In a speech yesterday, Acting Director of the Federal Housing Finance Agency Ed DeMarco said that he would make a new determination on the efficacy of principal reduction for underwater borrowers in Fannie and Freddie-backed loans by the end of this month. The GSEs own or guarantee $5 trillion worth of home mortgages, a substantial chunk, maybe 60%, of the housing market. So even though they only hold 29% of the seriously delinquent loans, their course of action on principal reduction is obviously critical.
DeMarco claims a philosophical difference, saying that payment reduction, not solely principal reduction, is the best strategy to a successful loan modification. Many analysts, most prominently Laurie Goodman at Amherst Securities, disagrees with that claim. Her point is that underwater borrowers are in a fundamentally vulnerable position, with any one financial shock bound to put them over the edge. And plenty of other reports show a direct correlation between negative equity and chance of foreclosure. So I think DeMarco’s wrong, and that principal reductions can benefit borrowers and investors, along with the housing market, by reducing the downward spiral from continued foreclosures.
And yet it is not obvious that, as the wide-ranging campaign by liberal groups has intimated over the past month, Ed DeMarco is a singular figure holding back the housing market. Nor is it the case that principal reduction on GSE loans, while good for individual borrowers, is the immediate path back for housing or the economy. Regardless of DeMarco’s decision, for example, there is an expected crush of foreclosures over the next year, as banks feel free to plow forward despite their foreclosure fraud issues. And this neglects a host of other problems in the housing market, especially servicer-driven foreclosures and the financial incentives that still run the wrong way for servicers, toward foreclosure and against loan modification.
What’s more, there’s a deeper economic angle at work here. Matt Stoller has a tremendous piece at Naked Capitalism about Handcuffs versus Hope and Change, the real divide on housing policy:
There are two schools of thought on fixing the housing market. The first is the Tim Geithner school, which we’ll call the “hope and change” school. Hope and changers, who occupy most elite positions in the administration, in banks, at the Fed, in the economics establishment in Congress, at housing nonprofits like the Center for Responsible Lending, in regulatory agencies, believe that the housing market will come back when the economy returns. Foreclosure problems may be tragic, or overblown, or not, but ultimately are incidental to fundamentals, like matching housing supply to demand or increasing employment through boosts in aggregate demand. Warren Buffett is probably the most famous member of this school.
The second is the “law and order” or “handcuffs” school, which has (loosely) as members people like former FDIC chief Sheila Bair, former SIGTARP Neil Barofsky, iconoclastic investors such as Bill Frey, foreclosure fraud defense attorneys, Congressional actors like Maxine Waters, criminologists like Bill Black and various securitization experts and bloggers. The handcuffs believes that law and order is not incidental to the breakdown of the housing market, but is central to it.
Obviously these aren’t fast and hard divisions, they just represent the two major frames of thought around the housing crisis. It’s not a partisan breakdown – most people in both parties are part of the Hope and Change crowd, but a chunk of the left isn’t, and there are a few right-wingers like Chris Whalen and various right-wing investors who are outraged at the abrogation of property rights.
I think that’s right, and it’s the proper context to look at these drumbeat of reports about a housing “comeback.” None of those reports take into account the lawbreaking aspect, and how these criminal issues have not been fixed. We have actually tried the hope and change model for a number of years – others would call it “extend and pretend.” The economy has not cooperated, nor have those pesky lawyers and (a scant few) regulators and foreclosure fraud activists, who keep bringing up the criminal fraud inherent in the system. [cont’d.]
There’s a tendency to believe that the idea of helping homeowners and seeking handcuffs are incompatible. I find them to be completely complementary. Runaway finance historically leads to bigger and more damaging financial crises. The flip side of Reinhardt and Rogoff’s theory about economic recoveries from financial crises taking so long is that this is pre-determined by a financial industry who doesn’t want to take the necessary losses. That’s what slows the recovery. A smaller and more tightly regulated financial sector simply cannot have this kind of impact. So over time, that’s the main issue. As Jamie Galbraith points out, runaway finance is uniquely tied to inequality, and only government can take away that power (unfortunately, in this country, the parts of the government set up to take away that power are captured by the industry). “In Argentina and Brazil,” Galbraith says, “inequality started to decline almost immediately once the financiers were knocked off their thrones.” Homeowners and everyone else will benefit far more from a properly circumscribed financial sector than another hope of a plan like HAMP or GSE principal reduction or whatever else.
I think this is an important point toward that as well:
I have spent time with several right-wing investors who are somewhat obsessed with “strategic defaulters”. That said, these investors do want to write down debt on homeowners for self-interest reasons, which is actually a very powerful incentive. They just want bank servicers to comply with the law and they want second liens written down as well, so that their wealth doesn’t get eaten by the big banks. Many of them are idealistic from the capital markets perspective, and point out that there will be no private mortgage market in a few years, that it will simply all be government-supplied credit. They fear, rightly, the day when whether you can get a mortgage will be subject entirely to political whims.
In order to understand the policies around housing, you have to understand this dynamic. You have to understand the perspective of all sides, from those hoping that demographics will provide a comeback (count Jamie Dimon in with them), to those who believe that you have to purge the system of criminal activity before it can begin to benefit people.