The FHFA analysis admitted that targeted principal reductions would benefit the finances of the government-sponsored enterprises (GSEs) and would even show a return on taxpayers’ investment. In one likely scenario, targeted principal reduction could save the GSEs $3.6 billion on about 500,000 mortgages. The analysis also argued that a small number of “strategic defaults”—where a borrower who could otherwise afford the loan payments purposely goes into default in order to reap the benefits of principal reduction—would eliminate the benefit to taxpayers.
There are significant limitations to the FHFA’s analysis, however. In calculating the benefit to taxpayers, the analysis simply accounts for the outstanding mortgage balance conserved by avoiding foreclosure on loans who receive principal reduction. The analysis does not account for how reducing principal on loans could change borrower behavior in ways that could ultimately benefit taxpayers by increasing economic activity. Once the burden of negative home equity is lifted, homeowners will likely be more inclined to spend money on other goods, providing a stimulus effect to the economy. Homeowners who have delayed marketing their homes for sale out of a desire to avoid losses will be able to list their homes. And avoiding foreclosure spurred by negative equity helps keep neighborhoods stable by avoiding vacancy and its associated harmful costs.
At the same time, research indicates that strategic default is not as severe a problem as the FHFA might fear. There are significant costs to default, including long-term damage to the borrower’s credit score. The FHFA could mitigate strategic default concerns by further raising the costs of defaulting to homeowners, such as including a shared equity appreciation component that would return a portion of future equity gains to taxpayers. A shared equity appreciation option, which has been used successfully by some loan servicers, was not considered in the FHFA analysis.
“Ed DeMarco and the FHFA have been tasked with preserving Fannie Mae’s and Freddie Mac’s assets and helping homeowners avoid foreclosure. Principal reduction would fulfill both of those goals,” said Dory Rand, President of Woodstock Institute. “Banning principal reductions harms homeowners, taxpayers, and the GSEs alike. President Obama should replace DeMarco with a director who is willing and able to fulfill these mandates.”
Negative equity continues to be a pressing issue in Illinois. In Illinois, the GSEs hold 357,000 underwater loans. Woodstock Institute research from May found that a quarter of loans in Illinois are underwater, while 40 percent of loans in African American and Latino communities are underwater.