Mortgage Investors Parse a Regulator's Words

 | Apr 12, 2012 | 11:30 AM EDT
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As Beltway Republicans rejoice that Rick Santorum's withdrawal from the presidential race has left the party more time to unify around Mitt Romney before Election Day, the news of shockingly weak March employment numbers has underscored the wild-card economic challenges that still face Team Obama and investors.

Many of these frustrations originate in the housing and mortgage sectors. There, risk-takers may see opportunities if they can guess correctly whether the administration's ineffectual response via an alphabet soup of federal programs might finally gain some traction.

Ed DeMarco, the acting director of the Federal Housing Finance Agency and regulator of Fannie Mae and Freddie Mac, has defiantly stood his ground during months of badgering from the Obama administration and Hill Democrats. But he may not have appreciated headlines that characterized his speech before the Brookings Institution on Tuesday.

Specifically, the final word in these reports seemed to be that the acting FHFA director was dismissive of principal forgiveness for near-default borrowers under the Home Affordable Modification Program, or HAMP. (Exhibit No. 1: American Banker's afternoon headline that "Hope of Principal Forgiveness Wanes as DeMarco Speaks.")

Indeed, we suspect that DeMarco had intended to show some respect for criticisms of his agency's steady resistance to principal reductions at Fannie and Freddie, including previous FHFA internal calculations to the effect that even a White House-proposed tripling of taxpayer-financed Principal Reduction Alternative (PRA) payments under the HAMP would still fall short of making such modifications economically sensible for Fannie and Freddie. To use a golf analogy, DeMarco was trying to hit it down the middle.

We found it notable, for instance, that FHFA's new "preliminary" analysis would make at least five key methodology changes in response to design flaws that were flagged by Amherst Securities mortgage guru Laurie Goodman during a mid-March Senate hearing.

The net of these and other changes produced a conclusion that if the Treasury, as promised, forks over as much as $9 billion in unused TARP money in the form of PRA payments (but ultimately is on the hook for just 43% of some 691,000 delinquent loans that would avoid default after modification), the GSEs would save as much as a net $1.7 billion. This led to initial "breaking news" stories with headlines saying that DeMarco "Inches Toward" or "Would Support" principal forgiveness, and "Write-Downs Would Benefit Fannie, Freddie."

Given that the government would have expended $3.8 billion (via the TARP-financed PRA payments), the net cost to taxpayers would be $2.1 billion, DeMarco said, although other factors would have to be considered.

Specifically, DeMarco fretted about how the 2 million underwater borrowers who have remained current on their GSE-held loans might react, i.e., whether they might skip two payments in order to become technically eligible for HAMP principal reductions. The threshold percentage of additional "strategic modifiers" that might tip the balance to alter the slightly positive "preliminary" net-present-value calculation (in response to the new incentives) might be as low as 13%, he added.

In other words, the costs to the GSEs from moral hazard, which are extremely hard to estimate, could stay DeMarco's hand.

Then there are the other direct and opportunity costs that would result from both FHFA's and the GSEs' devoting scarce time and resources to prepare for and administer such a program, he added.

Skeptics ultimately read into DeMarco's statements that he remains poised to reject principal forgiveness altogether.

Nevertheless, he acknowledged that the new analysis "does not account for any offsetting benefits in terms of greater housing market stability if HAMP PRA reduces total foreclosures relative to standard HAMP."

And the FHFA's new math might have the effect of waving a red flag in front of a bull on Capitol Hill. Specifically, assuming an average principal reduction of $51,000 per borrower and a federal payout for only permanent or successful mods, the net cost to taxpayers of $2.1 billion under DeMarco's base case would generate almost a 5-to-1 cost/benefit for taxpaying homeowners (i.e., reducing borrower debt by at least $10 billion).

While he reprised and went into depth regarding his past arguments favoring principal forbearance over forgiveness, he thus acknowledged that by applying less than a quarter of the $18 billion in taxpayer/unused-TARP funding that the Obama administration would repurpose to incentivize the GSEs, as many as 175,000 to 350,000 delinquent homeowners might be helped to avoid default.

So although DeMarco and the FHFA might indeed still reject principal forgiveness, we see the analysis released Tuesday as making such a decision less defensible before Democrats in Congress and in response to pressures from the White House.

We believe that the wily (some would say heroic) GSE conservator might ultimately have two choices when he reveals his decision over the next couple of weeks. Specifically, rejection, as many predicted anew on Tuesday, or a tailoring of a final GSE participation plan that would restrict eligibility and guard against exploding take-up from "strategic modifiers." For example, this might compel those who were current as of a certain date to produce evidence of hardship in order to become eligible.

One way or another, the result will point toward little to no measurable help for underwater homeowners, although any plan allowing for an uptick in strategic defaults might catch the mortgage markets off guard, forcing repricing of mortgage-backed securities and even leading to higher mortgage interest rates.

Meanwhile, and particularly interesting in our view, was the pronounced selloff among mortgage insurance stocks on Tuesday, despite DeMarco's rejection of the notion of precluding HAMP principal forgiveness for mortgage-insurance-enhanced loans. This means that either some investors are right in their conclusion that it's all but certain that nothing will be done now (and that any optimism about a benefit for the mortgage insurers should be discounted), or they have erred, and even a smallish green light for GSE participation could make the mortgage insurance portfolios modestly more attractive.


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