The real reason Fannie and Freddie don’t do principal modifications

Looking out for your retirement

Affordable housing advocates have been pushing hard for principal mods on mortgages backed by Fannie Mae and Freddie Mac.

Ed DeMarco, the former acting head of the Federal Housing Finance Agency had refused to embrace principal mods, choosing instead to do rate / term modifications through the Home Affordable Modification Program.

As the Acting FHFA Chairman, DeMarco’s prime directive was to protect the taxpayer, and the fear was that a mass principal refi program would trigger a wave of strategic defaults, where people who had the ability to repay their mortgage would choose to stop paying in hopes of getting a principal mod.

The left thought they had finally scored a victory by replacing Ed DeMarco with Mel Watt, a politician seen as more amenable to principal mods. So far, the left has been disappointed.

Why is the government resisting principal mods?

Because there is one big investor in MBS that the government is worried about – pension funds.

Principal mods for Fannie and Freddie mortgage-backed securities could be a game changer for this paper.

Why? Because lots of MBS from the late bubble years are backed by underwater, above market-rate mortgages. The prepayment speeds for these mortgages is depressed because the borrower cannot refinance.

This means that these bonds trade at premiums to par.

What happens if the feds start forgiving principal on these loans?

Well, first of all, someone is going to have to eat the loss on the principal mod. In all likelihood, that would be the government. But that doesn’t mean the pension fund escapes without losses.

The prepayment rates for those above-rate MBS would skyrocket as borrowers get principal mods and immediately refinance.

Those bonds will go from, say 110 to 100 in a heartbeat. Perhaps the funds would be protected if the government only modified loans actually held by Fannie and Freddie, but that creates another issue: Why should one borrower get a principal mod when their loan is held by Fannie, but another borrower is ineligible because their mortgage is in a MBS held by Texas Teachers or General Motors?

Think about the plight of the typical pension fund these days.

With interest rates pressed against the lower bound, they are having a terrible time earning enough on their portfolio to meet their future obligations.

The actuarial tables couldn’t care less that money is free and it is hard to earn a high single digit return in relatively riskless assets. Many pension funds are fully funded only if you squint at the underlying assumptions regarding their expected return on plan assets.

And you can bet that big funds like CALPERS are whispering in the ears of their representative imploring them not to go down this route.

The last thing they need are capital losses, let alone having to give up high yielding paper for the low yielding stuff that is being originated now. Don’t forget one last thing – where do politicians have their retirement money?

You guessed it.

Therefore, let's put this argument to rest. It's now pretty clear why principal mods on Fannie and Freddie paper are a long shot. 

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