Gretchen Morgenson has done a lot of outstanding reporting on the financial industry over the last decade, however today's defense of Ed DeMarco, the head of the Federal Housing Finance Authority falls wide of the mark. DeMarco has drawn considerable heat as of late because of his refusal to allow Fannie Mae and Freddie Mac to do principal reductions to make it easier for underwater homeowners to stay in her home.
Morgenson defends this refusal by saying that DeMarco's refusal is actually protecting taxpayers from providing yet another bailout to the banks. Her argument is that many of these underwater homeowners have second liens on their homes which are held by banks. If Fannie and Freddie do principal reductions on the first lien, then it greatly increases the likelihood that these second liens will be paid off, thereby enriching the banks at the taxpayers' expenses. (If a home goes into foreclosure, the first lien has absolute priority. Not a penny goes to the second lien unless the first lien is paid in full. This means that second loans generally have zero value in a foreclosure.)
There are two problems with this story. The first is that a very large percent of F&F underwater mortgages do not have a second lien. Core Logic estimates that 60 percent of underwater mortgages do not have a second lien. The share is almost certainly higher with F&F loans than with mortgages more generally, since F&F did not get into the worst of the subprime loans where homebuyers put zero down. This means that for the vast majority of underwater mortgages held by F&F there is no issue of subsidizing banks indirectly through a principle write-down, since there is no second loan.
The second issue is that the holder of the first mortgage can negotiate with the holder of the second mortgage to set terms for a principal write-down. It is possible that banks would be obstinate and refuse to make serious concessions. In this case, DeMarco with have a solid reason for refusing to go ahead with write-downs. However he has never indicated publicly that F&F have tried this sort of negotiation and been rebuffed. If this is the case, then DeMarco has a responsibility to explain the problem to the public and Congress. Most likely he has not said anything because he has never attempted to go this route.
Finally, Morgenson offers up a defense of DeMarco's conduct by noting that foreclosure rates are much lower on F&F loans than on the loans held by banks or in private issue mortgage backed securities. While this is undoubtedly true, it should be expected given that the loans issued by F&F were much higher quality than the loans that were placed in private issue mortgage backed securities.
Since F&F stayed away from the worst subprime and Alt-A mortgages they naturally would have lower default and foreclosure rates on their loans. This is not evidence that they have been especially effective in their modifications.
It is worth pointing out that the debate over this issue has become hugely overblown. It would not make a big difference to the overall economy or even the housing market if DeMarco were to allow principal reductions. The biggest effect is that perhaps another 200,000-300,000 homeowners may be able to avoid foreclosure in the next few years. This would be a good thing for these people. However the impact on the housing market and the economy would be negligible.