The Pros and Cons of Principal Reduction: Geithner vs. DeMarco
Late Tuesday there was a bit of sparring betweenrnEdward J. DeMarco, Acting Director of the Federal Housing Finance Agency andrnTreasury Secretary Timothy Geithner. DeMarcornsent a letter to Congress restating his opposition to allowing Freddie Mac andrnFannie Mae (the GSEs) to participate in the Principal Reduction Alternative (PRA)rnsponsored by the Home Affordable Modification Program (HAMP.) Geithner shot back an objection to DeMarco inrna letter accompanied by a five page explanatory memo. </p
As background, HAMP originally focused on reducing mortgage paymentsrnthrough interest rate reductions and loan term extensions, later addingrnprincipal forbearance to the mix. Whilernservicers could employ principal reduction at their investors’ discretion itrnwas seldom used. Then in 2010 Treasury offeredrnincentives to encourage principal reduction for loans with loan-to-value (LTV)rnratios above 115 percent and formalized a HAMP PRA making principal forgivenessrnthe first step in the modification process. rnEarly this year Treasury tripled its servicer incentives. They also offered incentives to the GSEs and urgedrnFHFA to permit PRA in GSE foreclosure prevention programs. </p
DeMarco has always couched his objections to principal reduction in termsrnof FHFA’s responsibilities as conservator of the GSEs. He defines these first as an obligation tornput the GSEs in a sound and solvent condition, preserving and conserving theirrnassets and properties; second to ensure that they operate in a safe and soundrnmanner and carry out their role in the housing finance markets, and finally, tornmaximize assistance for homeowners. DeMarco said that HAMP and otherrnforeclosure prevention efforts on the part of the GSEs have been important inrnmeeting these obligations. </p
Time did not allow a thorough reporting on the two sides yesterday but itrnseems important to look at the justifications each man has for their opposing positions.rnIn order to make the differences between FHFA and Treasury clear, we summarizernand present the contents of DeMarco’s letter to the House Committee on Banking,rnHousing, and Urban Affairs and follow it with the responses from Treasury asrncontained in the accompanying memo written by Michael Stegman, Counselor for Housing Finance Policy. Treasury’s comments are bold-faced.</p
In response to the Treasury proposal FHFA undertook a detailed analysisrnof the possible effectiveness of PRA for the GSEs’ books of business. The analysis had three components; arnmodel-based assessment of benefits to both GSEs and taxpayers; a considerationrnof costs, and a review of borrower incentives and how changes in borrowerrnbehavior could affect results.</p
The model-based analysis tested whether principal reduction reduces the likelihoodrnof default relative to loan modifications. rnThe most favorable analysis found that between 74,000 and 248,000 borrowersrnmight be eligible for a HAMP PRA with a projected net benefit to taxpayers ofrn$500 million, most of which comes from borrowers who have not made a mortgagernpayment in more than a year. DeMarcornsaid that experience indicates that the likelihood of successfully modifyingrnand reinstating these loans is small and the benefit is likely to be less thanrn$500 million. </p
An analysis of HAMP data was done for the Treasury Department byrnFannie Mae which showed that in the six months following modification andrncontrolling for loan and borrower characteristics, the re-default rate wasrnlower for loans with principal reduction than for those without it. “This early positive difference in re-defaultrnrates in favor of principal reduction,” Stegman says, “is expected to increasernfurther as the loans age.” The analysis suggestsrnthat reducing the LTV ratio “not only increases a borrower’s ability to pay,rnbut for these selected borrowers it also increases the likelihood that theyrnwill continue to pay.”</p
The targeted use of the PRA is not only consistent with FHFA’srnstatutory responsibilities it is also the most prudent way for it to meet itsrnobligations. It will help preserve thernassets of the GSEs as well as minimize foreclosures and maximize assistance tornhomeowners. As GSE loans represent morernthan half of outstanding mortgages, the reach and outcome of mitigationrnprograms depend significantly on GSE participation. Recognizing this, Treasury has tried to makernit easier and more compelling for the GSEs to align their programs with thosernin the private markets.</p
Specifically, Treasury supports use of principal reduction on arnloan-by-loan basis, not for the GSE portfolios as a whole. “Principal reduction should only be used whenrnthe modified loan has a positive net present value (NPV) greater than any otherrnmodification.</p
FHFA’s original analysis of principal reduction was applied to thernentire GSE portfolio of underwater borrowers. rnPerformed correctly on a loan-by-loan basis, principal reduction wouldrnapply in a limited number of cases and show a positive NPV result for both GSEsrnand taxpayers.</p
The corrected, Treasury said the analysis would show almost arnhalf-million underwater borrowers who could benefit and potential savings ofrn$3.6 billion to the GSEs compared to standard loan modification outcomes. After deducting Treasury incentives of $2.7rnbillion, there would still be a net savings to taxpayers of up to $1 billion. </p
The program would be costly to implement and whether the costs were paidrnby Treasury or the GSEs the effect would be an increase in taxpayer costsrnoffsetting at least some portion of the projected benefits. Some of these costs could be shifted fromrnother loss mitigation activities but the general result was that the benefits wouldrnaccrue to few homeowners and “would not outweigh the significant cost andrnchallenges to implement a program.”</p
Treasury has offered tornhelp FHFA address the problem of diverting management attention from higherrnpriority objectives by paying the additional administrative costs required tornimplement HAMP PRA. We also have offeredrnto work with the GSEs to rearrange Treasury priorities for other HAMP-relatedrnadministration projects to free up both human and technical resources for this application.</p
While investors andrnservicers can selectively offer PRA, the GSEs would have to make publicrnannouncements, devise uniform program eligibility standards, and produce a setrnof published decision rules for over a thousand servicers to apply. This could create a moral hazard situation inrnwhich borrowers might perceive that the government endorses forgiveness of debtrnif hardship can be proved, providing an incentive for borrowers to seek ways tornbecome eligible. DeMarco said if only arnsmall portion of borrowers (3,000 to 19,000) strategically defaulted it would resultrnin a net loss to taxpayers even using the most favorable model-basedrnassumptions.</p
The most undesirablernoutcome, DeMarco said, would be an impact on future mortgage creditrnavailability. Principal forgiveness rewritesrna contract in a way that other modification programs do not and risks creatingrna longer-term view by investors that the contract is less secure than everrnbefore. Longer term this could lead tornhigher mortgages rates, a constriction in lending, or both; outcomes that wouldrnbe inconsistent with FHFA’s mandate to promote stability, liquidity, and accessrnin the mortgage markets.</p
Treasury believes that the design of HAMP and the documentationrnrequired should address concerns about strategic defaults. In addition a borrower has no assurance thatrnsuch a default would result in obtaining a principal reduction or even arnmodification but would surely result in ruined credit and possible perjuryrncharges. For these reasons we do not believernthat the existence of PRA alongside other relief programs would negativelyrnaffect the future cost and availability of credit.</p
Never-the-less we have indicated our willingness to include an assetrntest or other hardship screen to increase the likelihood that only borrowersrnwith genuine hardships receive a principal reduction.</p
Importantly, banks are using principal reduction in their ownrnportfolios and providing substantial sums in reductions for a very highrnpercentage of eligible borrowers. “Thus,rnfacing the very factors faced by FHFA, including the risk of strategic default,rnprivate lenders have determined that the judicious use of principal reductionrnmakes financial sense.
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