principle. The idea behind principal reduction is straightforward: Instead of valuing a struggling borrower’s mortgage at its original value, you reduce the amount to something closer to the market value. That, the argument goes, lowers the borrower’s payments and makes him or her all the more likely to stay in that home.

The business press jumped yesterday when it seemed that Ed DeMarco, head of the FHFA (Federal Housing Finance Agency), the regulator that oversees Fannie and Freddie, seemed finally to change his principles on principal reduction. The American Banker this morning was rightly skeptical – DeMarco in fact only opened himself to discussing the topic. DeMarco’s argument against principal reductions is that they could trigger “strategic defaults.” Of course, this moral hazard argument is somewhat ironic coming from the regulator of taxpayer-owned Fannie and Freddie.

It’s unfortunate that DeMarco, who has taken a huge amount of criticism for his intransigence on mortgage modifications, trotted out this tired logic. Although calling him “America’s most dangerous man” is going a bit far, DeMarco’s speech (and accompanying presentation) was deeply disappointing in its focus on the bogeyman of “strategic modifiers”:

One factor that needs to be considered is the borrower incentive effects. That means, will some percentage of borrowers who are current on their loans, be encouraged to either claim a hardship or actually go delinquent to capture the benefits of principal forgiveness?

As Nick Timiraos points out, DeMarco’s model shows the taxpayer savings from principal reduction are lost if from 1 percent to 5 percent of homeowners who are underwater but not delinquent strategically default. HUD Secretary Shaun Donovan, however, says “the vast majority of homeowners don’t operate that way.”

After decades of Americans hearing the benefits of homeownership from all angles, it’s hard to believe that a Fannie-Freddie principal reduction program would lead to a wave of people defaulting. There’s some evidence that strategic default isn’t all that big a problem and may actually be declining. There’s even a whole genre of media profiles that chronicle just how difficult and painful it is for homeowners to decide to walk away from their homes.

But strategic defaults continue to scare DeMarco, just as they do Rick Santelli and Dick Bove. DeMarco’s tone is obviously different, but the vision of the American homeowner as the post-crisis welfare queen is the same.

It’s true that we don’t have good data to know precisely how homeowners will react to a principal reduction program at Fannie and Freddie. But if a principal reduction plan is, as DeMarco says it is, an argument about “which tools, at the margin” make a difference, why not give it a go? Bank of America, for one, is trying a variation of it.

It’s a strange day when a key regulator hews closer to the views of TV pundits than the Treasury Secretary. – Ben Walsh

And on to today’s links:

Government-owned AIG is getting back into the real estate investing game – WSJ

Consider Yourself Warned
Subprime loans are back as lenders return to “business as usual” – NYT

Foreclosure record-keeping is so bad, BofA is repeatedly suing itself in Florida – HuffPost

EU Mess
German bond yields are at record lows – WSJ

Tax Arcana
How big company execs’ “personal safety perks” (read: corporate jets, etc.) become tax write-offs – NYT

Shock! There are more efficient ways for the government to collect taxes – NYT

What’s going on with Google’s $12 billion toy? – WSJ

Primary Sources
Full text: The DOJ’s e-book price-fixing suit against Apple, publishers – Reuters Legal

Publishers caught conspiring in “upscale Manhattan restaurant” – MoJo

Facebook may have gotten a major deal on Instagram (on a per-user basis) – Wired

Why banks aren’t lending more – Bonddad Blog

Zimmerman to be charged in Trayvon Martin shooting – WashPost

Austan Goolsbee wants you to learn from his mother’s “strategic toilet paper reserve” – WSJ

Carlyle is seeking an IPO as big as $8 billion – Bloomberg

There is a penny lobby. And it is powerful – Fortune

As If You Needed To Ask
“Are people finally getting bored with the tech-blog circle jerk?” – SF Weekly

Just four jobs are worse than being a newspaper reporter – Poynter

Dismal Science
There’s no “invisible hand” of the market. Please update your records – Harvard Business Review

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5 comments so far

Stop torturing yourself. Strategic defaults don’t “scare” Rick Santelli; he merely thinks principal reductions are grossly unfair since it’s relief unavailable to other speculators like the kind he works among.

Why should house buyers’ losses be treated differently than other levered speculators?

And why draw solace from the fact “that we don’t have good data to know precisely how homeowners will react to a principal reduction program at Fannie and Freddie”?

Are you hoping, since the data doesn’t disprove it, that underwater homeowners will continue behaving irrationally when incented to default?

Incent default and you’ll get it, eventually. I’ll betcha.

Posted by dedalus | Report as abusive

Everything about Fed and government policy is disingenuous.
Q.E. does not increase bank lending, it just raises the price of risk assets(kudos to the MMT crowd for getting this) the goal of which is to assist banks on the asset side and give them some profits by front running treasury purchases and getting a free 25 basis points from the Fed in interest.

So what does this have to do with Fannie Mods? Everything. The last several years of mortgage lending going into 2008 was done with 80/20 loans (and I’m including the conforming market where Fannie & Freddie are). The banks own the 2nd liens. My having tax-payers take the hit on the first liens the bank 2nds are put in a better position. This is exactly what occurred in the
mortgage settlement with the banks, only Donovan and Obama won’t admit it.

Demarco is right, the benefit to the tax payer by modifying 1st lien Fannie Mae Loans is minimal. To benefit the loan would need to be in danger of default and savable by reducing the loan balance and payment with the lost money in reduction less than the cost of foreclosure. This is a collar trade if anything. And Demarco is right again, that a mod policy risks strategic defaults by those who would have paid.

So why is the Obama pushing this? First its good politics in an election year from the Democratic base, and second it helps the banks which are good donors.

It’s a shame politicians can’t say what they mean and mean what they say.

Posted by Sechel | Report as abusive

dedalus, if householder losses were treated like other leveraged speculators they would have been out of their houses years ago.

DeMarco had to respond because in the absence of his response people felt free to simply fabricate, where as now they have to resort to outright lying. We now know the famed “Frannie would save money if it did principal reductions” is only true for a minority of borrowers and only if the goverment makes up most of the difference. When Eissenger broke the [non-]story, one could at least pretend he hadn’t seen all the data – not that this stopped him making that bit up – but anyone who now claims principal reductions will save taxpayer any non-trivial amount of money is a balls-out liar.

Posted by Danny_Black | Report as abusive

“but anyone who now claims principal reductions will save taxpayer any non-trivial amount of money is a balls-out liar.” (DB, above)

Welcome back, from the dark side, Danny. Now, if you can just get past that infatuation with the likes of GS ….

OBTW: Just to reiterate – Second mortgages have to be wiped-out before Firsts take any write-downs at all; anything else is a criminal breach of trust.

Posted by MrRFox | Report as abusive

Also can I suggest that people actually read his speech rather than the mickey mouse claims about what he is saying. Fundamentally principal reductions would only “make financial sense” to Frannie because for every dollar the GSEs forgive, they get up to 63 cents from the government. This is the key part of the speech.

Posted by Danny_Black | Report as abusive
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