It’s settled: Principal reduction is smart policy

How the BofA settlement opened the door

The settlement reached this week among the Department of Justice, several state Attorneys General, and Bank of America is monumental. As the remaining cases from the mortgage crisis are resolved, this settlement represents the sort of smart and prudent deal that government and business must strike in order to hold banks accountable and alleviate the damage done to the global economy. But if there’s progress to be marked by this settlement, there’s much more to be done at the Federal Housing Finance Administration, the agency that has the potential to make the most of this opportunity.

Although the mortgage crisis has subsided in some states, it has also persisted in many others, particularly New York and New Jersey, where it remains a tremendous drag on the economy and a personal nightmare for countless families. The missing ingredient for a full recovery from this crisis has been principal reduction. Principal reduction is simple. It’s what a rational investor does when an asset is underwater, namely, the marking down of debt to match the value of the asset.

Principal reduction is the most effective solution to resolving mortgage distress. According to Standard & Poor’s (which is not alone in this assessment), loans where the modification includes principal reduction are the least likely to re-default among all types of modifications. Thus, even though other types of modifications (interest rate reductions, term extensions, and so on) may be able to lower the payment similarly, their long-term performance is nowhere near as strong.

At this point in the recovery, principal reduction has been successfully applied to portfolio loans (the ones that banks hold on their own books) and to many private-label securitized loans—and it has been by far the most effective solution, both in providing long-term financial stability to homeowners and in maximizing returns for investors—in large part because of the significantly lower re-default rate. The only reason principal reduction has not spread to all mortgages is that the Federal Housing Finance Administration (FHFA) will not allow Fannie Mae and Freddie Mac to accept any funds for principal reduction.

Despite numerous studies showing the promising upside of principal reduction (from Moody’s, Standard & Poor’s, the Treasury, and others), the FHFA, under its former director, Ed DeMarco, defended its decision largely on the basis of a study conducted at its request by Fannie Mae that relied on a relatively tiny sample of loans and lasted only eight months before being cut short for unexplained “operational reasons.” 

The failure to reduce principal has not been for lack of trying from other branches of the government. The Treasury offers generous principal reduction incentives through the Making Home Affordable program and multiple mortgage settlements have included principal reduction provisions.

In the settlement announced on Thursday, Bank of America and the law enforcement agencies on the other side of the table took a major step forward toward fixing this broken policy. For the first time, loans insured by the Federal Housing Administration (FHA) will be eligible for principal reduction under the consumer relief menu in a major settlement. HUD Secretary Julián Castro and FHA Commissioner Carol Galante are to be congratulated for taking this important step.

Yet, sadly, with Fannie Mae and Freddie Mac holding or insuring the majority of mortgage loans across the country, principal reduction remains off limits for most homeowners in distress. Under this settlement, the previous settlements with JPMorgan Chase and Citigroup, and those that will surely follow, there will be billions of dollars on the table for principal reduction, which has the potential to set tens of thousands of families on the road to financial recovery.

So what are we to do next? To start, Mel Watt, the current Director at the FHFA, must look again at the massive portfolio under the agency’s control. It’s a portfolio that represents not just thousands of loans, but thousands of missed opportunities at a college education, stable retirements, and altogether better lives for a large portion of America’s middle class that has been unfairly punished in their pursuit to own a home and contribute to their neighborhood. The funding is there for principal reduction; to refuse to accept it is a grave error that will keep our economic recovery middling and tepid.

To be sure, there are some homeowners for whom there is ultimately no way forward in the home they’re in now, and for those families, we need better solutions. The Bank of America settlement sets aside funding for the construction of affordable rental housing, which, in New York City especially, is essential to counter the affordability crisis that has been an early focus of Mayor de Blasio’s administration.

It’s often overlooked that former homeowners face the very same challenges that other prospective renters face. The Center for NYC Neighborhoods, a non-profit organization created in response to the mortgage crisis, manages a Housing Mobility Program that helps former homeowners in New York City who need new housing. Because these clients are often seniors on fixed incomes or New Yorkers with disabilities and limited incomes, securing their next housing option can be a daunting challenge.

To combat this problem, Bank of America and states receiving credits for the construction of affordable rental housing under the settlement should consider setting aside a portion of the units in such projects for former homeowners. This settlement is on behalf of those homeowners who were injured by the mortgage meltdown; even if they cannot stay in their homes, they should be afforded the opportunity to benefit from the settlement that is in part on their behalf.

So while we congratulate the parties to this settlement on a sound agreement, we hope that those holding the remaining keys to a true and just resolution also step forward and make prudent policy choices—for the sake of an economic recovery in which we can all be winners. 

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