Rumors have begun to swirl that the Obama Administration, facing what are very likely to be catastrophic losses in November, have cooked up a last-gasp attempt to prove that they are doing something about the economy.  The plan is to have FNMA/FHLMC (Fannie and Freddie to you and me) forgive billions in mortgage debt owed by homeowners that owe more than their homes are worth.

A few things here.

1. The number 1 predictor of foreclosure is negative equity.  Those that are underwater in their homes are 3x as likely to walk away as those that are even or have some money in their properties.  Some of the foreclosure wave has been caused by job losses, but as much as 26% of foreclosures are termed “strategic” – that is, homeowners walked away as a financial decision, not because they couldn’t make payments.  So to stem the tide of foreclosure, eliminating underwater mortgages is likely to be a good thing.
2. Foreclosure decisions are heavily impacted by the amount of the negative equity, not just its existence.  The National Bureau of Economic Research found that 17% of homeowners would default on purpose if their debt overhang was 50% of the value of the house, but almost nobody would if the overhang was 10% or less.  To reduce the volume of foreclosure, then, simply reduce the debt overhang to 10% or less of the home value.
3. Debt forgiveness is not, by itself, a bad thing.  I have long advocated for banks holding mortgages on underwater properties to forgive part of the principal owed and wipe out the overhang.  Doing this substantially reduces the likelihood of foreclosure and earns incredible goodwill in a time when banks could use it.  But few banks are doing this, and none with any regularity.  We can deduce from this that stopping foreclosure is not necessarily in the banks’ best interests.
4. When something as nasty as a foreclosure, with its attendant legal fees, loss of capital, and negative impact on home prices, stops being viewed as an unmixed evil, it is certain that something is screwing with the market.  That something is 99.94522% likely to be the government.  In this case, banks have come to understand that what makes for happy regulators and what makes for healthy banks are not necessarily the same thing.  Banks understand that in the event of trouble, they can count on the government to “do something”.
5. The economy always recovers fastest when government STOPS “doing something”, and leaves things for the markets to sort out.  Uncertainty is the enemy of markets.  In the event that government has to be acting, and it will tell you that’s in pretty much every event, the best thing to do is always reduce regulation and taxes and let people fix things themselves.  Unfortunately, an election year is never a time to expect this kind of restraint.

So if banks should write down mortgage debt, why shouldn’t Fannie and Freddie?  Two reasons.  One, banks are going to make different calculations about whether it makes financial sense for them to do this.  Those calculations are heavily affected by the competition, and what the competition is doing.  The decision to do something or not to do it will be made with reference to the markets and what will be in the best interests of the long-term health of the bank.  Fannie and Freddie have no such calculus.  They have no competition.  They can’t fail – the Treasury Department already said it wouldn’t let that happen, no matter what.  So the decisions will be made by bureaucrats without any requirement for financial sense.  Bad, bad combination.  Isn’t that a major reason we ended up in this mess in the first place?

Second, Fannie and Freddie (and by Fannie and Freddie, I mean Bernanke, Obama, and Geithner, et al.) aren’t playing with private money.  They’re playing with PUBLIC money.  Tax money.  If Chase Bank wants to write down a couple billion in mortgage debt, they’re making a financial calculation that this is going to be good for the company in the future.  If they’re wrong, only they and their shareholders suffer.  If, however, Fannie and Freddie make that same calculation, it will be a political one based on what will be good for the administration in an election year, not necessarily (and some would argue only accidentally) what is in the best interests of the taxpayers.  If Fannie and Freddie miscalculate, it harms the entire country.

The law of unintended consequences is at work here.  Connect the dots:

• Bank makes loan to home at a high loan-to-value (LTV).
• Housing market declines, leaving the house underwater.
• Bank sells loan to Fannie Mae at 100% of face value.
• Fannie Mae writes down the debt, re-establishing equity using (future) tax money.
• Mortgage note is now worth 80% of original value.

Pretend for a moment you’re a bank executive.  You can connect the dots, can’t you?  You will in the future make a) fewer high LTV loans or b) more high LTV loans?

Very good.  If you chose b), you are ready to be a bank executive.  Your risk is mitigated strongly by the backstop of tax money that Fannie/Freddie provide.  You make a miscalculation, no problem.  Fannie Mae (a stand-in for Uncle Sam) is there to bail you out.  If Fannie were a private entity, this calculus would be quite different, but the giant mortgage-purchasing behemoths FNMA and FHLMC are pure government now.  And this is only one of the consequences; doubtless there will be more, and even worse ones that I cannot forsee.

I think writing down mortgages is a good idea.  I advocate it.  But like all good ideas, this one can be done by the wrong parties for the wrong reasons, and in those cases the results will almost always be disappointing.

Stay tuned.

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