Sharing the Pain and Gain
in the Housing Market
How Fannie Mae and Freddie Mac Can Prevent Foreclosures and
Protect Taxpayers by Combining Principal Reductions with “Shared Appreciation”
SOURCE: AP/David Zalubowski
A foreclosure sign outside of a home.
Fannie Mae, Freddie Mac, and the Federal Housing Finance Agency could prevent
foreclosures by combining principal reduction with "shared
appreciation."
By John Griffith,
Jordan Eizenga |
Download the full report (pdf)
More than five years into what is arguably the worst
foreclosure crisis in American history, millions of families are still at
serious risk of losing their homes. Nearly one in four homeowners is
“underwater,” meaning they owe more on their mortgage than their home is worth,
and more than 7 million homes are still in the foreclosure pipeline, according
to analysis from Morgan Stanley. In fact, some analysts predict we’re only
halfway through the crisis.
The big question before lenders, investors, and
policymakers today is how to avoid another wave of costly and economy-crushing
foreclosures. There are several ways to lower an at-risk borrower’s monthly
payments and increase the chance of repayment: refinancing to today’s
historically low interest rates, extending the loan’s terms, modifying the
interest rate, deferring payments, or lowering the amount the borrower actually
owes on the loan—so-called “principal reduction.” In most cases the lender or
mortgage investor responsible for the loan considers all of these options when
deciding which intervention is best for the specific borrower.
That is, unless the loan is owned or guaranteed by Fannie
Mae or Freddie Mac, the country’s two biggest mortgage finance companies.
Fannie and Freddie have yet to embrace one option—principal reduction—as a
viable foreclosure mitigation tool.
In fact the two mortgage giants, which are now operating
under government conservatorship, are forbidden from lowering principal on any
mortgages they own or guarantee by their regulator, the Federal Housing Finance
Agency, or FHFA. That’s the case despite a growing consensus among economists,
investors, academics, and consumer advocates that principal reduction is often
the most costeffective way to avoid unnecessary foreclosure for certain groups
of borrowers.
Principal reductions are particularly effective for deeply
underwater borrowers that are facing long-term economic hardships, such as a
permanent reduction in wages or long-term increases in unavoidable spending.
These families are at high risk of default and often cannot see the long-term
upside from making expensive monthly payments into a bad investment. With more
equity in their home, these borrowers would be more likely to stick it out in
tough economic times by making deep cuts to savings or other areas of spending.
These are homeowners worth helping. Foreclosure is often
the worst-case scenario for everyone involved, but especially for underwater
borrowers who boast close ties to their communities and prefer to stay in their
homes. These kinds of homeowners consider the administrative fees, consequences
for their future credit, and other costs of foreclosure. So, too, do the
lenders or investors, who often have to shell out tens of thousands of dollars
in legal fees, foregone interest, and losses on the property. And each
foreclosure in the neighborhood decreases the value of everyone else’s home,
which is a drag on the local housing market.
Reducing principal is the only way to rebuild an
underwater borrower’s equity while permanently lowering monthly mortgage
payments. That’s one reason why almost one in five modifications of private
loans held in bank portfolios involves some principal reduction, according to
one survey. But FHFA is not convinced principal reduction is ever the best
option for Fannie or Freddie.
To be fair that position may make sense if the goal of the
agency is to protect the short-term interests of Fannie and Freddie. Principal
reductions require the lender to take a hit on their books today in order to
save more money tomorrow by reducing defaults and foreclosures. In the case of
Fannie and Freddie, that may mean billions of more dollars in temporary support
from taxpayers, who have already invested $150 billion in the companies since
2008.
But it’s important to realize that over the long run, the
goverment-sponsored enterprises are projected to lose even more money if they
don’t act today. And more than three years into the conservatorship, with no
clear path for the federal government to wind down its control of Fannie and
Freddie anytime soon, we need to start thinking long term. It’s time for
Fannie, Freddie, and FHFA to give their stance on principal reduction another
thought. This report explains why Fannie, Freddie, and FHFA should embrace a
targeted principal-reduction program for certain deeply underwater loans it
owns or guarantees. This is not a matter of charity, though more struggling
homeowners would likely be able to stay in their home as a result. At its core,
principal reduction is good business.
Indeed, we already know that principal reductions are
beneficial to Fannie and Freddie in the long term. FHFA’s own analysis shows
that reducing principal on all deeply underwater borrowers would save the
government-sponsored enterprises and the taxpayers supporting them
approximately $20 billion over the life of those loans relative to not doing
anything. A carefully designed principal-reduction program— one that limits the
long-term risks borne by Fannie and Freddie and focuses on borrowers that
actually need a reduction—makes the business case even stronger.
To maximize returns to Fannie and Freddie, we propose a
pilot program that reduces principal—often by as little as 5 percent or 10
percent—without creating skewed incentives for borrowers. Through so-called
“shared appreciation” modifications, Fannie or Freddie agrees to write down a
portion of the principal on deeply underwater loans in exchange for a portion
of the future appreciation on the home. The borrower has a reason to keep
paying, while the lender benefits when home prices eventually stabilize and
rebound.
Since the borrower has to give up a meaningful share of
future home price appreciation, basically establishing a cost for program participation,
the shared appreciation modification is not particularly attractive to
borrowers that don’t need it. And by phasing in the principal reduction—say,
over the course of three years contingent on meeting every monthly payment—the
borrower has additional incentive to stay current on their mortgage. Both of
these program rules deter borrowers from defaulting on their loan just to get a
reduction in principal, what some critics call the “moral hazard” problem.
That said, we fully understand that principal reductions
should not be available to everyone. As is the case with any loan modification,
the principal reduction must be in the best interest of both the borrower and
the lender, or in many cases the mortgage investor that owns the loan. This
consideration must be done on a loan-by-loan basis.
At this point, we don’t have enough data to determine when
exactly principal reduction is the best option for Fannie and Freddie compared
to other modifications such as interest rate modifications or principal deferral.
Indeed, that’s the main reason for a targeted pilot. For now we recommend
Fannie and Freddie focus on borrowers that are most likely to benefit from a
reduction, specifically borrowers that:
§
Have a mortgage
that’s worth at least 115 percent of the home’s current value
§
Are either
delinquent on their mortgage payments or at imminent risk of default
§
Face a long-term
economic hardship, such as a nontemporary decrease in income or a permanent
increase in unavoidable spending
§
Do not have
private mortgage insurance or a second lien, such as a home equity loan
To be sure, we believe that principal reduction could be
the best modification option for Fannie- or Freddie-backed borrowers that do
not meet all of these criteria. But we propose that the pilot focus on this
core group to test the model.
We also recommend that the shared appreciation pilot
operate through the Home
Affordable Modification Program, or HAMP. The Obama administration recently announced new incentives for Fannie and Freddie to write down principal through HAMP, which should help the companies keep more underwater borrowers in their homes, according to our analysis.
Affordable Modification Program, or HAMP. The Obama administration recently announced new incentives for Fannie and Freddie to write down principal through HAMP, which should help the companies keep more underwater borrowers in their homes, according to our analysis.
But before we go further into the details of our proposal,
let’s take a closer look at the negative equity crisis facing millions of
American families today, many of which have loans backed by Fannie Mae or
Freddie Mac.
John Griffith is a Policy Analyst
with the Economic Policy Team at the Center for American Progress. Jordan Eizenga was a Policy Analyst with CAP’s Economic Policy
Team at the time this report was written.
Download
the full report (pdf)
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