Principal Reductions Won’t Solve the Mortgage Mess

Edward DeMarco, the temporary director of the Federal Housing Finance Agency, continues to endure blistering criticism for refusing to allow Fannie Mae and Freddie Mac to pay for large-scale principal reductions for underwater borrowers (those who owe more than their homes are worth) or to facilitate refinancings for those stuck with high interest rate mortgages.

The embattled regulator says he is merely trying to prevent Fannie and Freddie from adding to the more than $190 billion in losses that taxpayers have covered since September 2008. But Representative Elijah Cummings has labeled him “the biggest hurdle standing between our nation and the recovery of the housing market.” House Democrats have accused him of hiding data purportedly proving that principal reductions would save money and reduce foreclosures. And Representative Barney Frank has called for his resignation.

Beating up DeMarco may prove cathartic for policy makers looking to assign blame for economic doldrums. The proposed remedy, however — having taxpayers pay for principal writedowns and mass refinancings — would do little to solve the nation’s housing woes.

Consider the math on principal reductions. There are 11.1 million residential properties with underwater mortgages, only about 3 million of which are backed by Fannie and Freddie. Almost 80 percent of those 3 million borrowers, however, are current on their mortgage, demonstrating their commitment and ability to make payments without a principal reduction. Consequently, principal writedowns for them would simply transfer money from taxpayers to the borrowers — with minimal effect on foreclosure prevention.

Targeted Federal Help

Targeting principal reduction to the 20 percent of underwater borrowers with delinquent Fannie and Freddie loans (approximately 600,000 in total) does have the potential to prevent some foreclosures, but at far too high a price. It is extremely difficult to target federal help to a select group of borrowers without providing an incentive for other borrowers to stop paying their mortgages. Indeed, research by Christopher Mayer, Edward Morrison, Tomasz Piskorski, and Arpit Gupta of Columbia University found a statistically significant increase in such strategic behavior in response to principal reduction announcements.

President Barack Obama has proposed using unspent money from the Troubled Asset Relief Program to offset prospective Fannie and Freddie losses from principal reductions. Taxpayers would still pay, but the Federal Housing Finance Agency could meet its legal mandate to avoid losses at the two firms themselves.

Even this would offer scant benefit. Principal reduction is seldom appropriate for underwater borrowers who have not made a mortgage payment in more than six months; it’s too late for most of them to avoid foreclosure. For that reason, the president’s proposal focuses on underwater borrowers who have made a mortgage payment in the past six months. But only about 10 percent of Fannie and Freddie loans meet that criterion. Thus such a targeted policy would assist only about 60,000 underwater borrowers.

A similar logic undermines proposals for government-backed refinancing of underwater and delinquent homeowners to enable them to take advantage of today’s low interest rates. Those who are current on their loans would benefit from a lower interest rate — but since their payments are current their homes are not at risk of foreclosure. (Most homeowners who are already delinquent won’t be able to pay their loans even at a lower interest rate.)

A stronger economy and more robust job growth are ultimately needed to boost housing demand, spur prices and construction, and finally end the foreclosure crisis.

Downward Pressure

Meanwhile, regulators can encourage programs to turn foreclosures into rentals, which will help ease the downward pressure on home prices. It would also help to remove some of the uncertainties that deter potential lenders from taking on housing-related risks, including the difficulty of taking back a home from a delinquent borrower and the threat of lawsuits resulting from loans that go bad through no fault of the lender, such as a borrower losing a job.

The federal government could also reduce uncertainties over the validity of the Mortgage Electronic Registration Systems used to keep title information, which is essential for mortgages to be packaged and sold to investors. Standard formats for title data would preserve local control while facilitating large-scale housing investments. Similarly, better coordination of information regarding second liens would facilitate some modifications that are dependent on bargaining between owners of the primary mortgage and second lien.

As the housing adjustment continues, we should avoid taking actions that accomplish little while providing incentives for borrowers to renege on obligations. Such efforts will only prolong the problem. Proponents of mass writedowns and refinancings are better off having DeMarco to kick around than having him accede to yet another costly, counterproductive program.