Up for the quarter, down for the year? See what's happening with home affordability in our latest "Income you need to buy a home in the top 50 metro areas".

Up for the quarter, down for the year? See what's happening with home affordability in our latest "Income you need to buy a home in the top 50 metro areas".

Should Fannie, Freddie do principal reductions?

Principal reductions became a contentious debate from the moment they were first discussed as a way to help struggling homeowners following the housing crash. With millions refinancing to ever-falling mortgage rates, homeowners who lost equity to the point of being underwater found themselves with little to no assistance. So should these homeowners have received a principal reduction? To find out, we asked Menna Bizuneh, assistant professor of economics at Pitzer College, and Sherwood Clements, instructor of real estate at the University of Alabama.

Q: At the height of the real estate crisis, should Fannie Mae and Freddie Mac have done principal reductions? Should they start doing them now?

Answer By
Menna Bizuneh,Ph.D.

At the height of the real estate crisis in 2008, several relief programs were suggested. One such program was principal reduction for homeowners as a means of mitigating negative equity and keeping “underwater” homeowners in their home. However, such a policy was not available for Fannie Mae and Freddie Mac, who own a majority of mortgages in the U.S. The argument on whether this relief option should have been implemented at the peak of the crisis can be negated because despite the lack of principal reduction by Fannie and Freddie, 80 percent of their borrowers still continued to pay their mortgages and foreclosure rates are back to their pre-crisis levels. Today, this debate about using principal reduction to keep homeowners in their homes has returned. Many see this policy’s ability to turn negative equity to positive equity, resulting in fewer foreclosures. Such benefits pose potential costs:

  1. The tab for principal reduction, which will be picked up by taxpayers, will be an estimated $70 million to $90 million a year, according to the Congressional Budget Office (CBO).
  2. A blanket principal reduction will result in a moral hazard problem where current mortgage-paying homeowners will strategically default to benefit from this policy, thereby increasing foreclosures.
  3. Last, but most importantly, principal reductions will have a long-term negative effect, signaling mortgage contracts to be risky and thereby increasing future interest rates.

Therefore, the minimal estimated benefits of default rates decreasing by 8 percent and overall economic growth of 0.1 percent do not outweigh both the short-term and long-term costs of principal reduction as a relief policy.

Answer By
Sherwood Clements,Ph.D.

At this time, the federal government still provides struggling homeowners assistance through the Home Affordable Modification Program (HAMP). This program allows distressed mortgagors to attempt to avoid foreclosure through several options:

  1. Reducing the current interest rate
  2. Extending the mortgage term
  3. Providing forbearance of principal
  4. Changing the interest rate from variable to fixed

Home values dropped significantly during the recent financial crisis. For example, the S&P Case-Shiller U.S. National Home Price Index dropped from an index value of approximately 180 to under 140 between 2008 and 2012. This begs the question: “Why doesn’t Fannie Mae and Freddie Mac allow a principal reduction if a home is underwater?”

Granted, borrowers whose homes are underwater are paying taxes that help maintain the home and even bailed out Fannie Mae and Freddie Mac, but Fannie and Freddie provide liquidity to the secondary market for mortgages and mortgage-backed securities (MBS) which help keep homeownership affordable. That said, I believe Fannie and Freddie can continue to execute two other strategies to aid struggling homeowners other than issuing principal reductions which could ultimately end up raising mortgage costs for everyone:

  • Reducing the interest rate: If they reduce a distressed borrower’s interest rate, one could argue that profits are being lost, similar to the principal reduction option. But as long as the interest rates are current-market rates, then this option would simply resemble a typical borrower refinancing their mortgage during a time in the business cycle when interest rates have decreased. And lower rates mean a lower payment which leads to a better situation.
  • Extending the term: Likewise, extending the term on a mortgage allows lenders to continue to make profits while allowing homeowners the chance to avoid foreclosure. From an investment standpoint, one could also argue that principal reductions aren’t warranted. In investing, we realize that purchasing stocks, bonds or most other investments involves risk. Homebuyers should hold themselves to the same standard. I often teach my students that if you are going to invest in real estate, then buy rental houses or real estate investment trust (REIT) stock. Do not look at your personal home as just an investment.

Homeowners should upgrade and make capital expenditures on their home for consumption purposes in order to help them live a happier life. Homeowners have to keep in mind that added costs do not always translate into equal market value when it comes time to sell. For example, in some locations of the country a swimming pool may not provide as much value as its installation costs. Our expenditures as homeowners can cause us to be underwater, just like the economic and financial markets can cause a home’s value to be underwater. So if Fannie Mae, Freddie Mac or the government as a whole is not going to provide us capital to make up for losses on improvements to our home, why should they do so for losses on our debt?

In my opinion, we can look at the question of whether or not Fannie and Freddie should do principal reductions from an ethical standpoint. Let’s assume you bought a home in 2006. Should you get a principal reduction because you made a purchase with lackluster timing? Should we not all expect to pay the debts that we made the decision to accept? An argument could be made that unethical business practices may have initiated at least a portion of the real estate bubble that eventually popped. While that may or may not be true, we all make the choice about when to enter homeownership.

Think Tank

Sherwood Clements
Sherwood Clements,
University of Alabama Culverhouse College logo
Instructor of Real Estate at University of Alabama Culverhouse College of Commerce
Menna Bizuneh
Menna Bizuneh,
Pitzer College logo
Assistant Professor
of Economics at
Pitzer College
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