Edward DeMarco, acting director of the Federal Housing Finance Agency, was back on Capitol Hill this week explaining to lawmakers why he can’t -- or won’t -- allow mortgage giants Fannie Mae and Freddie Mac to forgive the debts of homeowners at risk of defaulting on their loans.
DeMarco argues that debt forgiveness goes beyond his authority and would result in untenable losses for the mortgage giants. This is a curious position given that he is a presidential appointee and everyone from President Barack Obama to lawmakers to Federal Reserve Chairman Ben S. Bernanke has called on him to go ahead and do it. Economists and housing analysts say debt relief is essential to preventing a death spiral in which rising foreclosures and falling housing prices reinforce each other.
It’s no secret the housing market is dragging down the economy. Weak housing prices are hampering construction, which typically powers post-recession recoveries, and making consumers feel too poor to spend. Much of the problem stems from foreclosures, which continue to drag down home prices. New data this week showed that as of December, prices in 20 U.S. cities stood at their lowest since the housing crisis began.
Fannie and Freddie, which own or guarantee 60 percent of outstanding mortgages, are a critical part of any solution. Their loans account for about 3 million of the estimated 11 million mortgages that are “underwater,” meaning the borrowers owe more than the homes are worth and are hence prime candidates for foreclosure. To support strapped homeowners, Fannie and Freddie are refinancing loans and offering “principal forbearance,” in which principal payments are temporarily deferred. Helpful as those efforts are, they clearly are not enough.
The Obama administration agrees and has called on FHFA, which oversees Fannie and Freddie, to allow the mortgage giants to cut the principal balance for borrowers in danger of foreclosure. To make it worth their while, the Treasury recently offered to pay Fannie and Freddie as much as 63 cents for each dollar of principal that is forgiven.
DeMarco has so far rebuffed calls for principal reduction, saying it is difficult to do and violates his mandate to protect taxpayers against losses at Fannie and Freddie. Although his motives are commendable, we think he’s wrong. Fannie and Freddie can offer principal reductions in a cost-effective way that helps the companies minimize losses and may actually improve their financial condition down the road. The solution is a shared appreciation model, in which Fannie and Freddie agree to forgive a certain portion of a borrower’s debt in exchange for sharing in any future increase in the home’s value.
The idea is already being employed with some success by private-sector mortgage servicers like Ocwen Financial Corp., which has used shared appreciation principal reductions in more than 20 percent of its mortgage modifications, or about 9,000 loans. The result so far is encouraging: Ocwen’s redefault rate on principal reductions is about 8 percent, far lower than the 20 percent industry average for other types of mortgage modifications, such as refinancing.
No wonder, then, that the idea has caught the eye of legislators. Last month, Senator Robert Menendez, Democrat of New Jersey, introduced promising legislation that would require Fannie, Freddie and the Federal Housing Administration to use a shared-appreciation approach.
Here’s how such a program would work. The lender cuts the borrower’s outstanding balance, generally to 95 percent of the current market value of the home -- a move that reduces the monthly payments, restores equity and provides a renewed incentive to maintain the home in good condition. The written-down portion is set aside in a non-interest-bearing account, which is forgiven over a three-year period as long as the homeowner makes monthly payments. In exchange, the homeowner agrees to give up a portion -- typically 25 percent -- of any appreciation in the home’s value. The debt relief requires lenders to take an immediate loss, but they tend to fare better financially than if the home went into foreclosure, and they benefit once the housing market recovers.
Incomprehensibly, DeMarco told lawmakers that FHFA does not need to consider such an approach because it is essentially performing shared appreciation reductions through its forbearance program. He also points to FHFA analyses that show forbearance to be slightly less costly than forgiveness for cases in which all underwater borrowers get modifications. The difference -- about $300 million on $300 billion in loans -- is far too small for certainty. More important, it ignores the upside that a shared appreciation program would provide.
By requiring borrowers to give up a portion of what is most Americans’ largest investment, shared appreciation also mitigates the biggest knocks against principal reduction: that the prospect of debt forgiveness could encourage more homeowners to default, and that it rewards people for taking on too much debt. Some of that will still happen, but those unavoidable downsides do not outweigh the need for a stronger housing market, which will benefit all Americans by boosting the U.S. economy.
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