Geithner's Principal Reduction Dilemma

When the topic is principal reduction the glass is either half full or half empty. Yet, if mounting pressure on government-sponsored enterprises and their conservator results in a green light to writedowns on GSE loans as everyone expects, such solution will also require the approval and financial support of the department of treasury. 

So far hints about Treasury’s final stand on this issue are few. Right now the spotlight is on the Federal Housing Finance Agency even though ultimately principal reductions will have to be supported by the Secretary of the Treasury, Timothy Geithner. In the end principal reductions on GSE loans will be his dilemma.

According to an FHFA report compared to principal forbearance principal reduction modifications implemented on roughly 700,000 delinquent GSE loans would reduce GSE losses by $1.7 billion. In a letter to representative Cummings FHFA’s acting director Edward DeMarco estimated that principal reductions for all of the mortgages that are under water would require almost $100 billion in funding. 

“If in fact it is done and the GSEs absorb the losses, they would have to draw it from the Treasury,” says Robert Bostrom co-head, global financial institutions and funds sector, SNR Denton US LLP, New York, a former general counsel for Freddie Mac. “It will be Geithner’s decision to make.”

Such a bold move is equally likely to happen and to fail. 

The debate continues. It started back in January when DeMarco responded to members of Congress who criticized the FHFA for not allowing principal reductions on GSE loans with a letter where he argued that under the statutory provisions of the Emergency Economic Stabilization Act while the FHFA analysis can change based on different facts and circumstances principal, its main concern is that such reductions do not serve the interests of the taxpayers. 

Bostrom sympathizes with DeMarco‘s tricky situation. The FHFA has a statutory responsibility as conservator to preserve assets, he says, so its director “has rightfully” taken the position that “unless research shows that principal reduction would in fact be a loss mitigation tool for the GSEs, his hands are really tied.” Neither one of the three research studies the agency has done on this topic in the past have reached that conclusion.

On March 28th Geithner publicly acknowledged in his testimony before Congress stating that Treasury does not have the authority to force the FHFA to allow principal reductions. Yet, Bostrom argues, “It has not stopped the administration” from lobbying with the FHFA and has not changed “the extent to which Congress remains very upset with DeMarco and the FHFA.”

He however finds the language in the letter “is very telling.” Especially the part where the FHFA notes how “changing circumstances may call for updating” of its analysis. It is how FHFA has opened “a crack in the door to go through, if they feel they can get there through principal reduction.” 

It boils down to whether mounting pressure will force the FHFA to decide it has the authority to reconsider the situation and use principal reduction as a loss mitigation tool despite its specific mandate towards taxpayer’s money.

Between objective circumstances and subjective analysis, the latter is easier to change if the FHFA looks at loss mitigation differently. 

The principal forgiveness issue “is not that black and white,” it is not just about net-present-value tests and setting up criteria, Bostrom says, because it is difficult to calculate related costs. Nobody can foresee how many loans may get a principal reduction modification, even though everyone knows “costs associated with that process are huge.” In many states the foreclosure process lasts 500 to 600 days. And that means the cost of carrying a property as outstanding GSE debt in the books for two years due to property management needs, insurance, real estate tax, is very high. Plus, the sales price after foreclosure will be only a fraction of its worth.

“If you look at it this way, than principal reduction losses are not so huge, compared to alternatives,” he says. “It would be consistent with loss mitigation to do some principal forgiveness, which is why they might get there.”

But historically there have been moral hazards associated with principle forgiveness, which is why banks “are reluctant to go along with it.” It raises the issue of who should benefit from it, he says, and whether it should be used as a loss mitigation tool for the hundreds of thousands of “under water” homeowners who are paying their mortgages regardless of equity losses. Should current “under water” borrowers get some relief?

FHFA data show there are 3 million first lien mortgages whose outstanding balance is estimated to be greater than the value of these properties. “There’s no question” avoiding foreclosure on 3 million houses will have a positive impact on housing prices, Bostrom says.

Unfortunately it also will be the single biggest driver of unquantifiable losses for the GSEs. Another issue is the delinquency rate since according to FHFA data 80% of the GSE under water borrowers are current on their mortgages.

Keefe, Bruyette & Woods analysts called a potential increase in principal reduction modifications “ a modest positive for the mortgage industry” that would result in more sustainable modifications.

They argue that Geithner’s congressional testimony suggests that potential principal reductions may apply to delinquent loans that are modified through the Home Affordable Modification Program. HAMP may be an option to a small pool of delinquent borrowers and limited to homeowners whose home values are “severely underwater” at over 125%. In either case, “the impact on the broader mortgage market will be modestly positive.”

These data suggest fear that principal reduction modifications on GSE loans will turn into an incentive for strategic default “are not substantiated by data during the time PRA has been part of HAMP.” According to the most recent OTS and OCC Mortgage Metrics report, in 3Q11 18.4% of modifications done by portfolio lenders include principal reductions indicating that "private sector holders of underwater mortgages believe that principal reduction modifications can add value to their delinquent mortgages.”