Should Fannie, Freddie Write Down ‘Underwater’ Mortgages?

California Attorney General Kamala Harris became the latest elected official on Thursday to call on Fannie Mae and Freddie Mac to write down loan balances for borrowers who owe more than their homes are worth.

Ms. Harris is seen as a key figure in an effort by the Obama administration and state attorneys general to forge a $25 billion settlement with banks over foreclosure-processing abuses. She bolted from the talks in early October, calling the proposed settlement inadequate, but has been wooed since then by states in a bid to finalize the multibillion-dollar settlement.

In recent weeks, Democratic lawmakers in Congress have also expressed frustration with the resistance of Fannie and Freddie’s independent regulator, the Federal Housing Finance Agency, to carry out principal write-downs. Republican attorneys general, meanwhile, have spoken out against principal write-down.

Ms. Harris on Thursday didn’t specifically address the settlement talks, which have not included Fannie and Freddie. Instead, she called on the agency’s acting director, Edward DeMarco, to “step aside” if he “is unwilling to support principal reduction for these home loans in crisis.”
Why won’t Fannie and Freddie write down loan balances? There are three broad reasons. First, the firms guarantee $5 trillion in mortgages, of which around 20% are underwater. But the vast majority of those underwater mortgages—around 87% for Freddie Mac—are current. The companies are reluctant to write down loan balances because of a concern that will create a moral hazard that induces other borrowers to default.

Second, Mr. DeMarco has said that the firms’ current efforts to modify mortgages are successfully reducing borrowers’ monthly payments to affordable levels without the costly step of forgiving debt. Fannie and Freddie are supported entirely by taxpayers and have run up a $145 billion tab so far, and the FHFA is charged with conserving the firms’ assets. In a recent interview, Mr. DeMarco said that principal forgiveness isn’t justified given that mandate.
Third, many underwater loans often are covered by mortgage insurance, which reimburses Fannie and Freddie for part of the loss when those loans default and go through foreclosure. The upshot is that even in cases where it might make economic sense for the loan to be written down, it still isn’t in the economic interest of Fannie or Freddie to write down certain loans.

Why aren’t Fannie and Freddie part of the foreclosure settlement? Just as Fannie and Freddie don’t actually make loans, they also don’t handle the day-to-day management of those loans, or what’s known as “mortgage servicing.” Instead, they rely on hundreds of companies, but primarily large banks, to service their loans. They publish detailed guidelines about what steps servicers must take, including timelines they must meet to foreclose on borrowers that haven’t qualified for a mortgage modification.
The current foreclosure settlement is focused on banks that didn’t properly service mortgages. While Fannie and Freddie, the two largest mortgage investors in the U.S., clearly failed to prevent the massive meltdown in mortgage servicing (and some have argued that they turned a blind eye to long-festering problems), the firms themselves don’t service mortgages. That’s one big reason they aren’t a party to the settlement.

What would the settlement do? Under the terms being discussed with banks, they would have to pay around $25 billion in penalties. Around $5 billion would be paid in cash. Another $3 billion would be spent by refinancing underwater borrowers whose loans are on the banks’ books. The remaining $17 billion would be spent on housing-relief efforts, primarily by writing down loan balances for underwater borrowers who are struggling to make their payments.

Would the settlement apply only to loans that banks own? That’s still up in the air. Initially, the Obama administration had pressed for the settlement to require banks to write down loan balances for borrowers whose loans they didn’t service. The logic behind that move was that investors, along with borrowers, had been harmed by servicers’ failure to properly handle distressed loans.

But banks have strongly resisted that approach because it would require them to essentially pay investors. Instead, the current settlement discussions have focused on allowing banks to pay their fines by writing down loan balances on mortgages that they hold on their books.

Around 20% of all mortgages in the U.S. are held on bank balance sheets.
The proposed settlement wouldn’t preclude banks from writing down loans that they service for other investors, according to people familiar with the matter, but banks appear unlikely to choose that option at this point.

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