DeMarco Outlines Justification against GSE Principal Reduction

Acting Federal Housing Finance Agency (FHFA)
Director Edward J. DeMarco responded Friday to a request from 16 House
Democrats to explain the statutory authority that DeMarco has claimed prohibits
FHFA from offering principal reduction as part of loan modifications on loans
it owns or guarantees.  The request was
made last November after DeMarco told the House Committee on Oversight and
Government Reform that his agency had concluded that “the use of principal reduction within the context of a loan
modification is not going to be the least-cost approach for the taxpayer.”  When a committee member pointed out that several
banks are already implementing principal reduction programs in an attempt to
help delinquent or underwater homeowners and citing specific examples, DeMarco said “I believe that the decisions that we’ve made with regard
to principal forgiveness are consistent with our statutory mandate,” and committed
to providing documentation of that statutory authority to the Committee.

a letter sent to the Committee’s ranking member Elijah Cummings (D-MD) DeMarco laid
out the statutory requirements as originating in three congressional mandates;
first FHFA’s role as conservator and regulator of the government sponsored
enterprises (GSEs) which requires it to preserve and conserve the assets and
properties of the GSEs; second, maintaining the GSE’s pre-conservatorship missions
and obligations to maintain liquidity in the housing market; and third, under
the Emergency Economic  Stabilization Act
of 2008 (EESA), FHFAs statutory responsibility to maximize assistance to
homeowners to minimize foreclosure while considering the net present value
(NPV) of any action to prevent foreclosures.

The focus of the letter, however, is not
the statutory framework but rather why FHFA has decided that principal
forgiveness does not meet its core responsibility within that framework to
preserve and conserve the assets of the GSEs.

DeMarco’s rationale relies on an internal
analysis provided to him in December 2010 and updated in June 2011 which shows
that the use of principal reduction as a loss mitigation measure for GSE loans
under with the Making Home Affordable (HAMP) program or the FHA Short Refi
program would cost the Enterprises more than the benefits derived and
recommended that, instead the GSEs should more aggressively pursue propriety
loan modifications
that reduce the interest rate, extend the mortgage term, and
provide for substantial principal forbearance and promote HARP refinance
transactions for borrowers who are current on their mortgages but underwater in
respect to their equity. 

The GSEs collectively guarantee or hold
about 30 million loans and, using the FHFA Home Price Index to estimate home
values it appears that less than two million of these loans are secured by
properties valued at less than the outstanding debt; i.e. underwater.  Of these loans, more than half are performing
and about one-half million are severely delinquent or in foreclosure.  The table below clearly shows that high LTV
loans are only a small proportion of the GSE’s loans and that most of the loans
are either current or severely delinquent.

Using the Treasury HAMP NPV model the
FHFA study team compared the economic effectiveness of forgiving principal down
to a mark-to-market LTV (MTMLTV) level of 115 percent versus forbearance of the
same amount of principal for all loans with a MTMLTV greater than 115 percent.  The model suggested no better result from principal
reduction than from forbearance and showed the latter as slightly more
effective in reducing GSE losses.  The
team also evaluated the accounting and operational implications of the
principal reduction to measure those costs against benefits to borrowers.  The costs were found to include, in addition
to the immediate losses, the costs of modifying technology, providing training
to servicers, and the opportunity cost of diverting attention away from other
loss mitigation activities.

Principal forbearance, in
contrast, requires no systems changes and is a common approach in government
credit programs, including FHA. The borrower is offered changes to the loan
term and rate as well as a deferral of principal, which has the same effect on
the borrower’s monthly payment as principal reduction, but provides the investor
with potential recovery. The forborne principal is paid in full or part upon
sale of the property or payoff of the loan. This traditional approach would
minimize the Enterprise losses and treat GSE borrowers in a manner that is
consistent with other government programs.

Given the large portion of the
high LTV borrowers that are current on their mortgages, a principal reduction
program for this segment, such as the FHA Short Refi program, simply transfers
performing GSE borrowers over to FHA, at a cost to the GSEs. A less costly
approach for the Enterprises to assist these borrowers is to provide a GSE
refinance alternative, such as HARP. Clearly, the HARP program has been
underutilized to date, suggesting that the program features should be revisited
to remove barriers to entry wherever possible.

