Wherein Ed DeMarco incites a riot

8/01/2012 07:49:00 PM
Paul Krugman is on the warpath. And justifiably so: After months of stalling, FHFA acting director Ed DeMarco has finally rendered his verdict in the lengthy debate over writing off principal on Fannie and Freddie mortgages. That is, there shall be no principal reduction for Fannie/Freddie loans. This verdict jives with Mr. Demarco's already existing prejudice against principal reduction in general. I helped CAP's John Griffith pen a brief on this front back in April, so it's something of a pet issue for me.
Edward DeMarco, FHFA Acting Director

In coming out formally against write downs, DeMarco seems to be defying his statutory mandate, his agency's own research, and his own previous statements -- all at once.

As director of the FHFA, which since 2008 has served as the conservator of the GSEs, DeMarco is responsible for minimizing losses to Fannie and Freddie's balance sheets. However, DeMarco's rationale for resisting write downs -- that it would represent a net loss to taxpayers -- takes this principle a step too far.

FHFA fears a loss to taxpayers resulting from GSE participation in Treasury's HAMP PRA program, but only because the program involves Treasury's subsidizing write-downs (covering up to 63 cents of every dollar of principal reduction). From the narrow perspective of the GSEs, the two mortgage giants would come out ahead if they were to participate, according to the FHFA analysis DeMarco cites.

This is the perspective from which DeMarco is supposed to be assessing alternatives, and is also the one which he purported to take when he released FHFA's initial analysis at a Brookings event back in April:
Congress gave us a responsibility and a mandate. It gave the Treasury department a different responsibility and mandate, and a different funding source, with TARP funds. ... We’re trying to provide clarity about how this all works. But our responsibility is to that of conservator, so it’ll be how this affects the net present value to Fannie and Freddie...
However, as of yesterday, DeMarco appears to have changed his tune, now saying he rejects the proposal based on a net projected loss to taxpayers. So DeMarco has flipped-flopped on his own rationale. But even the tortured reasoning by which he came to his conclusion might still actually be directing him in the opposite direction.

As Krugman points out, FHFA's analysis did not take into account any macroeconomic benefits resulting from debt burden reduction, which, after all, is the very reason we demanded he revisit the policy in the first place. Dylan Matthews of Wonkblog decried this oversight as "a pretty glaring omission."

Krugman later noted that the potential loss to taxpayers only pans out in the case of copious "strategic modification," a concept DeMarco seems obsessed with, but has never commissioned any study to model or project. Basically, the fear is some borrowers would participate in the principal reduction program even if they'd be able to pay off their mortgage as-is. The principal written-off would thus represent a direct loss to the GSE holding the loan.

Two points to make about this claim: one is, FHFA's earlier report shows it would take 90,000 strategic modifiers to wipe out the financial gains associated with the program, but it makes no attempt to project how many borrowers may actually attempt to default strategically.

Secondly, why isn't DeMarco even considering some easy tweaks to make it less simple/appealing to game the program? Making the program short in duration is one way to discourage strategic default. Another is a "shared appreciation" model. In spite of Ocwen Financial using this approach to resounding success, DeMarco was dismissive of this idea when questioned about it. While he was right that this new tool would be associated with new operational costs, it is ludicrous to think that companies as massive as Fannie and Freddie (who own the vast majority of mortgage loans in the US) cannot afford to retool their technology to make this possible.

This might all be a tempest in a teapot: economic recovery is unlikely to hinge on this decision, but there does seem to be ample evidence and support for write downs -- including Mitt Romney's own economic advisor, Glenn Hubbard of Columbia. All the same, President Obama is certainly in a position to replace DeMarco, if not firing him per se. Since DeMarco is only the agency's acting director, all Obama need do is appoint a full-fledged director. What happens to dear Ed from there, I don't know. However I do feel that, as chief executive, the President has a responsibility to see his branch's agencies carry out his policy. That being the case, he should begin making moves to find DeMarco's replacement.