After a year of arguing with Fannie Mae and Freddie Mac over the benefits of loan write-downs, the Obama administration is taking another approach: show, rather than tell. Officials are betting that the eventual success of the government's $25 billion deal with five of the nation's largest banks will convince the mortgage giants to fall in line.
In an interview with The Huffington Post on Thursday, Shaun Donovan, secretary of the U.S. Department of Housing and Urban Development, said that last week’s national foreclosure settlement could "catalyze the national effort" for loan write-downs, also called principal reductions, and bring Fannie Mae and Freddie Mac on board to follow suit.
Currently the mortgage giants control about half of all outstanding mortgages nationwide; and many of the borrowers involved owe more than their homes are worth. These homeowners, however, are not eligible for relief under the new settlement. Only a small portion of U.S. homeowners, as few 1 in 10, potentially qualify for relief under the terms of the agreement.
Principal reductions are hailed by many economists and housing experts as the most effective way to help homeowners who are underwater on their mortgages and owe more than their homes are worth. About $300 billion of the Fannie and Freddie loan portfolio is at least 15 percent underwater.
Donovan said that if principal reduction works on the grand scale envisioned under the deal -- with underwater borrowers possibly receiving $32 billion in loan write-downs -- it would help overcome a "quasi-religious resistance to principal reduction" in the market. Officials have said that roughly 1 million borrowers could qualify.
As part of the deal, 49 states, 11 federal agencies and five big banks all agreed to go along with principal reductions.
But some investors who own underwater home mortgages have balked at reducing principal: And the biggest holdouts are Fannie Mae and Freddie Mac. The chief roadblock to their participation, say federal and state officials, is the Federal Housing Finance Authority, which has controlled the mortgage giants since they nearly went bankrupt in 2008. The agency and its chief, Edward DeMarco, have refused to write down loans. The agency has said it is avoiding principal reductions to save taxpayers money and is instead taking other remedies, including modifying home loans, to offer relief to troubled borrowers.
Federal officials who participated in the deal say all attempts to change DeMarco's mind on loan write-downs failed.
“Several states wanted to have that conversation to get Freddie and Fannie in, to get them to the table to talk, but the feds didn’t seem to be able to pull that string. And we knew that if the feds couldn’t do it, then it didn’t seem like the states could,” said Trish Conners, Florida's associate deputy attorney general.
Administration attempts to replace DeMarco have also failed. Last year, the Senate refused to bring to a vote the nomination of Joseph Smith, Obama's pick to head the agency. (Smith, the North Carolina banking commissioner, was named last week to head the effort to ensure that the banks comply with the terms of the settlement.)
"Our goal is to get a good nominee and get someone in there who shares our view," Donovan said.
Last week Kamala Harris, the California attorney general and a key supporter of the deal, renewed her call for DeMarco to resign because of his resistance to principal reductions. "I said before and say again, [Edward DeMarco] should step aside because the guy can clearly not figure out what his job requires. In particular, it requires … principal reductions on those Freddie and Fannie loans,” Harris said.
In a statement this month Fannie Mae said that it 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."
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 restructurings.
About a third of the modifications of bank-held loans in the third quarter of 2011 included a principal reduction. Forty percent of those loans defaulted after one year.
In contrast, almost none of Fannie Mae or Freddie Mac modifications from the same period included a principal reduction. Fifty-nine percent of those loans defaulted after one year, according to the Treasury Department.
The FHFA said it would not comment on DeMarco's positions. The agency did say last month that it would consider an Obama administration proposal to increase incentives under the Home Affordable Modification Program for investors to write down loans.
Donovan said while convincing Fannie and Freddie to do more loan write-downs is undoubtedly important, last week's settlement is meaningful because it will aid as many as 1 million homeowners. "It could really move the needle," he said.