Five years into a housing crisis that never seems to end, a dispute over offering homeowners assistance has come down to morality.
Edward DeMarco, the acting director of the Federal Housing Finance Agency, will not permit targeted debt relief for underwater homeowners -- also known as principal reduction -- because he said doing so would threaten the covenant between borrowers and lenders, and encourage those making their payments on time to default and cash in.
In taking this stand, DeMarco, responsible for overseeing oversees mortgage giants Fannie Mae and Freddie Mac, puts himself in an increasingly lonely position. The Obama administration, along with housing activists and many economists, says the "moral hazard" of debt relief is less dangerous to the economy than the foreclosures and suffering that will happen if nothing is done. The fear that writing down loan values for one set of borrowers encourages others to quit paying their mortgages is overblown, they say, and the argument about morality is way out of date.
"There is no evidence that people would rush to strategically default," said Brent White, a law professor at the University of Arizona who has written extensively about housing policy. "If homeowners needed an incentive to default they would be doing so already."
The FHFA estimates that principal reduction could benefit taxpayers to the tune of up to $500 million, though the benefit could be much less. The Department of the Treasury's estimate is higher, possibly up to $1 billion.
For many of the 11 million borrowers who owe more on their mortgage than their home is worth, the economically logical next step would be to walk away, White argues. Some have, but most are unwilling or afraid to break their contract -- even if it means unloading tens of thousands of dollars in bad debt, he said. So why would they default to obtain a smaller and much more uncertain, measure of relief?
Thressa Walker is one homeowner who probably would be better off walking away from her San Jose, Calif., townhouse, and her deeply underwater home loan.
She owes $538,000 now on a home worth $256,000. She received an interest rate reduction through the Home Affordable Modification Program, or HAMP, but because her first mortgage is owned by Fannie, she did not qualify for principal reduction. When she inquired about principal reduction for her smaller second mortgage, she was told she would need to stop making payments, she said.
But Walker doesn't want to abandon her home, and she also doesn't want to intentionally default, for fear that she will lose her only credit card and damage her credit, she said. Even if she did, DeMarco's decision ensures that she will remain on the hook for most of the negative equity in her home loan.
"I am stuck," she said.
If anything, DeMarco's decision increases the odds that she will walk away -- sticking Fannie Mae -- and by extension taxpayers that bailed out the mortgage giant -- with a home worth half of what was loaned out.
Up to 500,000 homeowners could qualify for principal reduction through HAMP if Fannie and Freddie got on board, according to government estimates.
Luigi Zingales, a University of Chicago economist, said he agrees that offering targeted principal reduction to some underwater borrowers would probably not trigger a tidal wave of intentional defaults. Most homeowners aren't that savvy or cynical, he said.
But, he said, it is also a little late in the game to be arguing moral hazard now. The Obama administration's response to the housing catastrophe -- including programs that DeMarco supports, such as interest rate reductions and forbearance plans -- has created a moral hazard, he said.
"Every sort of intervention can create legal uncertainty and moral hazard," he said.
If the phrase moral hazard sounds familiar, it is because Bush administration officials, including then Secretary of the Treasury Henry Paulson, used the phrase frequently in 2008 to explain why they failed to throw a lifeline to Lehman Brothers, the investment bank that gorged on subprime mortgages, then melted down.
When that decision threatened to ruin the economy, Bush officials quickly pushed a massive $700 billion bailout through Congress. Since then, banks have received hundreds of billions in taxpayer support. Homeowner aid, however, through a collection of Treasury initiatives, has totaled just $4.5 billion of the $50 billion set aside by Congress -- and much of that was used for incentives to encourage banks to modify loans.
Moral hazard didn't stop Congress from rescuing banks, but it is enough for DeMarco.
"I'm a free market guy, but there is a clear difference in treatment between the banks and homeowners," Zingales said. "It seems as though they remember moral hazard in one case and not in the other."
CORRECTION: A previous version of this story incorrectly said that the Obama administration views the moral hazard of principal reduction as more dangerous to the economy than foreclosures. The administration, in fact, sees the hazard of debt relief as less dangerous.
