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Strategic Modifiers Pose Threat to GSE Principal Forgiveness

FHFA chief talks about modifications through expanded HAMP

April 10, 2012

By staff

The regulator of Fannie Mae and Freddie Mac has found that enhancements to the government's loan modification program could make it profitable for the two housing finance agencies to offer principal forgiveness. But "strategic modifiers" could wipe out any benefit from the program. The regulator's preference is to offer principal forbearance.

Edward J. DeMarco, acting director at the Federal Housing Finance Agency, made the comments Tuesday at the Brookings Institution in Washington, D.C., according prepared testimony released by FHFA.

"Today we find ourselves in the midst of a national debate regarding mortgage principal forgiveness: Would homeowners, the housing market, and the taxpayer be best served by providing outright forgiveness of mortgage debt for certain homeowners who currently owe more on their mortgage than their house is worth today," DeMarco, who has been under much heat for his resistance to principal forgiveness, said.

The regulator identified two categories of borrowers.

There are those who overextended themselves, acquiring debt they couldn't afford or pulling cash out of the homes as home prices soared. Speculators purchased properties at the peak of the market, often with little or no downpayment -- possibly on the basis that prices would continue to increase.

The other category includes those who didn't take on the risk of buying more home than they could afford. It also includes borrowers who are working multiple jobs or cutting family budgets to make ends meet. Many in this group have negative equity despite big down payments.

DeMarco laid out a foreclosure-avoidance waterfall that uses a principal forbearance modification down to 100 percent of the property value or as much as 30 percent of the unpaid principal. No interest accrues on the portion of the loan that is set aside until the home is sold or refinanced. The program operates similarly to share appreciation except that the appreciation is based on the current value and limited to the amount of the forbearance.

He presented data that showed loans modified under HAMP with loan-to-value ratios at or below 80 percent had a current ratio of 76 percent, while it only fell to 74 percent for LTV ratios between 175 percent and 190 percent.

Instead, according to DeMarco's data, the performance of modified loans is more of a function of payment reduction. Fore instance, in modifications where the payment increased, only 44 percent were current. But the current ratio climbed to 57 percent when the payment was reduced between 0 percent and 10 percent, while it jumped to 79 percent on modifications that included a payment decrease of more than 30 percent.

But the FHFA chief also acknowledged data that show a reduced probability of default for upside-down borrowers who receive principal forgiveness. Theoretically, forgiving principal reduces losses.

He showed that with $50,000 in principal forgiveness for defaulted borrowers, the investor loses $50,000 when the borrower defaults whether home prices stay the same or increase. But had $50,000 in forbearance been given instead and home prices appreciated, the investor loss could have fallen below $50,000 and even possibly been zero.

What's worse, principal forgiveness provides benefits to parties in a first-loss position like mortgage insurers and subordinate lienholders at a cost to Fannie and Freddie. Nearly half of seriously delinquent loans with negative equity have at least one subordinate lien based on available information, while more than 40 percent have mortgage insurance.

He also showed that if all Fannie and Freddie loans with LTV ratios in excess of 115 percent were given $42 billion in principal forbearance, losses would decrease by $24.3 billion versus with no modification. But $42 billion in principal forgiveness would only result in a $21 billion loss reduction.

Concerns about the findings from a prior FHFA report prompted DeMarco to make adjustments to credit scores, debt-to-income ratios and home-value declines in order to bring the information up-to-date. Using the higher investor payouts established in 2010 through the principal reduction alternative to the Home Affordable Modification Program, FHFA estimated that HAMPs could cut losses from $63.7 billion with no modification to $53.7 billion versus the $55.5 billion net losses under the old HAMP.

But the risk of moral hazard will persist since Fannie and Freddie borrowers that are current will be encouraged to claim a hardship or become delinquent to qualify for principal forgiveness. While other lenders can be selective about who should get principal forgiveness, the two secondary lenders would have to develop a program to be implemented by more than a thousand seller-servicers.

There comes a point where the number of current borrowers who become a "strategic modifier" so they can benefit from HAMP principal forgiveness makes the proposition money-losing for the enterprises.

There are around 2 million current GSE borrowers who are "deeply underwater."

The number of Fannie and Freddie borrowers who might be eligible for the enhanced HAMP is less than a million versus the 11 million borrowers in the country whose LTV ratios exceed 100 percent.

"This is not about some huge difference-making program that will rescue the housing market," DeMarco said. "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."

If 691,000 borrowers participated in a HAMP principal reduction program with Fannie and Freddie, it would take 90,000 strategic modifiers to wipe out the benefit to the two companies.

But a more realistic participation rate would be 345,500, at which point it would take just 50,000 strategic modifiers to eliminate the benefit. A participation level of 172,750 would require only 20,000 strategic modifiers to offset the benefit.

Fannie Mae profile | Freddie Mac profile

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