Token principal reductions induce deeply underwater borrowers to keep paying
The GSEs will implement a targeted program of principal reduction to provide false hope and stave off further strategic defaults.
The demand for free money is infinite. The demand for anything free is high, but since money can buy almost anything, the demand for free money knows no bounds.
The lure of free money is very enticing. One of the most effective free-money advertising programs of all time emerged during the housing bubble. Lenders offered to give homeowners money and reduce their monthly payments to boot. Not just was this money free, lenders were actually paying borrowers to take it.
Of course, if something seems too good to be true, it probably won’t work out as hoped. The free money from the housing bubble was no exception. Many borrowers who were in stable loans and comfortable life circumstances were enticed by this free-money advertising ploy, and they mortgaged themselves into a very deep hole. Many haven’t recovered to this day.
Principal reduction is a tricky issue. It seems unfair that so many borrowers should endure such hardships when they merely accepted an offer from a lender who should have known better. However, while the housing bubble and bust was engineered by lenders, it took the participation of millions of borrowers who also should have known better. Financial innumeracy is no excuse, particularly when the ignorance of many was willful.
Principal reduction is the worst possible solution to the problem of excess debt left over from the Great Housing Bubble because principal reductions merely gives foolish borrowers a pass. If borrowers go through foreclosure, they have consequences that minimize moral hazard:
- Borrowers will be forced to rent, at least for a time.
- Borrowers will have reduced access to consumer credit as the foreclosure lowers their FICO score.
- Borrowers will have to save and be prudent in order to meet the standards of home ownership and get another loan.
All of those consequences — inadequate though they may be — are eliminated if the GSEs merely reduce principal. The borrowers who have the most to gain are those who borrowed most foolishly, and the people paying the price are (1) prudent borrowers and (2) those who didn’t borrow at all. Next time around, there will be no prudent borrowers, and everyone will participate. Who is going to pass on free money? This is the essence of moral hazard.
The appearance versus the reality
Joe Six-pack loan owner favors principal reduction because he believes his lender is going to reduce his mortgage balance to fair market value with no strings attached. Joe further believes he will get to keep all the upside. In other words, a typical loan owner believes free money is on the way. That isn’t going to happen because the cost is simply too large. There is no way the government can afford to make everyone whole, and I would be leading the rebellion if they tried.
Any principal reduction program would actually benefit a very small fraction of underwater loan owners, and those the receive principal reduction will likely see their balance reduced by a small amount so they are slightly less underwater.
The reality of principal reduction is that many will hope for some benefit, and very few will obtain it. The real purposes are twofold: (1) pandering politicians get to look like they did something and (2) loan owners will gain some false hope to keep them making a few more payments before they implode.
March 22, 2016, Ben Lane
After years of speculation and equivocation, Fannie Mae and Freddie Mac will begin to cut the mortgage balances for a number of homeowners later this year, according to a report from The Wall Street Journal.
The Wall Street Journal report, written by Joe Light, states that the Federal Housing Finance Agency recently approved a plan for the government-sponsored enterprises to engage in principal reduction on a large scale for the first time since the housing crisis.
For years their leaders claimed this would never happen. They all said the GSEs were in conservatorship, not receivership, and so a reduction in asset values would be counterintuitive to that status.
Perhaps this is why the scale of the reduction program is not as significant as some might expect, as Light reports.
From the WSJ:
Fewer than 50,000 “underwater” homeowners, who owe more than their homes are worth and are already behind in their mortgage payments, will likely be eligible, people familiar with the matter said.
Fannie and Freddie—which don’t make mortgages but rather buy them from lenders and wrap them into guaranteed securities—would also forgive principal only in cases where they determine the companies would lose less money with that option than foreclosure or other foreclosure-prevention methods. In addition, the new program will likely be limited to mortgages whose outstanding principal balance is under a certain dollar amount, people familiar with the matter said.
According to Light’s report, the plan will be officially announced “within the next few weeks.”
The issue of principal reduction has long been a hot button for many housing industry participants and observers alike.
Nearly four years ago, Ed DeMarco, who was the acting director of the FHFA at the time, said that the FHFA was not going to engage in principal reductions, despite the urging of then-Treasury Secretary Tim Geithner.
“I am concerned by your continued opposition to allowing Fannie Mae and Freddie Mac to use targeted principal reduction in their loan modification programs,” Geithner said in 2012. “In view of the clear benefits that the use of principal reduction by the GSEs would have for homeowners, the housing market and taxpayers, I urge you to reconsider this decision.”
But DeMarco refused Geithner’s request, stating at the time: “Given our multiple responsibilities to conserve the assets of Fannie Mae and Freddie Mac, maximize assistance to homeowners to avoid foreclosures, and minimize the expense of such assistance to taxpayers, FHFA concluded that HAMP PRA did not clearly improve foreclosure avoidance while reducing costs to taxpayers relative to the approaches in place today.”
As Light writes, when Melvin Watt took over as the official director of the FHFA in 2014, some thought that Watt would move quickly to cut mortgage principal, but Watt took a “slower, more-measured approach” to considering principal reduction.
Watt was still “considering” principal reduction in February 2015, when he said that even if the FHFA was going to allow principal reduction, it would likely end up being on a much smaller scale than some people expect.
If the agency does decide to allow debt cuts for some borrowers, “I think it will be substantially narrower than the vision people have,” Watt told Bloomberg at the time. “Reducing everybody’s principal would cost taxpayers billions.”
Let’s be completely realistic about what this program does. The actuaries at the GSEs have detailed metrics on loan performance. They know the delinquency rates and default losses associated with every level of borrower indebtedness. Someone completed a fancy analysis that showed that if the GSEs reduce the principal on 50,000 loans by some token amount today that the losses over time would be far less because the borrowers would continue paying.
This is not borrower relief. This is a calculated move to keep borrowers from obtaining relief through strategic default.
Despite the concerns about moral hazard, this is probably the right move for the GSEs and the US taxpayer. While they sort out who will get principal reductions, many people will keep paying to see if they can cash in their lottery ticket. The GSEs will drag this out as long as possible because the hope of principal reduction is actually more effective than the implementation. The GSEs never want people to know that the possibility is completely off the table and if a borrower hasn’t received it yet, they never will. That would eliminate the false hope that makes the entire program work.