Tuesday, July 31, 2012

FHFA rejects principal reduction but ignores shared appreciation

by Ethan Handelman, National Housing Conference

Ed DeMarco, Acting Director of the Federal Housing Finance Agency (FHFA), announced today that he would not direct Fannie Mae and Freddie Mac to allow principal reduction. The announcement comes despite earlier analysis suggesting that Fannie Mae and Freddie Mac could save significantly using principal reduction and it ignores options such as shared appreciation that could align borrowers’ and lenders’ incentives effectively. The result will be fewer underwater borrowers seeing relief from too-high debt and foreclosures we could have avoided.

FHFA’s decision was based on its analysis of what would happen if Fannie Mae and Freddie Mac offered a principal reduction option to borrowers in distress—a public, systematic, and untargeted approach to principal reduction. The conclusion, unsurprisingly, was that if even a small fraction of current borrowers chose to strategically default in order to qualify for principal reduction, the result would cost more than doing no reduction at all.

Quite simply, FHFA got the wrong answer because it asked the wrong question. Had it analyzed a targeted principal reduction option that required participants to make a substantial concession in order to participate, the results would likely have been very different. Shared appreciation modifications, for instance, offer underwater borrowers forgiveness of principal in exchange for a share of possible future appreciation. A truly distressed borrower would make that trade—most strategic defaulters wouldn’t.

Shared appreciation is one good way to target principal reductions, but there are others. By ignoring targeting options and looking only at sweeping implementation of principal reduction, FHFA has removed useful tools from the toolbox. It will be that much harder to fix the foreclosure and underwater mortgage problems as a result.

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