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FHFA Releases GSE Home Retention Metrics

The two government sponsored enterprises
(GSEs) Freddie Mac and Fannie Mae completed nearly twice as many foreclosure
prevention actions
in the first quarter outside of the Home Affordable
Modification Program as they did through it. 
According to the Federal Housing Finance Agency’s (FHFA) Foreclosure Prevention Report for the
quarter, there were 111,739 home retention actions taken by the two
companies including 60,348 loan modifications, 44,636 repayment plans, 6,245
forbearance plans and 507 charge-offs-in-lieu. 
The modification figure includes just over 31,000 transacted through

Approximately half of the loan
modifications resulted in a reduction in the borrower’s monthly payment of 30
percent or more.  FHFA has repeatedly stressed
that the larger the payment reduction the greater the chance the modification
will succeed.  Nearly all of GSE
modifications resulted in some combination of rate reduction, forbearance,
and/or term extension.  Servicers are not
allowed to do principal reductions as part of modifications of GSE loans
however FHFA said that nearly one-third of the loan modifications included
principal forbearance.

Home retention actions decreased in the
first quarter of 2012 as compared to the fourth quarter of 2011 from 120,698 to
111,739 and modifications (including those done through HAMP) were down by
almost 11,000. 

Total home forfeiture actions totaled
34,360 during the first quarter, down from 34,895 in the previous quarter.  Of this number 30,601 were short sales (down
from 31,785) and the remaining 3,759 were deeds-in-lieu of foreclosure, an
increase from 3,110.

The performance of modified loans
remains strong, especially among those modified after the first few years of
the foreclosure prevention initiatives. 
Fewer than 15 percent of loans modified in the second quarter of 2011
had missed two or more payments nine months after modification.

Delinquency rates for the GSEs continue
their slow decline.  Loans that are 30-59
days delinquent represent 1.7 percent of the portfolio down from 2.1 percent in
the previous quarter.  The 60+ day rate
is 4.2 percent, down from 4.5 percent and serious delinquencies are at 3.6
percent compared to 3.8 percent.

Delinquencies continue a wild state by
state variation.  Florida has by far the
largest number of delinquencies – over 270,000 with California not even close
at about 150,000.  Florida is also notable
for being the only state with a delinquency rate over 8 percent and for the number
of delinquent loans – 160,000 – that have been delinquent for more than one

interactive version of the map below is now available.   The new Borrower Assistance Map allows
state level access to information on delinquencies, foreclosure prevention
activities, Real Estate Owned (REO) properties and refinances for GSE

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FHFA Sends Annual Report to Congress on GSEs, FHLBanks

As required under the Housing and
Economic Recovery Act (HERA), the director of The Federal Housing Finance
Agency (FHFA) submitted the agency’s annual Report to Congress on the two government
sponsored enterprises (GSEs)
for which it is responsible and for the Federal
Home Loan Banking System (FHLBanks.)  In
addition to a lengthy recounting of the performance of the regulated entities
during the course of 2011, FHFA also provided an assessment on their safety and
soundness including information on any material deficiencies in their
operations, their overall operational status, and an evaluation of their
performance in carrying out their respective missions.

FHFA reported that it had conducted an examination
of both GSEs as to their financial safety and soundness and overall risk
management practices on a framework known as GSEER which stands for Governance,
Solvency, Earnings, and Enterprise Risk which comprises credit, market, and
operational risk management.  The agency
assigned rating of critical concern to both Fannie Mae and Freddie Mac in a
number of areas and ratings of substantial concerns in others. 

In the case of Fannie Mae, the report
says that the GSE “exhibits critical financial weaknesses as evidenced by its
poor performance and condition and prospects”. 
Credit risk remains high but is somewhat mitigated by the higher quality
of the single family book of business since 2009.  Business operations are vulnerable to
disruption, especially by human capital risk, and capital is wholly dependent
on the support of the U.S. Treasury.

In the case of Freddie Mac FHFA says its
credit risk remains high, the control structure is weak, human capital risk is
elevated, and their capital is also wholly dependent on the Treasury.

