With the Treasury's Christmas Eve announcement that it was uncapping its financial support for Fannie Mae and Freddie Mac came much speculation.
After all, the Federal Housing Finance Agency has only requested about $111 billion of aid for the government-sponsored enterprises so far (‘only’ being a very relative term, here) – far less than the $400 billion combined limit that was in effect up until last week's announcement. And according to at least one analyst, Credit Suisse's Mahesh Swaminathan, it's unlikely that either company would require more capital than the Treasury already stated it was willing to commit.
So if there is no immediate need to erase Fannie's and Freddie's caps – other than, perhaps, to comfort the market, as Swaminathan suggested to the Wall Street Journal – what drove the Treasury's decision to essentially pledge unlimited support for the GSEs?
One of the more popular theories to have gained traction in the last week is that the move is directly related to the Home Affordable Modification Program (HAMP). Specifically, industry observers indicate the money could be used to cushion losses resulting from principal reductions. At the moment, principal reductions are allowed, but not strongly emphasized, under HAMP.
‘Any [program] changes will likely increase near-term bailout costs to Fannie and Freddie if HAMP's current reliance on interest reduction is replaced, in part, by principal reduction,’ banking consultant Edward Pinto wrote last week. ‘The losses associated with a modification of a loan using an interest-rate reduction are spread out over time, while a modification using principal reduction results in taking a more immediate loss.’
Finance and economics blog Calculated Risk tied the uncapping to a recent HAMP directive that instituted a temporary review period for active trial mods set to expire on or before Jan. 31, 2010. The directive, 09-10, forbids servicers from canceling an active HAMP trial mod before that date for any reason other than failure to meet the program's property eligibility requirements.
‘There is a possibility that the Treasury is planning on introducing a principal reduction component to HAMP in January, and this could lead to significantly larger losses for Fannie and Freddie,’ wrote CR's Bill McBride, adding a ‘just speculation’ disclaimer.
‘There has been no announcement yet, and even if this is proposed, it might only apply to Fannie- and Freddie-related loans, and not private [mortgage-backed securities],’ the blog post continued.
For those keeping track at home, regulators reported that in the third quarter, some 36.7% of modified loans held in portfolio included principal reductions; 0% of private-investor and government-guaranteed modifications featured principal reductions, while Fannie Mae's and Freddie Mac's percentages were 0.4% and 1.6%, respectively.
Or, as Pinto told Servicing Management this month, ‘Many private portfolio lenders are [reducing principal]. The government – Fannie Mae, Freddie Mac and the Federal Housing Administration – is not.’
Consumer advocacy groups have long urged servicers to make wider use of principal reductions, and from a home-retention perspective, it's sensible: Reduced principal equals improved equity for the borrower and, as has become apparent in the last year, a borrower's equity position goes a long way toward determining the likelihood of default.
That's not to suggest principal reductions are without dangers, of course. There's the serious and legitimate concern that principal reductions are ripe for abuse, and that their broader application would only lead to a large onslaught of strategic defaults. And how on Earth do you reduce principal in an equitable fashion?
In congressional testimony earlier this month, Amherst Securities Group's Laurie Goodman offered some ideas for ‘frictions’ that could help prevent such defaults from occurring.
‘There is no single option here – shared-appreciation features, requiring all reduced principal mortgages to be made with recourse, introducing an impact on credit scores and limiting future access to credit or ability to borrow against the property are among the ideas that must be considered,’ she said.
What are your thoughts on principal reductions? Should they be used more heavily? Avoided altogether? Drop a line, and make your voice heard.
– John Clapp, editor, Servicing Management
(Please address all comments regarding this opinion column to clappj@sm-online.com.)
