Housing finance chief blocked plan to reduce mortgage principal, congressmen say

An auction sign in front of a home, in Salem, Ore.

By John W. Schoen, Senior Producer

Updated Tuesday at 5:15 p.m. ET: A top U.S. housing regulator failed to implement a plan to cut loan principal balances for millions of underwater homeowners even though a pilot program showed two years ago it could save taxpayers money, two House Democrats said Tuesday.
Edward DeMarco, acting director of the Federal Housing Finance Agency, which oversees mortgage giant Fannie Mae, "apparently ha(s) been withholding from Congress" documents showing the potential benefits of the program to taxpayers and homeowners, according to Reps. Elijah Cummins of Maryland and John Tierney of Massachusetts. The two Democrats, in a letter to DeMarco that was released to msnbc.com, said they obtained the documents from an independent source.
Cummins and Tierney cited internal documents at government-controlled Fannie Mae describing the pilot program with Citibank, beginning in 2009, that showed that “principal reduction programs have enormous potential to save U.S. taxpayers significant amounts of money.”
Late Tuesday, Demarco responded by saying that the pilot program was ended largely due to "operational concerns" and that "there was not full agreement to proceed" with the program at Fannie Mae and Freddie Mac.
(This story has been updated to reflect DeMarco's response.)
Since last fall, DeMarco has resisted pressure to reduce principal balances on underwater mortgages despite calls from more than 100 members of Congress, who have argued that the action could help reduce taxpayer losses on government-owned loans and keep more families in their homes. So far the government has spent more than $160 billion in taxpayer funds to prop up Fannie Mae and sister agency Freddie Mac.
DeMarco's resistance to the idea is based on his "philosophical" opposition to reducing the amount a homeowner owes, according to a former Fannie Mae official quoted in the letter.  
The collapse of the housing market in 2006 has erased some $7 trillion of equity from the value of American homes and left roughly 11 million homeowners underwater, meaning they owe their lender more than their home is worth.
Those homeowners, effectively unable to sell their homes, are locked out of the housing market and sidelined from creating the buying demand needed to support any housing recovery. Five years into the housing recession, they’re also more likely to consider walking away from their mortgage, adding to the backlog of foreclosures that could further depress home prices, forcing more households underwater.
To help stabilize the housing market, proponents of principal reduction argue that homeowners and lenders are better off avoiding those defaults and foreclosures.
According to the letter sent to DeMarco, those proponents include Fannie Mae officials who were favorably impressed with the results of the Citibank pilot program.
In a December 2009 review, Fannie Mae officials estimated that the pilot program of cutting loan balances would cost about $1.7 million to implement and generate potential taxpayer savings of more than $410 million. That review estimated that "more than half of Fannie Mae customers will see some benefit from the program" within six months.
According to a November 2009 presentation to Fannie Mae's risk analysts, redefault rates on loans given principal reductions in the trial program were "far below rates on other modification portfolios," according to the letter from Cummins and Tierney.
But the program was suspended in July 2010, without explanation, according to the letter. In November 2010, Fannie Mae officials continued to press internally for principal reductions. To make their case, they prepared a research paper that concluded that "Fannie Mae might reduce its losses substantially in many cases by writing down principal." The paper said Fannie Mae losses resulting from foreclosures following default were "large multiples of the amounts by which the loans were underwater," according to the documents cited in the letter.
In response to congressional pressure, DeMarco agreed to review the agency’s opposition to cutting principal balances on Fannie Mae and Freddie Mac mortgages. Last month, in a speech at the Brookings Institution in Washington, DeMarco outlined some of the reasons for his opposition to the policy.
“Most Americans that are underwater on their mortgage realize they've signed a contract -- they’ve got an obligation to make that payment and in fact they are," DeMarco said. Those underwater homeowners should be encouraged to continue doing so, he added.
But other government officials argue that by cutting principal or deferring a portion of the balance until a home is sold, some defaults could be prevented, thereby reducing losses and foreclosures. The recent mortgage settlement among 49 states, several federal agencies and five large banks aims to promote the practice by providing those lenders with financial incentives to cut loan balances.
"There is increasing data available, we believe, that shows that ... principal reduction can be good not only for homeowners and communities, but for investors as well," Shaun Donovan, secretary of Housing and Urban Development, told a Senate panel this year. "It can allow people to pay [their bills], stay in their homes and increase the value of those mortgages."
In his Brookings speech, DeMarco repeated his philosophical concerns - an argument also known as "moral hazard" - that offering principal reduction to some homeowners could prompt others who are current on their loans to ask to have their loan balances cut.
“The far larger group of underwater borrowers who today have remained faithful to paying their mortgage obligations are the much greater contingent risk to housing markets and to taxpayers,” DeMarco said.
Philosophical arguments aside, investors holding underwater mortgages have found that, in some cases, they can reduce losses by cutting principal balances.
“Private lenders are doing it for an increasing share of their (mortgage portfolios) when it makes sense,” Andrew Jakabovics, a research director at Enterprise Community Partners, told reporters in a panel discussion following DeMarco’s Brookings speech. “If (Fannie and Freddie) aren’t willing to do it, there are plenty of investors who are buying these notes because economically it makes a lot of sense.”
The White House also has encouraged Fannie and Freddie to include principal reduction as part of their mortgage relief efforts.
The debate took a bizarre twist last month when FHFA's inspector general, who is charged with detecting "fraud, waste and abuse" in the agencies, reported that Freddie Mac alone could save taxpayers “significant” sums of money if it pressed the companies servicing its mortgages to modify more loans. But the amounts to be saved were blacked out at the insistence of FHFA "and/or" Freddie Mac, according to the report.
In his Brookings speech, DeMarco said FHFA would soon complete its review and promised to have an answer within a few weeks. FHFA has now backed away from that timeline and would not provide a date for a decision.
“FHFA continues to work on its principal forgiveness analysis and is in discussions with the Department of the Treasury,” a spokeswoman said Monday. “A final determination ... is being deferred until we conclude these activities.”
FHFA was created by the Bush administration to oversee the bailout of Fannie Mae and Freddie Mac, government-chartered entities that collapsed under the weight of defaulting loans following the housing collapse.  DeMarco was named acting head of the agency about a year later when his Bush-appointed predecessor stepped down.
In December 2010, President Barack Obama’s nomination to replace DeMarco, former North Carolina banking commissioner Joseph Smith, was approved by the Senate Banking Committee, with three Republican crossing the aisle to support the appointment. But the nomination was blocked by Republicans on the Senate floor, in part because they felt Smith would be too generous in support of homeowners seeking to modify loans held by the government
"He will be a tool of the administration, cutting mortgages, throwing the bill to the taxpayers," Sen. Richard C. Shelby, R-Ala., ranking member of the Banking Committee, told reporters following Smith’s confirmation hearing.
Smith was recently appointed to monitor the compliance of five large banks with the terms of the state-federal settlement over fraudulent and abusive mortgage foreclosure practices.