The most significant
risks facing Fannie Mae are credit risk, human capital risk, dependence on a
legacy infrastructure that needs to be updated, and the need to execute the
strategic plan for the conservator ships. 
Fannie Mae’s management and its board were responsive throughout 2011 to
FHFA findings and are taking appropriate steps to resolve issues the report
says.  However Fannie Mae must continue
to identify and proactively reduce the risk and complexity of its business
activities, focus on loss mitigation and foreclosure prevention, and maintain
sound underwriting criteria for single family and multifamily portfolios.

FHFA assigns a limited concerns
rating to Fannie Mae governance, an upgrade from the last examination and is
working with the company to identify a new president and chief executive
officer.  This solvency or capital
classification for ratings remains suspended as it has been since the beginning
of conservatorship, but FHFA assigns earnings a critical concern rating.  Fannie Mae’s net losses increased in 2011 to $16.9
billion from $14 billion in 2010, driven primarily by high provisions for credit
losses.  New delinquencies along with
further declining home prices resulted in a substantial increase in loan loss
reserves.  These reserves increased $10.6
billion to $76.9 billion in 2011.  In
addition a steep decline in long-term interest rates led to mark-to-market
losses on derivatives used for hedging purposes.

Fannie Mae’s credit risk also rates
a critical concern.  Although risk is
high and the quality of risk management is adequate and the level of risk is
decreasing the principal concerns are the credit characteristics of Fannie Mae’s
legacy 2005 to 2008 vintage single-family book of business, opportunity’s to
improve multifamily risk management, and continued weakness of its mortgage
insurer counterparties.

FHFA assigns market risk a
significant concern rating, an upgrade from 2010.  Risk levels are high but the quality of risk
management is adequate.  The concerns are
largely centered around increased balance sheet illiquidity because of the
amount of distressed assets and whole loan portfolios resulting from loss
mitigation activities, the need to strengthen attendant risk management
practices, and the continued negative effects on earnings from the mark-to-market
negative effects from derivative contracts. 
However liquidity and funding risks are low and the related risk
management is adequate.

risk is a significant concern, another upgrade from 2010.  The level of risk is high and increasing but
the quality of operational risk management is adequate although Fannie Mae needs
to further strengthen project management. 
Its uncertain future, legacy information technology, manual processes that
reduce its flexibility, and the requirement to implement the strategic plan
keep operational and process risks at elevated levels.  However the company improved risk management
in 2011 by installing new operational risk leadership, implementing a risk
management framework, centralizing the reporting structure and other

In conducting its examination of
Freddie Mac, FHFA focused on matters previously identified as requiring
attention and the board and management’s response to deficiencies and
weaknesses identified by internal and external audits.

Governance was considered a
significant concern in the examination of Freddie Mac.  The company’s enterprise risk management
structure continues to benefit from a recent redesign however management is
finding it difficult to maintain an adequate control structure because of
increased employee turnover and reliance on manual processes.  The quality of information the Board of
Directors receives has improved and FHFA is working with the board to identify
a new CEO.  The board should continue to
focus on the key risks and issues facing Freddie Mac including the effect
employee turnover has on its ability to manage its information technology.

Freddie Mac received a critical concerns
rating on earnings.  Total revenues
increased slightly in 2011 and credit related expenses and mark-to-market
losses on derivatives also increased.  Derivative
losses were offset partly by interest rate related gains on assets. 

Credit risk was also considered a critical
concern although it is decreasing and its risk management is considered
adequate.  As with Fannie Mae, the
principal concerns center around the GSE’s 2005 to 2008 vintage single family
loans, coupled with underwriting and controls in the multifamily business line,
weak mortgage insurer counterparties, and increased concentration of
counterparty risk.   FHFA said that the
higher quality of Freddie’s more recent single family business and management’s
success in loss mitigation is alleviating some concerns.

Market risk is considered a significant
concern.  The level is high relative to
earnings and capital for the quality of risk management is adequate.  The retained portfolio’s growing proportion
of illiquid assets is increasing risk because of the level of distressed assets
and whole loan portfolios.  These assets
are less liquid, causing prepayment modeling difficulties and less reliable
interest rate risk metrics.  Human
capital risk in the investment and capital markets group and continued negative
effects from the mark-to-market derivative contracts are also a concern. 

