Easy money: Government principal reductions a bad idea

Rejecting the entreaties of the Obama administration, the independent federal agency that administers Fannie Mae and Freddie Mac said Tuesday it will not let mortgage companies offer debt forgiveness to borrowers.

The Federal Housing Finance Agency is charged by Congress with minimizing the cost of bailing out Fannie and Freddie, which were seized by the government in 2008 to preserve their role as the primary source of financing for new mortgage loans.

The FHFA spent months studying to what extent some half-million homeowners could benefit from such a program - of whom a good number are here in Nevada, arguably the state worst hit by the housing crash. The agency acknowledged many aid recipients would be more likely to continue making mortgage payments if their debts were partially forgiven.

But the agency's acting director, Edward J. DeMarco, said Tuesday the benefits most likely would be too small to offset potential costs, including the risk that some borrowers would stop making payments in pursuit of a better deal. Offering debt forgiveness "would not make a meaningful improvement in reducing foreclosures in a cost-effective way for taxpayers," Mr. DeMarco ruled.

The decision infuriated congressional Democrats. But it's the correct call.

In fact, Fannie Mae in 2010 decided against expanding a pilot program designed to reduce loan balances of underwater homeowners because it was difficult to operate and the benefits weren't clear.

By the end of last year, the loan performance of 200 underwater mortgages with reduced balances hadn't differed from a control group of borrowers who received standard loan modifications that don't reduce the principal owed, according to the FHFA's general counsel.

In addition, the proposal creates a perverse incentive, increasing the temptation for some borrowers to stop making any payments at all in hopes of qualifying for the principal reduction. The New York Times reports that "the entire benefit could be erased if as few as 3,000 borrowers decided to stop making payments."

And this doesn't even consider the long-term negative ramifications for lenders and borrowers - higher interest rates, tighter standards - were the government to step in and alter existing mortgage contracts by forgiving debt.

Widespread loan forgiveness would set a dangerous precedent, especially given that a number of federal and state programs already exist, designed to help those struggling to stay in their homes. Some banks have also initiated their own programs.

Mr. DeMarco does indeed deserve credit for sticking to his guns, despite all the political pressure.