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 $500 million.
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 modification.
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 and taxpayers.
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 assumptions.
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.
