FHFA Criticized for Arguments Used Against Principal Reduction

By: Esther Cho 03/15/2012

The FHFA’s decision to not allow for principal reductions on Fannie Mae and Freddie Mac loans due to taxpayer costs and other issues came under sharp criticism during a Senate subcommittee hearing Thursday.

John DiIorio, CEO of 1st Alliance Lending, a mortgage origination firm, argued in support of principal reduction, even when analyzing the benefits from a bottom-line perspective, not simply as a form of aid.

“Again, let me emphasize – these investors and mortgage holders that we work with agree to principal reduction in these situations voluntarily,” said Dilorio in his written testimony. “Moreover, they make the decision to do principal reduction not out of a sense of charity, but because they believe it is in their best financial interest to do so. They are sophisticated, and are doing these transactions to maximize asset value.”

Dilorio also called principal reduction the best economic option for the holder of the mortgage when done correctly and in a targeted manner.

Laurie Goodman, senior managing director of Amherst Securities, said there were a number of flaws in an FHFA study used to defend the decision to not apply principal forgiveness, and discussed three major criticisms and “technical flaws.”

For one, Goodman said the study was based on a hypothetical model rather than actual HAMP results.

As one of the technical flaws, Goodman said in her testimony that “the results were done on a portfolio level, not an individual loan level. Thus, the FHFA did not consider the possibility of following a forgiveness strategy for some borrowers and a forbearance strategy for others.”

Goodman also pointed that the FHFA did not differentiate between loans with mortgage insurance versus loans without it, and further explained that, “when there is mortgage insurance, it is generally not NPV-positive to the GSEs to do principal forgiveness – forbearance creates the preferred outcome, as the MI does not cover the forgiven amount.”

The study Goodman referred to was used by Edward DeMarco, FHFA acting director, to respond to a request from the House Committee on Oversight and Government Affairs on whether principal forgiveness on GSE loans would be in the interest of taxpayers.

“I would suggest that they if they have doubts about the value of principal reduction, they need not commit wholesale to principal reductions, but could start by dipping their feet into the water on a pilot or limited basis, to test out how and whether principal reduction is effective,” said Dilorio.

Mark Calabria, director of financial regulation studies at the Cato Institute, shared a different opinion on principal reduction, and cited industry facts from Fitch Ratings to support his opinions.

“The vast majority of underwater borrowers are current on their mortgages,” said Calabria. “Even the majority of deeply underwater borrowers are current. For prime borrowers with loan-to-values over 125 percent, over 75 percent are current. Over half of deeply underwater subprime borrowers are current.”

Calabria also pointed that GSE loans display a smaller percentage, just 9.9 percent of underwater loans, compared to private label securities, with 35.5 percent of loans underwater.

Citing a CoreLogic report which stated 22.8 percent of all residential properties with a mortgage are in negative equity, Calabria explained that the situation is concentrated in five states: Nevada, Arizona, Florida, Michigan, and Georgia, with those states having an average negative share of 44.3 percent, compared to 15.3 percent for the remaining states.

“Any taxpayer efforts to reduce negative equity would largely be a transfer from the majority of states to a very small number,” said Calabria.

In response to criticism FHFA has been receiving, Calabria said Acting FHFA Director DeMarco should be commended.

“Given FHFA’s estimate that a broad based program of principal reduction would cost almost $100 billion, the argument that an unelected, unappointed, acting agency head should, in the absence of statutory authority, spend $100 billion on taxpayer money is simply inconsistent with our system of government,” said Calabria, who also stressed that $180 billion in taxpayer dollars has been used to rescue the GSEs.

The moral hazard issue was also addressed during the hearing, which is the fear that offering incentives such as principal reduction will lead to borrowers purposely defaulting to reap benefits.

“We understand that the primary issue in the mind of the FHFA is that more than 90 percent of GSE loans are current,” said Goodman, who offered two solutions.

“The first solution is to require that the borrower be delinquent as of a certain date, so performing borrowers do not intentionally go delinquent in order to get the principal reduction,” said Goodman. “The other choice is to establish a series of frictions so that only those borrowers who need the principal reduction take advantage of the program. This could involve the inclusion of a shared appreciation feature or other frictions to default.”

Goodman’s example and explanation for a generally negative NPV when applying principal forgiveness for loans with mortgage insurance

- Assume a borrower has a $100,000 loan, on a house worth $75,000, and the GSEs have mortgage insurance from a mortgage insurer, which covers any loss down to $70,000.

- The borrower defaults, and the GSE offers the borrower $20,000 of principal reduction, which reduces the loan balance to $80,000, and gives the loan a 75% chance of eventual success. If the loan does not re-default (there’s a 75percent chance of that happening), the GSE ends up losing the $20,000 principal amount they gave up.

- But if the loan re-defaults and the house then sells for $70,000 (25 percent chance), the mortgage insurance pays $10,000 to the GSE for the lost principal, in which case the GSE still loses $20,000.