Edward DeMarco, acting director of the Federal Housing Finance Agency,… (Brendan Smialowski, Bloomberg )
You can love or you can hate the recent $25-billion federal-state mortgage foreclosure settlement, but there's no getting around one simple fact: There's a huge, gaping hole right in the middle of it.
The hole is that if your home loan has been bought from your lender by Fannie Mae or Freddie Mac, you're not eligible for the mortgage relief encompassed by the deal.
Since Fannie and Freddie control well more than half of all outstanding mortgages, this shortcoming looks to be what engineers would call "non-trivial."
This is curious, because the settlement, announced last week, had a sizable head of steam behind it. It was endorsed by the Obama administration, including the departments of Justice and Housing and Urban Development, and 49 of the 50 state attorneys general. By my count, the latter group breaks down as 24 Republicans and 25 Democrats; you can't get more bipartisan than that, unless you cut one Democrat in half and cede a piece to Team GOP.
The answer is that the participation of Fannie and Freddie has been blocked by a career civil servant named Edward J. DeMarco.
As acting director of the Federal Housing Finance Agency, DeMarco is the chief regulator and conservator of Fannie and Freddie, which were chartered by the federal government to buy up mortgages, thus encouraging lenders to make home loans.
He has very firm ideas about a key element of the settlement, which would cut the principal balance for some homeowners who owe more on their loans than their homes are worth: He dislikes this sort of write-down so much that he's forbidden Fannie and Freddie to do it. (Experts refer to the homeowners' distance beneath the waves as their "negative equity" and the write-down of loan balances as "principal forgiveness.")
DeMarco contends that forgiveness saddles lenders with bigger losses on restructured loans than any other form of relief except foreclosure, and therefore he'd be violating federal law if he gave Fannie and Freddie the green light. In a nutshell, that's why Fannie and Freddie aren't in the national foreclosure settlement.
But what about DeMarco's argument that principal forgiveness is the biggest loser among restructuring alternatives? The truth is that it doesn't seem to hold even a nutshell's worth of water. In fact, his own agency's analysis, which he provided last month to Rep. Elijah E. Cummings (D-Md.) and other Democrats on the House Committee on Oversight and Government Reform, contradicts it. And independent analyses, including one from the Federal Reserve Bank of New York, blow it to smithereens.
Let's look at the record.
If you're trying to keep financially strapped underwater homeowners out of foreclosure, there are really only three ways to do it. All are aimed at reducing the homeowner's monthly payment:
•You can cut the interest rate on the loan.
•You can defer payments on part of the principal owed, often by tacking the unpaid obligation to the end of the loan or reamortizing it over a longer period; this is known as principal forbearance.
•Or you can write down all or part of the excess principal to bring the balance closer in line with the home's value (forgiveness).
Interest rate cuts alone don't do much — cutting the rate to 4% from 5% on a balance of $100,000 saves a borrower about $60 a month. Principal modifications can be more effective, especially when combined with an interest-rate cut.
But the Holy Grail in restructurings is to prevent homeowners from re-defaulting after a modification, and the record shows that forgiveness is much better than any other option in achieving that.
The reason should be obvious. The most important factor in a borrower's likelihood of default is the loan's negative equity. Put simply, if you think you're so deeply underwater that you won't have equity in your home by the time you're ready to sell it, or ever, then default looks more rational the more your ability to pay comes under strain.
The closer you are to breaking even or going positive, the more you'll fight to keep the house. Forbearance doesn't get you any closer to that point (you still owe the original principal, one way or another), but forgiveness does.
Real-world experience supports these assumptions. In an August 2010 study, the New York Fed calculated that a principal write-down of a mortgage with 18% negative equity would cut the probability of re-default 40% within a year of the modification. That's four times as effective as any other restructuring format, even when the alternatives produce the same reduction in the monthly payment.