Viable Principal Reduction Plan Would Likely Have Limitations -CoreLogic

Among the most contentious issues at the Federal Housing Finance Agency (FHFA) when Edward J. DeMarco was its acting director was his refusal to allow Fannie Mae and Freddie Mac (the GSEs) to adopt a principal reduction (or PR) program, citing FHFA's duty as their conservator to protect their assets.  His opposition continued even as the Treasury Department offered incentives to lenders through the Home Affordable Modification Program (HAMP) it co-sponsors with FHFA.  This provoked considerable friction between the acting director and many members of Congress.

After he was replaced by Melvin L. Watt as permanent director in January 2014, principal reduction fell out of the news.  Housing advocates expected Watt to reverse DeMarco's policy, permitting Fannie Mae and Freddie Mac to employ PR as part of their loan modification packages but he has not yet done so.

With PR a portion of the outstanding mortgage balance (which has often been inflated by legal costs, late fees, and other penalties during the delinquency) is reduced to more accurately reflect the current market value of a home with negative equity In addition to creating an incentive to homeowners to make mortgage payments - a home that is underwater is more likely to become delinquent or redefault after modification - a reduced balance is an additional tool to enable lower monthly payments.

Even as the number of foreclosures has receded and millions of homes have returned to positive equity pressure has continued to initiate a principal reduction (or PR) program for GSE owned or guaranteed loans and in February Watt said that the issue was still being studied by his agency.  He told reporters that if PR were implemented it would be a narrower program than advocates have called for because he was also concerned for the GSEs' finances. 

How might a "narrower" PR program work?  In an article in CoreLogic's Insites blog company policy research and strategy analyst, Stuart Quinn, said that FHFA's ongoing assessment of any implementation "likely hinges of a few key questions" and expands on a 2012 speech given by DeMarco at the Brookings Institute.  The considerations include the difference between principal forgiveness and principal forbearance which was DeMarco's endorsed approach.  Other factors in the decision could be the future of home prices and FHFA's general mission.

Quinn says that properties that continue to remain underwater not only maintain higher levels of default risk but also reduce the properties available for purchase (as underwater borrowers usually must go through the short sale process).  Quinn speculates that if and when FHFA adopts a new policy "it will likely be targeted and may solely expand utilization of principal deferral as an option."

The article, "A Closer Look at Equity, Principles of Principal Reduction," puts the GSE's rate of seriously delinquent loans (SDQs) at the end of 2014 at 1.89 for Fannie Mae and 1.88 for Freddie Mac, close to their rates in September 2008 when the two were placed in conservatorship but substantially lower than at the peak. In more normal times the two ran rates of about 0.5 percent.

The GSE's SDQ figures include loans in foreclosure and for Freddie Mac approximately 53, 61, and 68 percent respectively of its SDQ's were in foreclosure proceedings at the end of 2014, 2013 and 2012 respectively.  Loans in foreclosure are unlikely to qualify for principal reduction due to their stage of distress, Quinn says, so, while the stage and requirements for eligibility would have to be determined by FHFA, the remaining population of eligible loans could be relatively small.  He projects a conservative estimate of just under 265,000 loans across both GSEs but says that given the concentration of numbers in judicial states with lengthy foreclosure timelines his figure may still be too high.  He also assumes that a net-present-value analysis would likely also be conducted on a loan-by-loan basis to determine eligibility.

Quinn looked at rates of homes in negative equity at two points of time - the first quarter of 2010 and the end of 2014 - in 35 Core Based Statistical Areas (CBSAs).  Many of the cities with the most severe problems at the earlier point had also shown the greatest improvement over time.  For example, in the Las Vegas area three out of four properties were worth less than their outstanding mortgage balance in 2010, but that rate was down by 50 percentage points four years later.  Some of the worse CBSAs in California such as Stockton, Modesto, and Fresno have made "remarkable recoveries" with negative numbers declining by one-third to one-half.  In the Midwest however many of those CBSAs hardest hit have not shown nearly that much progress.  Overall, every one of the 35 most underwater areas in 2010 continues to have elevated figures - a minimum of three out of 20 homes.

Quinn says that any policy of principal reduction coming from FHFA "will likely need to validate that it is targeting jurisdictions and individuals whose hardships are commensurate with the downturn, rather than reinforcing local policy decisions that could inhibit the rate of recovery." He cites The Neighborhood Stabilization Initiative (NSI) under FHFA that targets the City of Detroit and Cook County, Illinois and reinforces the approach of targeting slower recovering areas whose current home prices may not regain the market values reached during their peaks anytime soon.

To see how long it might take an average underwater home to reach positive equity without intervention Quinn tested a few key CBSAs using CoreLogic's Home Price Index (HPI) five-year forecast and amortized mortgage payments assuming a mortgage coupon of 5.22 percent.  The analysis acknowledges that it will take areas with higher rates of negative equity longer to normalize than areas with small numbers.   

Quinn says his analysis indicates that in most of the areas it will take nearly five to six years for the average underwater property to right side itself and while there is variation among the areas, most receive a larger contribution to rising equity from market recovery than from principal pay down.  "For instance, in the first few years, Riverside, California's home price appreciation contribution appears that it will outpace the scheduled principal payment, while the opposite is true in the Baltimore area."

He concludes that the sensitivities and diversity of stakeholders that will be impacted by principal reduction makes the policy decision particularly difficult to weigh and determine. "The ramifications of strategic defaults, operational costs of implementing the program, incentive offsets within the principal reduction alternative program under Treasury and net-present-value calculations will all play a role in determining whether a change in policy makes sense. As the decision continues to remain under review, housing market appreciation and scheduled pay-down will continue to chip away at the 5.4 million existing homes in negative equity that continue to remain off-market, with the largest proportion of those homes residing in the lower value house price tier."