Operational risk is a critical concern
as it is high and increasing and the quality of risk management needs
improvement.  Human capital risk and the dependence
on legacy operational and information technology infrastructure are among the
highest risks facing the GSEs. 

Model risk is a significant
concern but while the level is high it is stable.  FHFA’s concerns include the timeliness of
model valuations and the efficacy of models in the current economic

followed up a special review in October of 2011 with a directive requiring
Freddie Mac to phase out its retained attorney network and to work with FHFA
and Fannie Mae through the Servicing Alignment Initiative to develop and
implement consistent requirements, policies, and processes for default and foreclosure-related
legal services.

reported that as of the end of 2011, the FHLBanks exceeded the minimum leverage
ratio by having at least 4 percent capital-to-assets.  The weighted average regulatory capital to assets
ratio for the system was 6.9 percent in 2011 compared to 6.5 percent in 2010.  All FHLBanks were profitable for the year and
the system’s advance business continues to operate with no credit losses.  However the quality of the FHLBanks’
investments in private label mortgage backed securities (MBS) remains a
significant concern.  Exposure to such
securities dropped by 20 percent during 2011 as did the credit charges
associated with the securities.

2011 two FHLBanks were under consent orders because of their financial
conditions.  The FHLBank of Seattle saw deterioration
in the value of its private label MBS starting in 2010 while Chicago had been
operating under a cease and desist order since October 2007.  Seattle remains under the enforcement action
but Chicago’s order was removed in early 2012.

overall all scale of the FHL banks advance operations continued to decline in
2011 reaching $418 billion at year end compared to $479 billion at the end of
2010.  Investments in private label MBS
have adversely affected the overall operation of some banks reducing their
ability to repurchase or redeem stock as the banks shrunk.  FHFA has taken action where needed to address
this problem.

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MBA: Investors Increase Commercial, Multifamily Mortgage Holdings

Three of the groups that most heavily
invest in commercial and multifamily mortgages increased their outstanding
balance of such debt in the first quarter of 2012 according to data released
this morning by the Mortgage Bankers Association (MBA).  The level of all commercial/multifamily debt increased
by $8.1 billion
or 0.3 percent to $2.373 trillion compared to a total in the
fourth quarter of 2011 of $2.365 trillion. 
The multifamily portion of that debt now totals $818 billion, up $6.9
billion or 0.8 percent from the previous quarter total of $811.4 billion.

Banks and thrifts saw the largest dollar
increase in commercial/multifamily holdings during the first quarter, $13.5
billion or 1.7 percent.  Agency and GSE portfolios
and MBS went up by $6.8 billion or 2 percent.  The third sector, life insurance companies,
increased $3.8 billion or 1.2 percent.  The largest drop was in the holdings of commercial mortgage-backed securities (CMBS), collateralized
debt obligations (CDO), and other asset-backed securities (ABS) which went down
$11.7 billion or 2 percent.  On a
percentage basis the largest increase was 5.3 percent by other insurance
companies and the largest percentage drop was in the household sector, down 11

amount of commercial and multifamily mortgage debt outstanding increased during
the first quarter, as lenders put out more in new loans than paid-off or paid
down,” said Jamie Woodwell, Vice President of Commercial Real Estate Research
at the Mortgage Bankers Association.  “Banks; Fannie Mae, Freddie Mac and
FHA; and life insurance companies all increased their holdings of commercial
and multifamily mortgages, more than offsetting declines among CMBS and other
investor groups.”

The $6.9 billion increase in multifamily
was accounted for by an increase in agency and GSE portfolios of 6.8
billion or 2 percent, commercial banks raised their holdings by $2.4 billion or
1.1 percent and life insurance companies increased by $595 million or 1.2
percent.  The largest decrease was $2.5
billion or 2.7 percent by CMBS, CDO, and other ABS issues.  On a percentage basis agency, GSE portfolio
and MBS increased 2 percent while finance companies had the largest percentage
decrease at 2.9 percent.

