Principal Write-downs: The Next Big Mortgage Push
It has been a vicious cycle for several years now: falling home prices lead to foreclosures, and more foreclosures result in lower home prices. The Obama Administration has tried to stop the cycle with several different approaches, all under its Home Affordable Modification Program, with limited success.
The latest government tactic is to help underwater homeowners-those who owe more on their mortgages than their homes are worth and are most likely to "strategically default" just to get out of the situation. President Obama, select members of Congress, and the Federal Reserve have all put pressure on Fannie Mae and Freddie Mac, to start offering principal write-downs for such borrowers. This would essentially reset these loans to market value and keep millions, hopefully, from going into foreclosure and further slowing down the housing recovery.
But Fannie and Freddie's regulator, the Federal Housing Finance Agency (FHFA), has hesitated to take this approach. Fannie and Freddie have been under government conservatorship since October 2008, costing taxpayers millions of dollars and FHFA acting director Edward DeMarco has been very cautious about letting either company take on any new risk or loss. DeMarco has said he does not think principal write-downs make financial sense, when many underwater borrowers are still making their payments with no problems.
DeMarco prefers instead something called principal forbearance. This allows lenders to set aside a portion of a mortgage loan, with payments on that amount not due until the house is sold or the loan is paid off. This allows borrowers to obtain lower monthly payments without Fannie and Freddie taking a loss on the loan. And the popularity of forbearance modifications has been growing. There were almost 103,000 principal forbearance plans in 2011, up from 94,000 in 2010 and just 15,000 in 2009.
Banks' reluctance to offer principal reductions is evident by comparison. In 2011, lenders wrote down 35,000 mortgage balances, which while up from 29,000 in 2010 is still significantly lower than forbearance modifications.
DeMarco has also preached against principal write-downs because of the "moral hazard" they would create, namely that underwater borrowers (who could afford to keep making their payments) would purposely stop in order to qualify for the write-downs.
Yet, many still argue that bringing at least a portion of the 11 million underwater homeowners' loans down to market value would help stabilize the housing market. Mark Zandi, chief economist for Moody's Analytics, believes that home prices will begin to rise again if lenders performed even just a half million principal reductions.
"Once prices start to rise, that gives other homeowners an even greater hook to hold onto their homes," Zandi said in a Fortune article.
Some have suggested that putting restrictions on the principal write-downs could help curb the moral hazard. For example, one proposal is that borrowers who receive write-downs should have to share future increases in equity with their lenders. So, if a homeowner gets his loan restored to market value, but then his home goes up in value over the following years, the bank would claim 50 percent of the equity gained up to a certain dollar amount. That way only seriously suffering borrowers would apply for the write-down process and banks could have a chance to recoup some of their losses in the future.
Still, banks and especially the FHFA remain reluctant to take this route on a grand scale. And unless something changes dramatically, it doesn't look like Fannie and Freddie customers will be seeing principal write-downs anytime soon.