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Varun Gupta Headshot

Common Sense Rebuttal of FHFA's 'Mortgage Principal Waiver' Denial

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The Federal Housing Finance Agency (FHFA), regulator of Fannie Mae and Freddie Mac, declined Federal Government's proposal for principal reduction on underwater mortgages chronically behind on payment. FHFA said its analysis found that principal reduction does not prevent foreclosures while saving taxpayers money. "FHFA has concluded that the anticipated benefits do not outweigh the costs and risks," said Edward DeMarco, the agency's acting director, who has steadfastly resisted calls to implement the loan modification technique. Lets evaluate this denial by the FHFA against facts and common sense:

The current economic crisis began with a housing crash that continues to weigh down on the economy. U.S. households hold most of their tangible net worth in the form of home equity and with falling home prices, their net worth continues to fall. Canadians recently became wealthier than American owing to the steady housing market in Canada while the U.S. market has continued to languish. There are millions of homeowners who have negative equity on their homes and combined with declining real term wages and unprecedented high levels of unemployment, it is no surprise that delinquency rates continue to be high -- 7.4% of the nation's mortgage holders were behind on their payments 30 days or more in the January-to-March quarter. While delinquency rate has declined from a peak of 10.1% in first quarter of 2010, it remains higher than 6.99% rate in third quarter of 2008. The share of homes that had received a foreclosure notice and hadn't been seized by banks stand at 4.39%.

Falling net worth, increasing negative equity, foreclosures and people falling behind their mortgages dents consumer confidence across the spectrum and creates a vicious cycle. People looking to buy houses postpone their purchase and wait for the prices to fall further, banks weighed down by foreclosures and fears of impairments cut down lending, foreclosures add to the inventory of unsold houses and fire sales further depress home prices while those falling behind payments cut down spending to make mortgage payments or eventually give up houses and move into rental housing. For any economic recovery to take place, this vicious cycle must be broken.

U.S. households' mortgage debt (single family houses) averaged $10.1 trillion during second quarter of 2012. While there is a general trend towards de-leveraging, the speed of de-leveraging has been far slower than the pace of leverage build-up during the bubble years due to tough economic conditions. Borrowers took on 1 trillion in new principal and 90 billion in extra interest in 2006 alone while mortgage debt has reduced by less than one trillion in last 3 years. American consumers have realized that existing level of debt is unsustainable and they need to de-leverage but continuing tough economic conditions and falling wages make that process painfully slow. Therefore a reduction in mortgage debt, adjustment in tenor and refinancing at lower rates is the only way to bump up confidence and get the economy going again.

Principal waiver on chronically underwater mortgages and undergoing foreclosure would work like a well directed tax cut with a multiplier effect. People who would be able to stay in their houses with lower monthly mortgage payments would finally be able to spend money on consumption and approach their future with a renewed sense of optimism. Banks would have precious management time free up from foreclosures, have greater visibility into future trends on these delinquent mortgages and finally open lending taps to small businesses. Needless to mention declining foreclosures would lead to stability in home prices as well.

In light of these simple facts and common sense benefits of principal reduction on mortgages undergoing foreclosure process, I wonder what drove FHFA to deny what could have been the best stimulus in a weak economy facing significant external headwinds. The only problem with principal reduction is that of Moral Hazard. Waivers sometimes end up working like entitlements that people start taking for granted. This moral hazard has the potential of firing up both the irresponsible consumers and banks to fuel a leverage build up. While no one can be sure this problem can be tackled with certainty but it surely can be minimized by effective regulation of the mortgage market. Simple rules like a maximum 80% loan to value ratio, no complicated ballooning structures, prudent rating of mortgage securities and higher allocation of capital for high LTV mortgages can ensure we don't see the same irresponsible lending and borrowing. Provided the Government was willing to prudently regulate, I believe FHFA to have fumbled on this common sense policy issue.