Check out Ed DeMarco's biggest enemies:
Paul Krugman, Nobel Prize Winning Economist
Nobel Prize-winning economist and New York Times columnist has repeatedly called for FHFA director <a href="http://krugman.blogs.nytimes.com/2012/07/31/fire-ed-demarco/" target="_hplink">Ed DeMarco to be fired</a> over his his opposition to principal reduction. In addition to arguing that principal reductions would benefit the overall economy, Krugman told his readers that "deciding whether debt relief is a good policy for the nation as a whole is not DeMarco's job."
Timothy Geithner, U.S. Treasury Secretary
Treasury Secretary Timothy Geithner stated that principal reductions would help up to 500,000 homeowners and save taxpayers up to $1 billion, in <a href="http://www.huffingtonpost.com/2012/07/31/ed-demarco-principal-reduction_n_1724880.html" target="_hplink">a letter he wrote to Ed DeMarco. </a> He also wrote that DeMarco's resistance to principal reductions was not "the best decision for the country, because, as we have discussed many times, the use of targeted principal reduction by the GSEs would provide much needed help to a significant number of troubled homeowners, help repair the nation's housing market, and result in a net benefit to the taxpayer."
Rep. Elijah Cummings (D-MD)
Rep. Elijah Cummings is less than thrilled by Ed DeMarco's decision not to provide principal reductions. Cummings wrote in <a href="http://www.huffingtonpost.com/2012/07/31/ed-demarco-principal-reduction_n_1724880.html" target="_hplink">an email</a>: <blockquote>"It is incomprehensible that Mr. DeMarco would reject the chance to save up to a billion dollars in taxpayer funds while helping nearly half a million homeowners stay in their homes," Cummings said. "He should immediately withdraw this reckless and misguided letter and start following the law Congress passed."</blockquote>
James Lockhart, Former Chairman Of The Federal Housing Finance Agency Chairman
President George W. Bush's Chairman of the Federal Housing Finance Agency, James Lockhart (seated to the far right), has argued that the FHA ought to experiment with principal reductions, <a href="http://thehill.com/blogs/on-the-money/1091-housing/225101-cummings-housing-regulator-fhfa-wasting-taxpayer-money-by-refusing-principal-forgiveness" target="_hplink">the Hill reports.</a> "Foreclosure is not the answer. ... We're destroying neighborhoods with foreclosures."
Sen. Richard Durbin (D-IL), Senator Majority Whip
Senate Majority Whip Richard Durbin (D-IL) told reporters that he believed DeMarco's decision was "short-sighted" and "an abdication of his responsibilities, " <a href="http://thehill.com/blogs/on-the-money/banking-financial-institutions/241343-fhfa-opts-against-principal-mortgage-reductions" target="_hplink">the Hill reports.</a> "The alternative to principal reduction is foreclosure -- a disastrous outcome for homeowners, taxpayers and the American economy. It is way past the time for leadership to stabilize our real estate market."
Shaun Donovan, Secretary of Housing and Urban Development
Secretary of Housing and Urban Development, Shaun Donovan, has urged the use of principal reductions to prevent foreclosure, <a href="http://thehill.com/blogs/on-the-money/1091-housing/225101-cummings-housing-regulator-fhfa-wasting-taxpayer-money-by-refusing-principal-forgiveness" target="_hplink">the Hill reports.</a>
William Dudley, President Of The New York Federal Reserve
William Dudley, president of the New York Federal Reserve, argued for the development of an earned principal reduction program for borrowers who are underwater but still making mortgage payments, <a href="http://www.newyorkfed.org/newsevents/speeches/2012/dud120106.html" target="_hplink">In a speech to the New Jersey Bankers Association. </a>
Christine Lagarde, International Monetary Fund Managing Director
International Monetary Fund managing director, Christine Lagarde, argued that the U.S. should implement some form of mortgage relief, including principal reduction, in <a href="http://www.huffingtonpost.com/anna-cuevas/imf-lends-support-to-loan_b_1447133.html" target="_hplink">a speech she delivered at the Brookings Institute earlier this year.</a>
The Obama administration has long supported principal reductions, arguing that such write-downs would reduce delinquencies, help 11 million underwater borrowers and help get the housing market back on track, <a href="http://www.reuters.com/article/2012/05/10/us-usa-housing-donovan-idUSBRE8491DW20120510" target="_hplink">Reuters reports.</a> Under DeMarco's directorship, the FHFA blocked the White House's idea for home-energy improvement when it told firms not to participate, <a href="http://www.washingtonpost.com/politics/edward-j-demarco/gIQAK9StKP_topic.html" target="_hplink"><em>the Washington Post</em> reports.</a> President Obama attempted to replace DeMarco with North Carolina banking commissioner Joseph Smith in 2010, only to be rebuffed by Senate Republicans who refused to confirm Smith, leaving DeMarco in place.
