FHFA finally gives cramdowns merit

Long objecting to principal reductions (a.k.a. cramdowns), the Federal Housing Finance Agency (FHFA), overseer of government owned and sponsored enterprises Fannie Mae and Freddie Mac (collectively Frannie), now reluctantly views cramdowns as a potentially effective tool to aid negative-equity homeowners.

Recently, the FHFA director, Edward M. DeMarco, gave an analysis demonstrating his continued hesitancy towards cramdowns. However, it now seems he is finally willing to consider the possibility, not simply reject cramdowns outright.

Cramdowns are the process of reducing a home loan’s principal balance to more closely reflect the current fair market value (FMV) of the home. A 94% loan-to-value (LTV) ratio (100% minus 6% lost in transactional costs) would allow the owner to sell without netting any proceeds from the sale, as occurs in all shortsale scenarios.

Those buyers who leveraged their purchase of a home at the height of the boom now find themselves owing more on their mortgage than the property is worth. These underwater homeowners are left with few options if they are having trouble making payments. Often their only available course of action is to pursue a shortsale or accept foreclosure. Others who can pay, whether or not they are rendered insolvent by the underwater asset of a home, are left to strategically default to rid themselves of ownership, as a shortsale by a qualified homeowner is distasteful to lenders.

In contemplating cramdowns, the FHFA weighs the interests of U.S. taxpayers versus those of underwater homeowners, while keeping Frannie’s well-being in mind. Sponsoring cramdowns will decrease Frannie’s losses by an estimated $1.7 billion. However, it would end up costing taxpayers approximately $2.1 billion (a couple of weeks in the Iraq War) since the Treasury Department covers the losses Frannie would incur to make these cramdowns. In defense of its reluctance to grant cramdowns, DeMarco claims the FHFA’s current programs allowing distressed homeowners with Frannie-owned mortgages to refinance offer sufficient support to help homeowners in need. The director proudly claims programs like the Home Affordable Modification Program (HAMP) have assisted homeowners to complete 1.1 million loan modifications nationwide since 2008 (though the program was largely shooting blanks in California due to the 125% LTV limit to participate, leaving  all involved  financially worse off).

In his speech, DeMarco estimates the FHFA would theoretically be able to provide cramdowns to about 10% of the 11 million underwater homeowners. He goes on to say these cramdowns would make no real difference to the nation’s housing market, (which is conflicting logic since 10% of 11 million is actually 1.1 million – the same amount of loan modifications the FHFA uses as evidence to demonstrate that Frannie is leading the way in loan modifications paid for totally by the homeowner).

Ultimately, the FHFA is hesitant to implement a cramdown program due to the perceived moral hazard it would create by allowing some homeowners principal reductions and not others. They suspect homeowners with the means to remain current on their homes will purposefully become delinquent – the strategic default that is currently a growing wave – in order to qualify for cramdowns and reduce their LTV ratio. That point of view, if accurate, would cost taxpayers even more than the FHFA projected.

first tuesday take: All this is ultimately about bailing out the lenders –  Frannie included.  Homeowners will get nothing beyond the right to retain title to their homes. While they will have no present equity in a cramdown, at least the principal in the loan payments will now be building up equity and not just going to the lender until the LTV hits 94% in a decade or so. Until then, these negative equity homeowners are economical tenants, not literal owners at all.

Cramdowns are the best option for California to emerge from the housing recession quickly. first tuesday has long advocated for their use. A bitter dose of medicine in the short-term in the form of government deficits is far preferable to the protracted illness of a delayed recovery. However, with 60% of mortgages on California homes currently owned by Frannie (and approximately 2.5 million underwater homeowners existing in the state), it’s not looking good.

The ice may be thawing, but DeMarco’s speech by no means demonstrates the FHFA has had a dramatic warming of heart. Its ultimate position on cramdowns is the same as it always has been, but its stance has just become less adamant and it seems at least willing to consider them.

In response to the recent big bank settlement that opened the door for cramdowns for a few lucky homeowners, our Attorney General has stated she will separately pursue principal reductions for California homeowners with mortgages owned by Frannie. We have yet to see evidence of any progress on this front.

The FHFA’s decision on whether or not to implement cramdowns for Frannie is being made in the next few weeks. At this point, it does not seem likely, especially given their assumption that other qualified homeowners will give in to the moral hazard as have mortgage bankers and Wall Street funded lenders. The 99% are being classified with the 1%, an amusing conclusion.

The decision will be made using a two-dimensional scale, balancing taxpayer costs with homeowner benefits, disregarding the long-term effect implementing cramdowns will have on the housing industry (and the FHFA’s own balance sheet).

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