Faulty reasoning keeps Fannie and Freddie out of foreclosure deal

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.

What gives?

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.

DeMarco acknowledges that forgiveness reduces re-default rates more than forbearance; he just doesn't believe that the difference is enough to make forgiveness worthwhile. But the New York Fed analysis says he's wrong — the net present value of the restructured mortgage, which takes into account losses from defaults and foreclosures as well as the lower balance being paid by the borrower, is much higher than that of alternative restructurings, not to mention no restructurings at all.

All this makes DeMarco's adamantine opposition to principal forgiveness mysterious. In November, he told Cummings' subcommittee that he didn't think the law permitted him "to use taxpayer money for a general program of principal forgiveness."

But a "general program" is not what Fannie and Freddie are being asked for. Housing reformers want them to consider forgiveness as "one of several tools" to extricate the country from the mortgage overhang, in the words of Wade Henderson, chief executive of the Leadership Committee on Civil and Human Rights, a Washington group that will be meeting with DeMarco next week.

DeMarco's agency says that doing no modifications at all on the $300 billion of the Fannie and Freddie loan portfolio that is at least 15% underwater would cost taxpayers $102 billion through foreclosures. In other words, the taxpayer is already on the hook for that much. Offering forgiveness to borrowers, however, assuming that the offers are limited to loans that would have enhanced net present value as a result, would cut that loss by at least $28 billion — and the recovery would be nearly $400 million greater through forgiveness rather than forbearance. (The agency's calculations were based on reducing the balances so that no loan was more than 15% underwater.)

So how does forgiveness entail the use of taxpayers' money? The truth is, forgiveness reduces the taxpayers' bill.

Cummings, in a letter to DeMarco last week, hinted that he thought DeMarco's position was ideological. Yet it's hard to put one's finger on DeMarco's ideology, and indeed the Washington establishment has never known quite what to make of him.

In 2010, after he issued 64 subpoenas to Wall Street banks and other financial firms for information about the mortgage securities, many of them very smelly, that turned up on Fannie's and Freddie's books, DeMarco became a darling of progressives and a bane of conservatives. Sen. Richard Shelby (R-Ala.) and former Sen. Christopher J. Dodd (D-Conn.), the ranking member and chairman of the Senate Banking Committee, both called for his head in a letter to President Obama.

His cause was taken up promptly by Democrats in the House, who asked that, even if Obama were to replace DeMarco, he make sure that DeMarco's campaign "will continue to be pursued vigorously."

Now the shoe is on the other foot, and rather than lionize DeMarco as a "bank scourge" (pace the Huffington Post, circa August 2010), it's liberals who are calling for his head.

The real problem is that DeMarco can't easily be dislodged. He's "acting" head of the Federal Housing Finance Agency because he can't be forced to leave until a replacement is nominated by Obama and confirmed by the Senate. The last attempt to do so failed when Obama's candidate, former North Carolina Banking Commissioner James A. Smith, was threatened with a filibuster by none other than Sen. Shelby, who complained that he would be a "tool" of the White House. Smith, as it happens, has just been appointed as independent monitor of the new foreclosure settlement agreement.

Solving the housing crisis is going to require that a lot of moving parts in government and the private sector work together. When one agency can keep the most important cogs, Fannie and Freddie, from moving in sync with the rest of the pieces, what are the chances of moving the machine forward?

Michael Hiltzik's column appears Sundays and Wednesdays. Reach him at mhiltzik@latimes.com, read past columns at latimes.com/hiltzik, check out facebook.com/hiltzik and follow @latimeshiltzik on Twitter.

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