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FHFA makes it official: Principal reduction is coming

Plan is 'final crisis-era' modification program

[Correction: This article is updated to accurately reflect the Wall Street Journal's reporting on this issue]

A day that many in the housing industry thought would never come is finally and actually here, as the Federal Housing Finance Agency is making official what was first reported several weeks ago – widespread principal reduction is coming.

In what it is calling a “final crisis-era modification program,” the FHFA announced Thursday that it will be launching a principal reduction program for some borrowers whose loans are owned or guaranteed by Fannie Mae or Freddie Mac.

But the program is not quite as widespread as was first reported.

Initial reports in the Wall Street Journal suggested that the FHFA’s principal reduction program may make fewer than 50,000 “underwater” borrowers eligible for principal reduction, but what wasn't known until Thursday was the exact number of borrowers the FHFA's program could affect.

The FHFA said Thursday that it expects approximately 33,000 borrowers to eligible to participate in the principal reduction program due to very specific eligibility requirements.

According to the FHFA, principal reductions will be available to owner-occupant borrowers who are 90 days or more delinquent as of March 1, 2016, meaning that borrowers will not able to “strategically default” in able to receive principal reduction.

Additionally, the program will only apply to borrowers whose mortgages have an outstanding unpaid principal balance of $250,000 or less, and whose mark-to-market loan-to-value ratios are more than 115%.

For years, the leadership of the FHFA, Fannie, and Freddie claimed this day would never happen. They all said the GSEs were in conservatorship, not receivership, and so a reduction in asset values would be counterintuitive to that status.

Just last month, FHFA Director Mel Watt gave a speech at a public policy luncheon hosted by the Women in Housing and Finance, in which he said that the issue of principal reduction has been the “most challenging” that the FHFA has faced in his two years there.

Watt also said that his objective for any principal reduction plan was to achieve a “win-win” situation for borrowers and the GSEs alike.

“Many have asked why it has taken so long to reach a conclusion,” Watt said at the time. “The direct answer is that making this determination involves consideration of an extremely complicated set of factors.”

But Watt said Thursday that he believes this plan is that proverbial “win-win” for borrowers and the government-sponsored enterprises alike.

“This plan will no doubt be viewed by some as too small and too late and viewed by others as too large and unnecessary,” Watt said.

“However, the plan is consistent with FHFA’s statutory obligation to ‘maximize assistance for homeowners’ by providing some borrowers what could well be their final opportunity to avoid foreclosure,” Watt continued.

“It is also consistent with our statutory obligation to provide this assistance in ways that we reasonably expect will not have adverse economic consequences for the Enterprises,” Watt said. “By meeting both of these statutory obligations, the program satisfies my commitment to implement a principal reduction plan only if we could structure one that would be a ‘win-win’ for both borrowers and the Enterprises.”

According to the FHFA, this program will give seriously delinquent, underwater borrowers “last chance” to avoid foreclosure by providing principal reduction in a straightforward and timely manner.

“FHFA believes that this final crisis-era modification program will provide seriously delinquent borrowers a last opportunity to address negative equity and to avoid foreclosure and will also help to improve the stability of neighborhoods that have not yet recovered from the foreclosure crisis,” the FHFA said in prepared materials.

According to the FHFA, the eligible loans are heavily concentrated in Florida, New Jersey, New York, Illinois, Ohio, Pennsylvania, Nevada and in” hardest hit communities.”

The principal reduction requirements and stipulations are different than the GSEs currently streamlined modification programs, the FHFA said.

Here’s how, courtesy of the FHFA:

In existing Streamlined Modifications, servicers capitalize outstanding arrearages into the loan’s principal balance; set the loan’s interest rate to the current market rate; extend the loan’s term to 40 years; and, if a borrower has a MTMLTV ratio greater than 115%, forbear principal to 115% of the MTMLTV ratio or 30% of the unpaid principal balance (UPB), whichever is less. Principal forbearance defers payments on a portion of outstanding principal until the end of the loan and makes it non-interest-bearing. This reduces a borrower’s monthly payment but, unlike principal forgiveness, does not reduce a borrower’s overall indebtedness.

