The debate on “principal forgiveness” goes on. Policymakers from Treasury secretary Timothy Geithner to numerous members of Congress are urging lenders and mortgage servicers to reduce loan balances to help homeowners remain in their houses and prevent additional foreclosures, given the fact that 12 million homeowners are “underwater” on their mortgages and in danger of defaulting.Even Christine Lagarde, the head of the International Monetary Fund, has called on the U.S. government to reduce mortgage debt “as a way to help revive that nation’s economy and stimulate growth in the wider industrialized world.”
The debate seems to be particularly intense with regard to loans held or guaranteed by Fannie Mae and Freddie Mac, where acting Federal Housing Finance Agency director Edward DeMarco seems unconvinced that principal writedowns are in the best interests of the institutions he oversees and, ultimately, the taxpayer.
We have sympathy for DeMarco’s position for numerous reasons, among which are the following:
• There would appear to be no way in which the selective reduction of principal could be fairly or equitably administered. While Fannie Mae and Freddie Mac may have substantially loosened their credit criteria leading up to the housing collapse, they generally lent money at very competitive fixed rates and avoided mortgage products which were overly exotic or whose terms were hidden from borrowers or poorly disclosed. The argument for principal reduction rests on theories such as “it’s not the borrowers’ fault that values in their neighborhood have fallen.” But let’s look at the case of two borrowers — one family who bought with zero down and their neighbors who put 30% down. Assume in this example that both loans were sold to or guaranteed by Fannie or Freddie. After a 30% value decline, Borrower A is now 30% upside down and Borrower B is at 100% loan-to-value. Should the taxpayer, which effectively owns both mortgages, pay to put borrower A on an equal footing with borrower B? Why wouldn’t every borrower in the community want an equivalent reduction in principal with that which was granted to borrower A?
• As a loss mitigation tool, principal reduction would only apply to those borrowers who are severely delinquent or in danger of imminent default and not to borrowers who honor the terms of their note through timely payment. But what sort of perverse incentive is that? Wouldn’t it encourage all borrowers to stop their monthly payments so that they could qualify for principal reduction? And how would this affect Americans’ future behavior toward other contracts they enter into to borrow money?
• To the extent that individual mortgages are pooled together into MBS, how would the prospect of principal reduction affect the decision making of investors in mortgage securities in the future, knowing that repayment might be optional, contingent on a number of economic circumstances and political reactions? One would expect that mortgage investors would demand a higher return for a higher risk, which would lead to increased costs for all mortgage borrowers.
• A number of studies have shown that the aggregate amount of negative equity is highly concentrated in certain states. A recent study by the Brookings Institution, for example, has shown that well over 50% of the negative equity in the country is concentrated in five states—California, Florida, Arizona, Massachusetts and Nevada. The distribution of taxpayer funds in such an uneven way would certainly raise public policy issues of fairness.
• It has been suggested that DeMarco may be reconsidering the issue of principal reduction if there are leftover funds in the Troubled Asset Relief Program (TARP) to fund the reductions. But surely such a decision should be made only upon solid evidence that the overall cost to the taxpayer is reduced by such forgiveness, whether financed in the form of TARP funds or additional governmental funding for Fannie and Freddie.
As we have written before, there may be a role for principal reduction in easing the foreclosure crisis, but only under very limited, controlled circumstances.
First, it must be determined that the borrower was induced to enter into a complex mortgage transaction whose terms were readily capable of misinterpretation. Secondly, it must be determined that the borrower did not falsify income, employment, or other information in obtaining the mortgage. Thirdly, if the first two hurdles have been crossed, the amount of the principal reduction must be converted into a second trust which could be repaid if property appreciation were to occur in the future.
Otherwise, policymakers should stop talking about principal reduction and focus on loan modifications, short sales, deeds in lieu of foreclosure, leasing arrangements, or other more practical ways of minimizing foreclosures and returning the housing market to normalcy.
Alexander Boyle is the retired vice chairman of Chevy Chase Bank. Robert Broeksmit is a senior director at Treliant Risk Advisors and a former president of B.F. Saul Mortgage Co., a unit of Chevy Chase.