Principal reductions: DeMarco vs Geithner
DeMarco, in a letter to Congress, explains that the Treasury has put a lot of effort, and is willing to put very large sums of money, into something with the rather unwieldy name of HAMP PRA, where PRA stands for Principal Reduction Alternative. But here’s the thing: PRA is going to get nowhere unless Fannie and Freddie sign up for it. And they can’t sign up for it until DeMarco signs off on it. And DeMarco is refusing to sign off on it.
DeMarco has released a 15-page paper explaining his decision, although in reality his letter, and the reasoning in it, is much clearer. He basically says that principal reductions would be costly to implement, and he doesn’t have a lot of time for Treasury’s offer to pick up the tab: “although principal forgiveness may provide some financial benefit to Fannie Mae and Freddie Mac,” he writes, “it presents operational challenges for them and their servicers as well as a risk of loss to the taxpayer”. It’s not his job to worry about costs to Treasury or taxpayers generally — but he’s making it his job.
But the main thrust of DeMarco’s argument is less financial than it is moral. Any kind of principal-reduction strategy risks encouraging strategic default, and DeMarco hates the very idea of strategic default. And even if there’s no strategic default at all — and the letter from Geithner makes a very strong case that strategic defaults as a result of this plan would be de minimis — DeMarco still hates principal reductions on, well, principle:
Perhaps the greatest risk of the Enterprises’ allowing principal forgiveness is one with far more significant long-term consequences for mortgage credit availability. Fundamentally, principal forgiveness rewrites a contract in a way that other loan modification programs do not. Forgiving debt owed pursuant to a lawful, valid contract risks creating a longer-term view by investors that the mortgage contract is less secure than ever before. Longer-term, this view could lead to higher mortgage rates, a constriction in mortgage credit lending or both, outcomes that would be inconsistent with FHFA’s mandate to promote stability and liquidity in mortgage markets and access to mortgage credit.
This is a classic “parade of horribles” argument, and it’s not a particularly strong one, either. As Jared Bernstein says, “in unusual times, like the aftermath of the worst housing bubble implosion in decades with 30+% price declines, guess what? Write downs happen.”
But the weirdest thing about this argument is that the horribles aren’t particularly horrible. Higher mortgage rates? Um, fine: no one is exactly complaining that mortgage rates are too high right now. A constriction in mortgage credit lending? That’s fine too: it was too-lax credit lending that caused this whole problem in the first place. Both together? Even that’s fine: it would help bring homeownership rates down from their current too-high levels, and encourage more people to rent rather than own, creating a more flexible national labor force.
The fact is that while it’s imperative that we fix the problem of broken mortgages issued at the height of the credit bubble, the last thing we want to do is return to those days and tell anybody who wants a house that they can just go out and buy one, whatever their creditworthiness or cash position. If you want to make mortgages safer, you should ensure that homeowners have large amounts of positive equity in their homes. That means significant down-payment requirements for people buying houses. And it also means significant principal reductions for those who are currently underwater.