What do the federal bureaucrats who run Fannie Mae and Freddie Mac know that private mortgage lenders don't?
Private lenders apparently believe that when homeowners fall behind on their mortgage payments, sometimes their loan principal should be reduced. In the third quarter of 2011, 18% of homeowners who received a modification on a loan held in a bank's portfolio saw their principal cut.
Banks are not doing charity work here. They've run the numbers, and concluded that under some circumstances, what makes the most sense for their own bottom lines is to grant a principal reduction.
As Columbia Business School professor Christopher Mayer said, referring to banks granting principal reductions, “I believe they like profit.”
It's assumed that principal forgiveness will encourage a certain percentage of borrowers to stop paying their mortgages in the hope that they, too, will get a break from their lender. But the borrowers who get their principal reduced will be more likely to keep paying, especially if they are close to building equity in their homes again. And lenders can earn more money from a mortgage that gets paid off than they do from a foreclosure sale.
"Every time I talk to someone in the private sector, they say principal reductions are incredibly effective," Mayer said.
The Federal Housing Finance Agency (FHFA), which has been making key business decisions at Fannie and Freddie since they became wards of the state in 2008, takes a different view.
"We have been through the analytics of the underwater borrowers at Fannie and Freddie," FHFA head Edward DeMarco said during a congressional hearing in November, "and we have concluded that the use of a principal reduction within the context of a loan modification is not going to be the least-cost approach."
That explanation did not satisfy a group of House Democrats who have been calling for Fannie and Freddie to start granting principal reductions. So they pressed the FHFA to make public its analysis of the relevant data.
Last month, the agency sent to Capitol Hill a six-page document that comprises the FHFA staff's most recent analysis of the issue. The document paints a far less definitive picture about the agency's findings than DeMarco portrayed in his Capitol Hill testimony.
The analysis, which has gotten far less attention than it deserves, compares the expected taxpayer losses on hypothetical borrowers who would receive principal forgiveness modifications versus those who get principal forbearance.
(Under principal forbearance modifications, which Fannie and Freddie currently use, borrowers see a reduction in their monthly payments, but when they eventually pay off the loan, they are still responsible for the deferred principal.)
The agency estimates that for Freddie borrowers who qualify for the Obama administration's loan-modification program, and who owe at least 15% more than the value of their homes, principal forgiveness would cost taxpayers about $166 million compared to forbearance.
But for Fannie borrowers in the same situation, principal forgiveness would actually save taxpayers $534 million – or three times the losses on the Freddie loans – compared with forbearance.
FHFA also analyzed scenarios in which borrowers don't qualify for modifications because a foreclosure sale of their homes would yield more money for the lender than a modification would. While those scenarios showed a small advantage for forbearance over forgiveness, that group of borrowers seems irrelevant; no one is proposing principal reductions for homeowners who don't qualify for loan modifications.
Under the more important scenario – those borrowers who do qualify for modifications – the agency's analysis found virtually no difference in the cost to U.S. taxpayers between principal forgiveness and forbearance and if anything gave a slight edge to forgiveness.
Nevertheless, DeMarco wrote in a letter to congressional Democrats, “The net result of the analysis is that forbearance achieves marginally lower losses for the taxpayer than forgiveness.”