Edward Demarco has been under a lot of pressure lately. To hear some people tell it, the acting head of the Federal Housing Finance Agency is the only person standing in the way of a full housing recovery.
A consensus has been emerging among some observers that principal write-downs must be part of any effective solution to the housing crisis, but DeMarco has steadfastly opposed them for the agencies he oversees. Given that those two enterprises—Fannie Mae and Freddie Mac—account for most of the mortgages in the country, his judgments carry enormous weight.
He made his case one more time at a Brookings Institution event on April 10. Taking the audience through a course in Loss Mitigation 101, DeMarco outlined the various approaches the Enterprises use in helping distressed homeowners. The most common loan modification tool is forbearance—tacking the delinquent balance onto the end of the loan. In the meantime it doesn’t accrue interest, so the borrower is not overburdened. The upside for the loan investor is that the entire amount is repaid as the loan matures, or in the event of a sale. With principal forgiveness, any amounts written off are gone forever.
Citing Fannie Mae studies, DeMarco noted that default rates do not increase when homeowners are deep underwater. Most people keep paying, even when they have no hope of regaining any equity soon. That willingness to pay—the goodwill of average consumers—is what keeps the system afloat.
And he noted the most powerful argument against principal reductions: the moral hazard of tempting current borrowers to default so they can receive the same benefits as their delinquent neighbors.
Critics point out that private mortgage investors have employed principal write-downs very effectively in their loan modifications. But as DeMarco noted, Fannie and Freddie exist in a different universe: Any policies they adopt must be consistent for the hundreds of servicers they work with. Unlike private investors, they can’t custom-design solutions for individual borrowers. And, Fannie and Freddie must publish their policies for everyone to see, making it more likely that consumers would discover them and devise ways to qualify—including strategic default.
During his speech, DeMarco noted in passing that Fannie and Freddie actually do have a principal forgiveness option. It’s called a short sale.
Loan deficiencies are routinely (though not always) forgiven in a short sale. At last, you can be free of your unbearable mortgage debt. You just won’t have a house anymore.
Most of us would like to have our cake and eat it too. DeMarco urges people to choose one or the other.