Under the Principal Reduction Modification, servicers will follow the same modification steps they currently follow for Streamlined Modifications, except that principal reduction will be used instead of principal forbearance. Consequently, the amount of principal and/or capitalized arrearages that would have been forborne under a Streamlined Modification will be forgiven instead. This will reduce the borrower’s debt burden. Additionally, this will result in the same loan modification payment for borrowers as they would have received under a Streamlined Modification.

According to the FHFA, the modification terms include capitalization of outstanding arrearages, an interest rate reduction down to the current market rate, an extension of the loan term to 40 years, and forbearance of principal and/or arrearages up to a certain amount to be converted later to forgiveness.

While 33,000 borrowers are eligible for the principal reduction program, the FHFA believes that far fewer borrowers will actually take advantage of the program.

According to the FHFA’s documentation, only 9.5% of eligible borrowers take advantage of the streamlined modification program, which forbears but does not forgive principal, and if the same percentage of eligible borrowers elect to participate in the principal reduction program, only 3,155 borrowers will see their principal cut.

The FHFA notes that there are “reasonable grounds” to expect that more borrowers will participate in the principal reduction program than in the streamlined modification program, due to the fact that the GSEs will be offering principal reduction modifications to borrowers for the first time, which is expected to persuade some borrowers who have not responded to modification solicitations in the past to take advantage of this program.

Additionally, the FHFA notes that the public interest in a principal reduction modification program has remained high throughout and since the financial crisis, and continuing strong support from “outside organizations” increases the likelihood of higher participation rates for the principal reduction modification compared to the streamlined modification.

The fact that the FHFA is finally engaging in principal reduction ends years of speculation, discussion, and debate.

Nearly four years ago, Ed DeMarco, who was the acting director of the FHFA at the time, said that the FHFA was not going to engage in principal reductions, despite the urging of then-Treasury Secretary Tim Geithner.

"I am concerned by your continued opposition to allowing Fannie Mae and Freddie Mac to use targeted principal reduction in their loan modification programs," Geithner said in 2012. "In view of the clear benefits that the use of principal reduction by the GSEs would have for homeowners, the housing market and taxpayers, I urge you to reconsider this decision."

But DeMarco refused Geithner’s request, stating at the time: "Given our multiple responsibilities to conserve the assets of Fannie Mae and Freddie Mac, maximize assistance to homeowners to avoid foreclosures, and minimize the expense of such assistance to taxpayers, FHFA concluded that HAMP PRA did not clearly improve foreclosure avoidance while reducing costs to taxpayers relative to the approaches in place today.”

When Watt took over as the official director of the FHFA in 2014, some thought that Watt would move quickly to cut mortgage principal, but Watt took a more cautious approach.

Watt was still “considering” principal reduction in February 2015, when he said that even if the FHFA was going to allow principal reduction, it would likely end up being on a much smaller scale than some people expect.

Watt was already laying the groundwork for a limited principal reduction program in 2015, when he told Bloomberg that the agency will not be cutting the principal of all borrowers. “I think it will be substantially narrower than the vision people have,” Watt told Bloomberg at the time. “Reducing everybody’s principal would cost taxpayers billions.”

Watt’s measured approach rankled some on the left, notably Sen. Elizabeth Warren, D-Mass., who launched an offensive on Watt during a November 2014 hearing on Capitol Hill.

“I’ve asked about this repeatedly and you’ve said you’d look into allowing Fannie and Freddie to engage in principal reduction; you said it again today,” Warren said at the time. “You’ve been in office for nearly a year now and you haven’t helped a single family, not even one, by agreeing to a principal reduction. So I want to know why this hasn’t been a priority for you. The data are there.”

But, now the FHFA is finally putting principal reduction on the table.

Eligible borrowers should expect a letter from their mortgage servicer about a principal reduction no later than Oct. 15, 2016, the FHFA said. 

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