Deutsche Bank (DB) projects that if the Federal Housing Finance Agency were to adopt principal modification, it would come in the form of earned principal forgiveness, according to the investment firm’s outlook for 2013 report.

Simply, borrowers with good payment histories could earn forgiveness by continuing to perform. This would avoid the "moral hazard" created by rewarding delinquent borrowers with forgiveness only. 

The discussion of principal forgiveness is set to reopen if current acting director Ed DeMarco of the FHFA is replaced, significantly increasing the chance of those modifications in agency mortgage-backed securitizations. 

The firm said a successor is bound to happen — "no later than the second quarter of 2013" — due to the fact that DeMarco isn't allowing for principal reductions at the government-sponsored enterprises, arguing it is prohibitively expensive and would not result in the maximum benefit to the taxpayers.  

In 2010, under the Home Affordable Modification Program, earned forgiveness was first implemented.

Currently, only the Government National Mortgage Association (Ginnie Mae), Federal Housing Agency and the U.S. Department of Veteran Affairs loans have received HAMP principal modifications to date, even though conventional loans are technically HAMP eligible. 

HAMP Principal Reduction Alternative modifications also are only available to delinquent borrowers or those in danger of becoming delinquent. 

"This element of HAMP creates clear moral hazard — as strategic defaults may increase so that borrowers can gain access to forgiveness modifications. This leads to a question of best execution of a potential principal forgiveness program by FHFA," the report states.

As a result, it seems that momentum may shift toward principal reductions in conventional MBS. The implications to MBS investors are speeds picking up in higher coupon, conventional MBS because of principal modification related buyouts in pools. 

Conventional pass-throough offering documents would allows GSEs to buy delinquent loans out of a pool. In turn, Fannie Mae and Freddie Mac could used the buyouts as a tool to manage overall credit exposure.

A forbearance modification could also trigger a buyout of the loan given that "the interest stream on the underlying loan has been altered as a result of the mod," said Deutsche in its report.

Click on the graph to view which cohorts would likely be most exposed to modifications as function of current loan to value.

However, there are two factors that may shift toward a traditional forgiveness program.

First, significant operating complexities associated with earned forgiveness could lead the GSEs to offer only forgiveness to delinquent borrowers.

Second, enterprises would have an asset in their books that has no experience or infrastructure to finance or securitize.