The Pros and Cons of Principal Reduction: Geithner vs. DeMarco
Late Tuesday there was a bit of sparring between
Edward J. DeMarco, Acting Director of the Federal Housing Finance Agency and
Treasury Secretary Timothy Geithner. DeMarco
sent a letter to Congress restating his opposition to allowing Freddie Mac and
Fannie Mae (the GSEs) to participate in the Principal Reduction Alternative (PRA)
sponsored by the Home Affordable Modification Program (HAMP.) Geithner shot back an objection to DeMarco in
a letter accompanied by a five page explanatory memo.
As background, HAMP originally focused on reducing mortgage payments
through interest rate reductions and loan term extensions, later adding
principal forbearance to the mix. While
servicers could employ principal reduction at their investors' discretion it
was seldom used. Then in 2010 Treasury offered
incentives to encourage principal reduction for loans with loan-to-value (LTV)
ratios above 115 percent and formalized a HAMP PRA making principal forgiveness
the first step in the modification process.
Early this year Treasury tripled its servicer incentives. They also offered incentives to the GSEs and urged
FHFA to permit PRA in GSE foreclosure prevention programs.
DeMarco has always couched his objections to principal reduction in terms
of FHFA's responsibilities as conservator of the GSEs. He defines these first as an obligation to
put the GSEs in a sound and solvent condition, preserving and conserving their
assets and properties; second to ensure that they operate in a safe and sound
manner and carry out their role in the housing finance markets, and finally, to
maximize assistance for homeowners. DeMarco said that HAMP and other
foreclosure prevention efforts on the part of the GSEs have been important in
meeting these obligations.
Time did not allow a thorough reporting on the two sides yesterday but it
seems important to look at the justifications each man has for their opposing positions.
In order to make the differences between FHFA and Treasury clear, we summarize
and present the contents of DeMarco's letter to the House Committee on Banking,
Housing, and Urban Affairs and follow it with the responses from Treasury as
contained in the accompanying memo written by Michael Stegman, Counselor for Housing Finance Policy. Treasury's comments are bold-faced.
In response to the Treasury proposal FHFA undertook a detailed analysis
of the possible effectiveness of PRA for the GSEs' books of business. The analysis had three components; a
model-based assessment of benefits to both GSEs and taxpayers; a consideration
of costs, and a review of borrower incentives and how changes in borrower
behavior could affect results.
The model-based analysis tested whether principal reduction reduces the likelihood
of default relative to loan modifications.
The most favorable analysis found that between 74,000 and 248,000 borrowers
might be eligible for a HAMP PRA with a projected net benefit to taxpayers of
$500 million, most of which comes from borrowers who have not made a mortgage
payment in more than a year. DeMarco
said that experience indicates that the likelihood of successfully modifying
and reinstating these loans is small and the benefit is likely to be less than
An analysis of HAMP data was done for the Treasury Department by
Fannie Mae which showed that in the six months following modification and
controlling for loan and borrower characteristics, the re-default rate was
lower for loans with principal reduction than for those without it. "This early positive difference in re-default
rates in favor of principal reduction," Stegman says, "is expected to increase
further as the loans age." The analysis suggests
that reducing the LTV ratio "not only increases a borrower's ability to pay,
but for these selected borrowers it also increases the likelihood that they
will continue to pay."
The targeted use of the PRA is not only consistent with FHFA's
statutory responsibilities it is also the most prudent way for it to meet its
obligations. It will help preserve the
assets of the GSEs as well as minimize foreclosures and maximize assistance to
homeowners. As GSE loans represent more
than half of outstanding mortgages, the reach and outcome of mitigation
programs depend significantly on GSE participation. Recognizing this, Treasury has tried to make
it easier and more compelling for the GSEs to align their programs with those
in the private markets.
Specifically, Treasury supports use of principal reduction on a
loan-by-loan basis, not for the GSE portfolios as a whole. "Principal reduction should only be used when
the modified loan has a positive net present value (NPV) greater than any other
FHFA's original analysis of principal reduction was applied to the
entire GSE portfolio of underwater borrowers.
Performed correctly on a loan-by-loan basis, principal reduction would
apply in a limited number of cases and show a positive NPV result for both GSEs
The corrected, Treasury said the analysis would show almost a
half-million underwater borrowers who could benefit and potential savings of
$3.6 billion to the GSEs compared to standard loan modification outcomes. After deducting Treasury incentives of $2.7
billion, there would still be a net savings to taxpayers of up to $1 billion.
The program would be costly to implement and whether the costs were paid
by Treasury or the GSEs the effect would be an increase in taxpayer costs
offsetting at least some portion of the projected benefits. Some of these costs could be shifted from
other loss mitigation activities but the general result was that the benefits would
accrue to few homeowners and "would not outweigh the significant cost and
challenges to implement a program."
Treasury has offered to
help FHFA address the problem of diverting management attention from higher
priority objectives by paying the additional administrative costs required to
implement HAMP PRA. We also have offered
to work with the GSEs to rearrange Treasury priorities for other HAMP-related
administration projects to free up both human and technical resources for this application.
While investors and
servicers can selectively offer PRA, the GSEs would have to make public
announcements, devise uniform program eligibility standards, and produce a set
of published decision rules for over a thousand servicers to apply. This could create a moral hazard situation in
which borrowers might perceive that the government endorses forgiveness of debt
if hardship can be proved, providing an incentive for borrowers to seek ways to
become eligible. DeMarco said if only a
small portion of borrowers (3,000 to 19,000) strategically defaulted it would result
in a net loss to taxpayers even using the most favorable model-based
The most undesirable
outcome, DeMarco said, would be an impact on future mortgage credit
availability. Principal forgiveness rewrites
a contract in a way that other modification programs do not and risks creating
a longer-term view by investors that the contract is less secure than ever
before. Longer term this could lead to
higher mortgages rates, a constriction in lending, or both; outcomes that would
be inconsistent with FHFA's mandate to promote stability, liquidity, and access
in the mortgage markets.
Treasury believes that the design of HAMP and the documentation
required should address concerns about strategic defaults. In addition a borrower has no assurance that
such a default would result in obtaining a principal reduction or even a
modification but would surely result in ruined credit and possible perjury
charges. For these reasons we do not believe
that the existence of PRA alongside other relief programs would negatively
affect the future cost and availability of credit.
Never-the-less we have indicated our willingness to include an asset
test or other hardship screen to increase the likelihood that only borrowers
with genuine hardships receive a principal reduction.
Importantly, banks are using principal reduction in their own
portfolios and providing substantial sums in reductions for a very high
percentage of eligible borrowers. "Thus,
facing the very factors faced by FHFA, including the risk of strategic default,
private lenders have determined that the judicious use of principal reduction
makes financial sense.