The Treasury Department's pledge of unlimited support for Fannie Mae and Freddie Mac may foreshadow changes to the Obama administration's Home Affordable Modification Program (HAMP).
The Treasury said last week that it would inject as much money "as necessary" into Fannie or Freddie over the next three years to ensure that the government-sponsored enterprises have positive net worth. Previously the government had committed to buy up to $200 billion of preferred stock in each GSE. Those commitments, from which Fannie has drawn $60 billion and Freddie has taken $51 billion, were scheduled to expire at yearend.
Analysts said one reason the Treasury increased its commitment was that it expects to expand the modification program to let servicers reduce borrowers' principal balances. Such an expansion would compound the GSEs' losses and further erode their capital.
"Once they do principal reductions, they'll take a hit on the outstanding balance and need to write that off," said Ed Pinto, a consultant and former chief credit officer at Fannie Mae. "So they're creating room here by taking the caps off in terms of support they're offering to Fannie and Freddie."
As it stands, neither GSE would need more than $200 billion from the government to cover foreseeable losses, observers said.
"The Treasury's open-ended capital backstop is more of a confidence-building step than a response to actual/projected need," Qumber Hassan and Mahesh Swaminathan, fixed-income analysts at Credit Suisse, wrote in a note to clients Sunday.
Many mortgage experts have suggested that the only way to keep redefault rates on modified loans low is to reduce principal for borrowers, particularly those with negative equity who have a reduced incentive to stay in their homes. Modifications where servicers reduced principal have among the lowest redefault rates in the industry.
The Obama program allows the GSEs to forbear or defer a portion of principal until the loan is paid off and to waive interest on the deferred amount, but it does not allow for principal reduction.
Uptake for the program, which was introduced in March, has been slow. By late November, according to the Treasury, 31,382 borrowers had received permanent modifcations, or just 4% of the number who had begun trial mods under the program.
Regulators have attributed the low conversion rate to understaffing among servicers and borrowers' failure to return the necessary documentation. Last week Treasury gave borrowers whose trial mods were scheduled to expire a second one-month extension, until Jan. 31, to complete the paperwork.
The HAMP "by all accounts hasn't really worked and there is pressure to make it more effective," said Bose George, an analyst at KBW's Keefe, Bruyette & Woods.
George suggested that the Treasury has two options. It can further reduce the paperwork borrowers must provide to convert a trial mod into a permanent one. (Conversion also entails making three consecutive payments.) Or it can let Fannie and Freddie reduce principal for a narrow segment of defaulted borrowers.
Fannie, Freddie and their regulator and conservator, the Federal Housing Finance Agency, referred all questions to the Treasury, which did not respond to questions by press time.
Pinto said the Treasury has not acknowledged that the largest bank-owned servicers already have been taking significant principal reductions on loans held in their own portfolios.
Portfolio lenders reduced principal for 17,259 borrowers in the third quarter, according to a report released last week by the Office of the Comptroller of the Currency and the Office of Thrift Supervision. By contrast, Fannie reduced principal for 80 borrowers in the period, while Freddie Mac did so for 54 borrowers, the report found.
Pinto said modifications on loans held in servicers' own portfolios have performed better than those serviced for the GSEs largely because portfolio lenders have more flexibility in offering principal reductions, particularly for problematic option adjustable-rate mortgages.
Portfolio lenders had redefault rates of 12.1% after three months and 24.9% after six months, compared with Fannie's redefault rate of 27% after three months and 44% after six months, according to the report from the OCC and OTS.
Allowing principal reductions would create a significant risk of "moral hazard," by potentially encouraging millions of borrowers who are current on their mortgages to default, Pinto said.
One way around that problem, he said, would be to give the lender recourse to go after the borrower — not just the collateral — if there is a redefault.
"If a borrower gets a principal reduction, you make the loan recourse so the borrower knows they're on the hook and they can't just walk away," Pinto said. "It basically separates those borrowers who are looking for a deal from those who are actually serious about keeping their home. The thing that got us into this problem is we put borrowers who were essentially renters into homes."