The Breakdown

Explaining Southern California's economy

FHFA's Edward DeMarco doesn't give an inch on mortgage principal reductions

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Edward DeMarco, the acting director of the Federal Housing Finance Agency, isn't backing down when it comes to his long-held view that the two government mortgage giants, Fannie Mae and Freddie Mac, shouldn't reduce loan principal for underwater borrowers. 

In March, Fannie and Freddie produced an analysis that ProPublica's Jesse Eisinger wrote about. It suggested that the FHFA should be empowered to do principal reductions. 

But now the FHFA has released a new study, titled "Review of Options Available for Underwater Borrowers and Principal Forgiveness," that argues against principal reductions and in favor of another option, which I explained in a post that I wrote when I covered Eisinger's reporting:

DeMarco favors principle forbearance. The difference is simple: principal reduction takes a $400,000 mortgage on a home that's only worth $300,000 and writes it down to be a $300,000 mortgage. The $100,000 difference becomes a loss to the taxpayer, but it enables the homeowner to avoid default and provides him with an incentive to stay in the game.

Principal forbearance involves reducing the borrowers monthly obligation, much like in a writedown, but the size of the loan doesn't change. You have a $400,000 mortgage. House is worth $300,000. You can't make the payments and can't refinance because you're underwater. So you get to operate like your have a $300,000 mortgage for a while, but you're still responsible for the $400,000 total.

By staking out this position, DeMarco isn't making any friends at high levels of government in either Washington or California. This is from the LATimes:

The Obama administration, Democratic officials and housing advocates have been pressuring DeMarco to allow Fannie and Freddie to lower the principal for underwater homeowners as a way of reducing foreclosures. Fannie and Freddie own or back about 60% of all mortgages. Some, including California Atty. Gen. Kamala Harris, have called for Obama to fire DeMarco because of his refusal to allow Fannie and Freddie to reduce principal.

Of the 4.6 million underwater Fannie and Freddie borrowers, 620,000 — 13 percent — are in California. The state is second only to Florida, which has 16 percent. California is far ahead of number three Michigan, at 8 percent. So you can see why Harris is demanding action. 

However, as the FHFA points out, "more than 50 percent of the Enterprises’" — that's Fannie and Freddie — "underwater borrowers are located in five states, and more than 70 percent of the Enterprises’ underwater borrowers are located in ten states. In contrast, these five states account for 29 percent of the U.S. population, and the ten states account for 39 percent of the U.S. population.

To the FHFA, this means that underwater loans are not "evenly distributed." Essentially, it doesn't want to sign on to principal forgiveness nationally when the problem of underwater loans is isolated in states that have been disproportionately affected by the financial and housing crises. DeMarco is also reluctant to get the FHFA into the business of rewriting mortgage contracts, especially in states like California and Florida — which together account for a third of Fannie and Freddie's underwater inventory:

Whether homeowners live in areas where house prices have fallen dramatically, perhaps fueled by extensive housing speculation or the collapse of the local economy; purchased homes at the top of the market with little or no money down; or refinanced, extracting equity that had been built up over many years; they are not responsible for the drop in house prices that has caused them to be underwater, but they are responsible for the contractual commitment to pay their mortgages.

This is where the rubber hits the road. The FHFA is concerned that if it offers a national plan of principal reduction, it would encourage underwater homeowners, located in relatively few states, to give in to a moral hazard and look for ways to reduce their loans, even if they're current or could benefit just as effectively from principal forbearance.

It's not surprising that the FHFA is making this case. But it's not going to please DeMarco's critics one bit.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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