The Breakdown | Explaining Southern California's economy

How long does the government expect borrowers to stay underwater on mortgages?

A recent ProPublica/NPR report on Freddie May refusing to refinance mortgages for struggling homeowners shows that the market is still coming to terms with new ways of measuring risk.
A recent ProPublica/NPR report on Freddie May refusing to refinance mortgages for struggling homeowners shows that the market is still coming to terms with new ways of measuring risk.
David McNew/Getty Images

There's a battle looming between Congress and the Federal Housing Finance Agency, the entity that's been responsible for mortgage giants Freddie Mac and Fannie Mae since the two were taken over by the government during the financial crisis. California and New York are also in the fray, given that those states' attorneys general have been resisting a mortgage settlement with big banks. But that resistance may be collapsing, now that principal writedowns are on the table. Meanwhile, the FHFA remains opposed to writedowns.

So what would principal writedowns entail? Well, the problem many homeowners are up against is that they owe more than their homes are worth. If they paid $300,000, with a 10 percent downpayment, the principal is $270,000. That's what they financed through the mortgage at whatever interest rate they were able to obtain. The monthly expense is made up of a payment that applies to the principal, the interest, and in may cases, insurance and property taxes. (And my example is boilerplate — in some regions, much higher loans, so-called "jumbo loans," make the situation more difficult.)

If you can't make these payments, you're in trouble — at threat of foreclosure. But if your $300,000 house with principal of $270,000 in only worth $200,000, due to the housing meltdown, you're stuck in a loan that's not really working for you anymore. You could stay current on the payments, but it could be years before you get back to where the loan makes sense. Refinancing isn't an option, because refinancing basically only works if your house has increased in value, providing you with some additional assessed value to use as leverage.

This is where principal writedowns come in. The idea is to effectively create a new loan that will adjust your payments based on a $200,000 market value, rather than the $300,000 value that formed the basis of the original loan. The trade off for banks — and for Freddie and Fannie — is that they have to accept the lower asset value in exchange for keeping the owner in the house, which translates into a continued flow of payments and the avoidance of foreclosure expenses.

However, folks like Barney Frank want Freddie and Fannie to do writedowns. This is from the LATimes:

[FHFA head Edward] DeMarco said last month that the FHFA had concluded that extending the terms of mortgages was preferable to reducing principal because it would result in less loss to taxpayers, who now own 80% of Fannie and Freddie. So far, taxpayers have pumped about $183 billion into Fannie and Freddie to keep them afloat and to offset losses from toxic mortgage-backed securities they own.

Many lawmakers and housing advocates have criticized DeMarco for the agency's opposition to principal write-downs, which they said is the best way to help underwater homeowners and stabilize the housing market....

DeMarco has been catching a lot of flak lately, due to a ProPublic/NPR investigation in how Freddie Mac has been managing risk in its portfolio and on its immense balance sheet. But the FHFA has defended its decision to not to writedowns, as recently as January 2012. This is from a letter DeMarco sent to the Committee on Oversight and Government Reform:

In considering principal forgiveness, FHFA compared taxpayer losses from principal forgiveness versus principal forbearance, which is an alternate approach that the Enterprises [Freddie and Fannie] currently undertake to fulfill their mission at a lower cost to the taxpayer. FHFA based its conclusion that principal forgiveness results in a lower net present value than principal forbearance on an analysis initially prepared in December 2010, which is attached, along with updated analyses produced in June and December 2011, which are also attached.

Putting this determination in context, as of June 30, 2011, the Enterprises had nearly three million first lien mortgages with outstanding balances estimated to be greater than the value of the home, as measured using FHFA’s House Price Index. FHFA estimates that principal forgiveness for all of these mortgages would require funding of almost $100 billion to pay down mortgages to the value of the homes securing them.  This would be in addition to the credit losses both Enterprises are currently experiencing.  Another factor to consider is that nearly 80 percent of Enterprise underwater borrowers were current on their mortgages as of June 30, 2011.  (Even for more deeply underwater borrowers – those with mark-tomarket loan-to-value ratios above 115 percent, 74 percent are current.)  

This trend contrasts with nonEnterprise loans, where many underwater borrowers are delinquent. Given that any money spent on this endeavor would ultimately come from taxpayers and given that our analysis does not indicate a preservation of assets for Fannie Mae and Freddie Mac substantial enough to offset costs, an expenditure of this nature at this time would, in my judgment, require congressional action.  

The FHFA is drawing a clear contrast between its loans and the loans of commercial banks. Those banks should consider principal writedowns because their borrowers are headed for foreclosure in far greater numbers. Freddie and Fannie, meanwhile, have close to two-thirds of their borrowers current — even the ones who are underwater. 

The question is whether this whole "mission" that Freddie and Fannie together are allegedly serving is important enough to dodge writedowns. The FHFA's analysis says "No" to new loans but "Yes" to longer loan terms. In the agency's own words, principal forbearance means "no interest is charged on a portion of the underwater amount." You're right if you think that sounds like a very modest solution. But if most of your loan book was current — even a majority of the underwater slice — you'd probably be reluctant to bow to political pressure to do writedowns.

What enrages some members of Congress and much of the public is that the FHFA is acting very businesslike here — and the business it's liking is the business of the taxpayer. It could, by its own estimation, pour another $100 billion into the mortgage crisis. But you can just feel its reluctance to give a big break to borrowers it doesn't think are going to default. For the ones it does, it can noodle with the interest payments. But that just means the agency is counting on borrowers being OK with swimming underwater for a long time.

The interesting thing here is that Congress could compel the FHFA to do principal writedowns. But the FHFA knows that isn't likely, even though it raises the prospect in its communications with the Capitol. I wonder now whether this will become an issue in the presidential election, or whether the FHFA will ultimately get to play by its own rules.

Follow Matthew DeBord and the DeBord Report on Twitter.