Thus far, the Federal Housing Finance Administration (FHFA), the conservator for Fannie Mae and Freddie Mac, has been reluctant to forgive the outstanding principal balances on mortgages owned by Fannie and Freddie. In the view of the FHFA, the reductions in principal would come at a net cost to taxpayers and would therefore be inconsistent with the agency’s mandate to limit taxpayer losses in conservatorship. To encourage the FHFA to rethink this position, the Obama Administration issued a Supplemental Directive that would use TARP funds to pay Fannie and Freddie to reduce outstanding loan balances. Specifically, Fannie and Freddie would receive as much as $0.63 for every $1 of mortgage debt they forgive. Once these payments are taken into account, the FHFA could now justify large scale principal forgiveness in cases where “principal forbearance” is currently the best loss-minimizing approach.
First off, it is worth considering the basic deception of this arrangement. The FHFA won’t forgive mortgage principal because it believes doing so would increase taxpayer losses. According to Fannie Mae’s most recent credit supplement, about two-thirds of modified loans are current 12-months after a modification. New modifications that involve principal reductions would increase losses to taxpayers because the marginal increase in modified loan performance from current levels would not be sufficient to offset the losses on the principal reduction. So to avoid taxpayer losses on the FHFA line item on the budget, the Obama Administration would simply move those losses to the TARP-financed Home Affordable Modification Program (HAMP) line.
If this is where the analysis ended, the program might be defensible. Mortgage borrowers would finally receive the direct transfer of taxpayer resources the largest banks enjoyed in the fall of 2008. Unfortunately, the subsidy from taxpayers to struggling homeowners is actually the least problematic part of the program. The main beneficiaries of the program would be the holders of second liens – home equity loans and lines of credit – that should be reduced in value to zero before the senior note holder loses a cent. Other main beneficiaries would be mortgage insurers, which could avoid billions of dollars in insurance payouts if the program succeeds in avoiding foreclosure, and “strategic defaulters” who take advantage of clearly delineated rules to reduce their outstanding mortgage balance.
“Homeownership” is a misnomer. Unless a household has sufficient liquidity to buy a home with cash, it is a renter. The question is whether the household rents the property directly from a landlord or whether it chooses instead to rent the capital necessary to purchase the home. In exchange for financing the purchase, the creditor demands that the home serve as collateral for the loan. In the event that the household does not make timely payments of mortgage interest and principal, the mortgage lender has the authority to take possession of the home through foreclosure. Therefore, the household’s “ownership” of the home is contingent on its ability to make mortgage payments, with the mortgage lender holding a claim on the home that is more senior and legally superior.
In addition to a mortgage loan for purchase, a household can also take out “second liens” such as home equity loans, home equity lines of credit, and other types of borrowing. The Fed began tracking home equity loans in 1990, when they totaled $214 billion. Over the next 16 years, second liens quintupled in value to more than $1.1 trillion, or nearly 11% of all outstanding mortgage debt. When a home equity loan is added to the property, the homeowner’s claim on the house is third in terms of priority. If the household fails to make payments on its home equity loan, the owner of the loan can force foreclosure, pay off the first lien, and collect the remainder from the sale of the house.
As in corporate finance, the success and long-term stability of this arrangement depends critically on strict legal enforcement of claims priority on the asset: the house first belongs to the first mortgage lender, then the second lien holder, and then “homeowner,” in that order. Strict enforcement of seniority is arguably even more critical in residential finance because households can choose to take on additional debt without the knowledge or consent of the mortgage lender. During the period of rapidly rising house prices, home equity loans were a popular method to extract equity from a home. Imagine a household that took out a 90 LTV loan on a $300,000 house in 2003 in Las Vegas (a down payment equal to 10% of the house price and a first mortgage worth 90%). Assume that in 2007, after house prices doubled on a cumulative basis, this household took out a $150,000 home equity loan without the knowledge of the original lender to buy a boat and Mercedes Benz. By 2012, prices in Las Vegas had fallen by 62%, which means the house would be worth $228,000 but the borrower would have $420,000 of mortgage debt against it.
If claims priority were strictly enforced, this situation would actually result in a fairly small loss for the senior creditor (generally Fannie and Freddie). Mortgages with LTVs greater than 80 require mortgage insurance, which is a policy that provides the investor with protection should the value of the house fall below the unpaid principal balance on the mortgage. Assuming a 10% discount in foreclosure, the hypothesized house would generate $205,000 at auction and the mortgage insurer would pay at least $30,000 (10% of the original house value) and possibly more. The combined $235,000 in proceeds would leave the senior creditor with a loss of $35,000 while the owner of the home equity loan would see its entire $150,000 loan wiped out.
In the recent mortgage settlement, the government decided to abrogate contracts and treat the first and second liens equally. That means the $270,000 mortgage in 2003 would incur losses on a directly proportional basis to the $150,000 loan made in 2007. The Supplemental Directive tries to strike a more equitable balance by providing the second lien with incentive payments at a lower rate (a max of $0.42 per dollar forgiven). While this seems consistent with the claims priority, it is not at all clear that the second lien holder would have to accept this arrangement. It could instead refuse to participate. In this case, any principal reduction on the first loan (from $270,000 to $228,000 or less in the example) would accrue entirely to the second lien holder or the mortgage insurance company, a point FHFA made in a letter earlier this year. Fannie and Freddie are being asked to crystallize losses, even as the homeowner remains underwater (including both loans) and the junior creditor retains the potential for full repayment should house prices recover in the future.
At the end of 2011, there was $873 billion in second liens outstanding. Of this total, $665 billion were held by U.S.-chartered commercial banks and over half of this amount was held by the four largest institutions. The $665 billion is equal to nearly half of the $1.4 trillion in estimated bank capital, which would mean capital reserves would be halved if these loans were written down to zero. Conversely, a strict enforcement of claims priority would actually leave Fannie and Freddie in a reasonably good position moving forward. According to the most recent Census data, 31.2% of homeowners own their houses. This means that, in the aggregate, first lien mortgages of the kind Fannie and Freddie own are senior to about $1.8 trillion in combined homeowner’s equity and second liens. Why would these senior creditors voluntarily share some of that cushion with second lien holders, especially when many of these home equity loans were extended without their knowledge or approval to finance non-housing purchases at the height of the bubble?
It is fitting that the Obama Administration’s modification program is financed through TARP because this program could prove to be the biggest bailout for large banks since the initial round of capital purchases in the fall of 2008. The Obama Administration could have chosen to have the banks write-off the second liens in the spring of 2009 when the banks still had their TARP capital and were protected from insolvency and illiquidity by FDIC guarantees and Fed lending. Instead, the Obama Administration chose to allow the banks to leave TARP with the second lien issue unresolved. With the FHFA adamantly opposed to using Fannie and Freddie for bank bailouts, the Obama Administration has decided to return to TARP – to once again supplement losses that should be incurred by bank shareholders and management.