Part 1: Defending Ed DeMarco

Below is part one of a two-part series–”The argument about mortgage principal reductions”–which discusses the role of principal reductions in loan modifications. Part one explains, and partially defends, the decision not to include principal reductions as part of loan modifications. In part two, which will be published on Friday, we offer a compromising, cost-saving solution that still allows borrowers to take advantage of a principal reduction if they need it. Here is part one:

Mortgage principal reductions. Proponents say they are a crucial missing piece to helping struggling homeowners. Opponents see them as another taxpayer-funded giveaway to prop up a housing market still populated with people ill-suited to the requirements of homeownership. Good or bad, there’s certainly not a lot of black or white contained in the argument, just many shades of grey.

Like all government offers of assistance, there is no doubt an audience which can benefit. There are arguably some borrowers for whom a principal reduction would be a home-saving strategy, better suited to their needs than a standard loan modification.

But for homeowners who aren’t especially struggling, for those who aren’t eligible for HAMP and for those who haven’t lost enough home equity to be underwater, the words “principal reduction” can  evoke a different set of emotions, as in, “why should those people get thousands in mortgage debt eliminated when I get nothing?” To be fair, wouldn’t everybody like to see their mortgage chopped by thousands of dollars?

Well, Federal Housing Finance Agency head Ed DeMarco—the man who is in charge of the agency that oversees Fannie Mae and Freddie Mac—put an end to the debate when he officially announced that the FHFA would not endorse principal reductions in conjunction with HAMP modifications. As expected, not everyone was exactly happy with his decision.

“Fire Ed DeMarco,” “Firing FHFA Chief Ed DeMarco Could Be ‘The Biggest Stimulus Program In America‘” and “Demote, Defang DeMarco,” were just a few of the scathing headlines written in the days following the FHFA’s decision.

Homes, like any asset, can devalue

But is it fair, or even logical, to call for Mr. DeMarco’s job? He is in charge of ensuring that Fannie Mae and Freddie Mac don’t lose any more money. He is, in his own words, shielding the taxpayer from additional costs.

Let’s think about this for a second: Assets devalue all the time. If you buy a new car, drive it off the lot and see what it’s worth even 30 days later, you’ll find that your brand-new car is worth substantially less. Would you go back to the dealer and ask the finance company to write down the loan amount to the car’s current market value? They would laugh you out of the office! The same goes for stocks and bonds and any other item which has a value established in a free marketplace. Prices of assets go up and down all the time.

DeMarco’s decision may be the right one

Looking back, DeMarco has been against principal reductions all along. With the agency he heads managing two entities in conservatorship, his mission since becoming head of the FHFA has always included limiting the amount of loss to the taxpayer. Furthermore, DeMarco is also concerned about the “moral hazard” of allowing people to get out from under their contracted obligations while others get no such deal.

To be perfectly honest, since he is charged with limiting losses to Fannie Mae and Freddie Mac, DeMarco’s decision may be the right one, since the estimated cost to the taxpayer (in the FHFA’s own analysis) would be about $2.1 billion. This remains true even if he is standing in the way of what the White House, certain members of Congress and many economists would like to see happen.

What does a principal reduction accomplish?

Forgiving principal today accomplishes several things:

1. It causes an instant loss for an investor who owns the loan with no chance of recovery
2. It can provide a financial reward for the homeowner when home prices recover (if there is no requirement for repayment of the gift)
3. It creates a perverse incentive for some number of additional borrowers to strategically default so they might be able to obtain a loan-reducing modification

Also: In the event that the borrower is underwater, will the principal reduction be sufficient to wipe out their deficit, or will we still be leaving folks underwater, but only by a smaller amount?  How is this beneficial?

It’s time for a compromise

Instead of a black and white, accept or reject, attitude when it comes to principal reductions, perhaps an alternative, a compromise, could bring the administration and one of its top directors back on the same page.

Is there is potentially a fairer, more equitable way to approach the issue than just adding a principal reduction on top of today’s HAMP modification program?

We think so. Debt forgiveness (a principal reduction) could be done when the home is sold, and then, only if needed.