Top law enforcement officials in several states are signaling they will pressure Fannie Mae and Freddie Mac to correct what is widely seen as one of the biggest deficiencies of the $25 billion mortgage settlement announced on Thursday: It simply doesn't help that many homeowners.
Borrowers whose loans are backed by the government-controlled mortgage giants -- nearly half of all outstanding mortgages in the United States -- are not eligible for payouts under the deal. State officials who negotiated the deal say they could not convince Fannie Mae and Freddie Mac, or the Federal Housing Finance Agency, which oversees the loan giants, to join onto the settlement because they are steadfastly opposed to principal reductions -- loan write-downs for borrowers whose homes are at risk of foreclosure.
"This is a glaring weakness of the overall settlement," said one state official who spoke on condition of anonymity. "Fannie and Freddie were absolutely opposed to principal reduction. You'd ask why, and they'd say 'moral hazard to the taxpayer.'"
So far, the mortgage giants and the FHFA have only said that they're avoiding principal reduction because of the cost to taxpayers.
Principal reductions are hailed by many economists and housing experts as the most effective way to help homeowners who are underwater on their mortgages, owing more than the home is worth. About 1 in 5 homes in the U.S. are currently underwater.
The attorneys general of New York, California and Massachusetts have all said in recent days that they are disappointed that Fannie Mae and Freddie Mac were not part of the settlement, and that they plan to continue pressuring the mortgage giants to write-down loans.
New York Attorney General Eric Schneiderman, whom President Obama tapped in January to head a task force that will investigate financial fraud leading up to the market crash of 2008, likely has the most leverage. Schniederman has said the new unit will investigate wrongdoing in the packaging and guaranteeing of home loans. He is already working with the FHFA's inspector general as part of this probe, which is expected to include serious scrutiny of Fannie Mae and Freddie Mac's behavior.
The task force also includes Robert Khuzami, the enforcement chief at the Securities and Exchange Commission. In December the SEC sued six former Fannie Mae and Freddie Mac executives for misleading the public about the mortgage giants' exposure to risky subprime mortgages as the housing bubble deflated.
Schniederman's office declined to comment on whether the new scrutiny might lead to a lawsuit or other legal action.
Schneiderman told CNBC on Thursday that the settlement was the first step in the government's investigation into the financial crisis, and that Fannie and Freddie "have to be a part of any final resolution." ABC News also reported that Schniederman said his "eyes are on Fannie and Freddie next."
“Attorney General Schneiderman is committed to securing principal reduction for a far broader scope of loans than will be impacted by the servicing settlement, which was a down payment on the relief needed to help homeowners and get the housing market moving again,” Danny Kanner, a spokesman, told The Huffington Post.
The settlement with Bank of America, Wells Fargo, Ally Financial, Citigroup and JPMorgan Chase came after a long investigation by the states into reports that banks were using forged or "robo-signed" signatures to speed foreclosures. Under the deal, the banks agreed to provide $20 billion in mortgage relief to struggling homeowners in 49 states.
Federal authorities, including Department of Housing and Urban Development Secretary Shaun Donovan, helped bring the deal together, but weren't able to persuade Edward DeMarco, acting director of the FHFA, which oversees Fannie Mae and Freddie Mac, to go along, officials involved in the deal say. In a press conference on Thursday, Donovan said that the Obama administration is considering taking "additional steps to make mortgage principal reductions available to Fannie and Freddie homeowners," according to the Hill.
Last week, Massachusetts Attorney General Martha Coakley wrote in a letter to DeMarco that she was concerned about Fannie Mae and Freddie Mac's "unwillingness to increase the availability of federal loan modification programs, including principal forgiveness."
The mortgage giants say they are avoiding principal reductions to save taxpayers money and are instead taking other remedies, including modifying home loans, to offer relief to troubled borrowers.
Fannie Mae said in a statement that the agency had conducted small-scale pilot programs and determined that principal reduction poses a number of challenges, "including significant technological and systems complexity and substantial cost without proven effectiveness." Fannie Mae said it concluded that principal forbearance -- deferring the payment of the principal of a loan -- would save more taxpayer money than principal reductions.
Fannie Mae spokesman Andrew Wilson declined to provide more details on the pilot programs, such as when they occurred, how many loans were involved and the actual results. He also declined to comment on the negotiations leading to the mortgage settlement and the recent statements made by state attorneys general.
The FHFA and Freddie Mac declined to comment when reached by The Huffington Post.
Despite Fannie Mae's claim that principal reductions are not cost-effective, Treasury Department data shows that modification efforts that include principal reduction are more likely to prevent default than other loan modifications.
About a third of modifications of bank-held loans in the third quarter of 2011 included a principal reduction. Their one-year re-default rate was 40 percent.
In contrast, almost none of Fannie Mae or Freddie Mac modifications from the same period included a principal reduction. Their one-year re-default rate was 59 percent, according to the Treasury Department.
But there is internal resistance to principal reductions at the mortgage giants, said a former Fannie Mae employee who spoke on condition of anonymity to The Huffington Post last fall.
"It's a very philosophically dogmatic point of view," the ex-employee told HuffPost in November. "Not only within Fannie Mae but more broadly in the mortgage industry. ... You don't forgive principal."
The fear: If you let a delinquent borrower off the hook, then people who could make payments would purposefully default to get a better deal.
The ex-employee's story is similar to an account published by two Democratic Congressmen in a letter to DeMarco on Wednesday. According to the letter from Elijah Cummings (D-Md.) and John Tierney (D-Mass.), a former Fannie Mae staffer told them that Fannie Mae nixed a pilot program for principal reductions in mid-2010 because they were "philosophically opposed to writing down principal balances," the ex-staffer said.
Technically the federal government, which took over Fannie and Freddie in 2008, could force the mortgage giants to write down principals of their mortgages. But DeMarco, acting director of the FHFA, has repeatedly said he opposes principal reductions because he fears it would cost taxpayers too much money.
"We have concluded that the use of principal reduction within the context of a loan modification is not going to be the least-cost approach for the taxpayer," DeMarco said at a Congressional hearing in November. "I do not believe that I've been appropriated taxpayer funds for the purpose of providing this more general support to the housing market."
Fannie Mae and Freddie Mac have cost taxpayers about $169 billion since the government saved them in 2008.