Rep. Darrell Issa, House Government Reform And Oversight Committee Chairman
House Government Reform and Oversight Committee Chairman, Rep. Darrell Issa (R-CA), wrote a letter to DeMarco urging the FHA director to "carefully evaluate relevant information prior to making a decision that could cost taxpayers billions if the government were to pay down the principal value of underwater mortgages for select homeowners," <a href="http://thehill.com/blogs/on-the-money/1091-housing/225383-house-republicans-urge-housing-regulator-to-remain-steadfast-on-principal-reductions" target="_hplink">The Hill reports.</a>
Rep. Spencer Bachus (R-AL), Chairman Of House Financial Services Committee
Chairman of the House Financial Service Committee, Rep. Spencer Bachus (R-AL), told reporters that Ed DeMarco stood up for "the best interests of the American people" by rejecting principal reduction, <a href="http://www.nytimes.com/2012/08/01/business/us-agency-bars-fannie-and-freddie-from-reducing-principal.html" target="_hplink"><em>The New York Times</em> reports.</a>
Sen. Bob Corker (R-TN)
Sen. Bob Corker (R-TN) <a href="http://www.corker.senate.gov/public/index.cfm?p=News&ContentRecord_id=f3d4c62d-0f70-42fc-b485-99d0bb6b05b4" target="_hplink">thanked Ed DeMarco</a> for "making his decision based on objective analysis and with the taxpayer in mind."
American Bankers Association
ABA executive vice president on mortgage policy, Bob Davis, announced the association's support for Ed DeMarco's rejection of principal reduction, <a href="http://thehill.com/blogs/on-the-money/banking-financial-institutions/241343-fhfa-opts-against-principal-mortgage-reductions" target="_hplink">the Hill reports.</a> "As FHFA's research illustrates, principal reductions do not measurably help troubled borrowers avoid foreclosure, yet increase the cost to taxpayers at a time when our nation's fiscal situation is already strained."
Edward DeMarco, Federal Housing Finance Agency Acting Director
Acting director of the Federal Housing Finance Agency, Ed DeMarco, announced to Congress that he would <a href="http://www.huffingtonpost.com/2012/07/31/ed-demarco-principal-reduction_n_1724880.html" target="_hplink">not permit mortgage giants Fannie and Freddie Mac to assist struggling homeowners by reducing their principal.</a> In a letter DeMarco sent to Congress, the acting director stated that he did not believe that there would be a substantial financial benefit to the taxpayer and that reducing principal would introduce "moral hazard" into the housing market. "This could give borrowers who are current on their mortgages a message that the government endorses forgiving a portion of mortgage debt if hardship can be demonstrated, creating a very broad incentive for underwater borrowers to seek ways to become eligible." Under DeMarco's directorship, the FHFA blocked the White House's idea for home-energy improvement when it told firms not to participate, <a href="http://www.washingtonpost.com/politics/edward-j-demarco/gIQAK9StKP_topic.html" target="_hplink"><em>The Washington Post</em> reports.</a> President Obama attempted to replace DeMarco with North Carolina banking commissioner Joseph Smith in 2010, only to be rebuffed by Senate Republicans who refused to confirm Smith, leaving DeMarco in place.<a href=" Under DeMarco's directorship, the FHFA blocked the White House's idea for home-energy improvement when it told firms not to participate, a href="http://www.washingtonpost.com/politics/edward-j-demarco/gIQAK9StKP_topic.html" target="_hplink"emThe Washington Post/em reports./a President Obama attempted to replace DeMarco with North Carolina banking commissioner Joseph Smith in 2010, only to be rebuffed by Senate Republicans who refused to confirm Smith, leaving DeMarco in place.a href="http://www.huffingtonpost.com/peter-s-goodman/ed-demarco-fannie-freddie-principal-reduction_b_1336190.html" target="_hplink"http://www.huffingtonpost.com/peter-s-goodman/ed-demarco-fannie-freddie-principal-reduction_b_1336190.html/a" target="_hplink"> leaving DeMarco in place.</a>