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Principal Reduction: But One Tool for Home Repair

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Suppose you are going to repair your damaged home and your only tool on hand is a roll of duct tape. Your resourceful neighbor points out that you could probably also use a hammer, a drill, and a saw.

If you're the FHFA, you tell him, "I can do a better job with just my duct tape, so thanks but no thanks."

That, in a nutshell, is the problem with the most recent analysis by this key regulator of the mortgage giants Fannie Mae and Freddie Mac when it comes to adding the tool of principal reduction to their anti-foreclosure toolkit. They've made progress in their evaluation of the costs and benefits of loan forbearance and loan forgiveness, but, somewhat bewilderingly, they appear to be comparing the two as if they were mutually exclusive. An optimal program of course will employ both, as some homeowners will benefit more from one than the other, and vice versa.

Some loans will fare better (have a higher net present value, or NPV) for Fannie and Freddie under forbearance, others under principal reduction, and many will fare better if they don't get either type of loan modification -- some folks simply need to get out from under the weight of their unsustainable home loans. The problem is that FHFA director Ed DeMarco is resisting the realization that all three of these options maximizes the interests of the GSEs and thus the U.S. taxpayer.

A bit of background:

Fannie and Freddie a) are currently 80 percent owned by taxpayers and b) hold or insure millions of mortgages, many of which are underwater. The last time I visited this issue, I pointed out that FHFA's analysis of how much taxpayers would save under these two options was flawed in various ways.

They've now improved that analysis, as presented in a speech by Director DeMarco a few weeks ago, a talk tellingly sub-titled "Is Principal Reduction the Answer?" (vs. is it one of the answers?). And when they improved their methods, they found that PR produces slightly more savings than PF (principal forbearance).

But the difference is slight -- less than $2 billion on potential losses of over $60 billion. Moreover, DeMarco expressed serious concerns that were the FHFA to ramp up PRs, they'd be incentivizing a slew of "strategic defaults" -- people who are current on their mortgages would intentionally fall behind in order to qualify for reduced principal.

The FHFA hasn't yet said what they're going to do, but they've been seriously dragging their feet and I'm afraid that given the rather fundamental mistake they seem to be making they may get this wrong. Neither I nor anyone else, including the White House (which recently tripled the incentives for the FHFA to add the PR option), believe that this is the silver bullet. In fact, that's the point. There is no such bullet. But PR is the best way to keep some homeowners from losing their homes, and for these cases, it can help carve out of bottom on the still moribund housing market a lot faster than forbearance.

There are two remaining flaws in their calculus. First, DeMarco is almost surely over-stating the threat of strategic default. A homeowner who is current on their mortgage is just not likely to stop making payments, somehow slip to at least 15 percent underwater, reduce their income enough to get through the Home Affordable Modification Program (HAMP) hardship screen, and take a certain and large hit to their credit score, all on the outside chance that they are found eligible for HAMP, and, if eligible, qualify for principal reduction rather than some other, lesser form of modification (HAMP is the program through which these modifications are made available).

In other words, the bar for getting loan forgiveness through HAMP is set fairly high, expressly to avoid this moral hazard. DeMarco himself believes that only "several hundred thousand homeowners" are in this universe. (I think he's lowballing, but what matters here is what he thinks.) I doubt many people who are now current on their mortgages will play that lottery.

The second flaw is the "Keep your damn tools, I'll just use my duct tape" problem. From what I can tell, the FHFA analysts are comparing the NPV outcomes under forbearance to those under PR. Except for the folks with deep negative equity, that will almost always favor forbearance (and shield banks from principal writedowns). For homeowners with just a little negative equity -- the low loan-to-value (LTV) folks who are less likely to default-PR represents an expensive loss to banks and investors. But for those with high LTV ratios, who are much more likely to default, it's a much better deal for investors, GSEs, taxpayers, and of course, the homeowners themselves.

So the right way to determine who should get HAMP PR is to figure out under which scenario is the homeowner least likely to default. And the right way to do that is to evaluate the incremental value of providing PR to those who qualify for forbearance to see if adding the new option further increases the NPV of the modification.

In some cases, particularly folks who are less underwater, the additional step won't be necessary. But for those with high LTV's, the advantage of PR should show up pretty clearly.

I agree with DeMarco (from his Brookings speech):

"This is not about some huge difference-making program that will rescue the housing market. It is a debate about which tools, at the margin, better balance two goals: maximizing assistance to several hundred thousand homeowners while minimizing further cost to all other homeowners and taxpayers."

That's why it's so important that their FHFA's analysis makes use of all the tools. Don't get me wrong -- you can go a long way on duct tape alone. But whether you're trying to repair a home or a housing market, you need to use all the tools you can get.

This post originally appeared at Jared Bernstein's On The Economy blog.