While commercial banks hold the biggest share
of commercial/multifamily mortgages with $808 billion or 34 percent of the
total, agency and GSE portfolios and MBS are first in the percentage of multifamily
mortgage debt outstanding, 43 percent or $352 billion.  Banks and thrifts hold $221 billion or 27
percent, CMBS, CDO, and other ABS issues hold $88 billion or 11 percent, and
local governments have 8 percent or $69 billion.

analysis summarizes the holdings of loans or, if the loans are securitized, the
form of the security. For example, many life insurance companies invest both in
whole loans for which they hold the mortgage note (and which appear in this
data under Life Insurance Companies) and in CMBS, CDOs, and ABS for which the
security issuers and trustees hold the note (and which appear here under the
latter designation).

recently improved its reporting of commercial and multifamily mortgage debt
outstanding.  The new reporting excludes two categories of loans that had
formerly been included – loans for acquisition, development and construction
and loans collateralized by owner-occupied commercial properties.  By
excluding these loan types, the analysis here more accurately reflects the
balance of loans supported by office buildings, retail centers, apartment
buildings and other income-producing properties that rely on rents and leases
to make their payments.

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Paper Suggests Lower GSE Fees May Pay Off in Reduced Defaults

The Federal Reserve Bank of New York
recently released a paper that looked at the impact of HARP revisions on loan
defaults and pricing
.  The paper, Payment Changes and Default Risk: the Impact
of Refinancing on Expected Credit Losses
was written by Joseph Tracy and
Joshua Wright. 

When the Home Affordable Refinance Program
(HARP) was initiated, its goal to stimulate the economy and reducing defaults
by lowering mortgage payments in households with high loan-to-value mortgages. These
were borrowers who were otherwise unable to refinance.

HARP was implemented in 2009 but refinancing
activity was much lower than expected. 
Just over one million refinances have been done under HARP rather than
the 3 to 4 million expected.  This
confirms, the authors say, the original rationale for HARP, that in the wake of
the housing bust borrowers need help refinancing.

HARPS lackluster results have provoked discussion
about the impediments to refinancing including credit risk fees, limited lender
capacity, a costly and time consuming appraisal process, limitations on
marketing, and legal risks for lenders.  HARP
was recently revised to better address these impediments. .

Concerns about revising HARP included
doubts about its fairness and about macroeconomic efficiency.  The Federal Housing Finance Agency (FHFA) has
a responsibility to weigh the value of any proposed changes in terms of a possible
impact on the capital of the government sponsored enterprises (GSEs).  These could include a reduction in the income
generated through interest on the GSE’s Holdings of MBS, on the expected
revenues from the put-backs of guaranteed mortgages that default, and finally
on the impact of refinancing on expected credit losses to the GSE fees. 

One outcome of an improved program would
be more borrowers in a position to refinance. 
Estimates can be made of the average reduction in monthly mortgage
payments that would result from a refinance; the question is how this payment
reduction would affect future defaults. 
Ideally a study could determine the difference in expected credit losses
from two identical borrowers with identical mortgages where one borrower
refinances and the other does not.  However,
once the existing mortgage is refinanced it disappears so both
mortgage/borrower sets cannot be similarly tracked and the impact of the
payment change on a borrower’s performance must be inferred.

A recent congressional budget office
working paper estimates that reduced credit losses would produce an incremental
2.9 million refinances of agency and FHA mortgages and that such a program
would reduce expected foreclosures by 111,000 or 38 per 1000 refinances,
reducing credit losses by $3.9 billion.

Using data from Lender Processing
Services the authors selected eligible borrowers from among borrowers who had
been current on mortgage payments for at least 12 months and had estimated loan-to-value
ratios (LTV) over 80 percent. To measure motivation the authors selected loans
where the borrower could recover refinancing costs in two years.  Using these parameters it was determined that
refinancing would reduce the required monthly payment by 26 percent on average.

The authors found impacts on results
from various combinations of local factors such as house prices, employment
rates, the local legal methods of handling delinquencies, and contagion risk,
i.e. the exposure of the borrower to others who had defaulted.  There were also effects from FICO scores and
debt to income ratios and loan specific factors such as the purpose of the
loan, full documentation of the loan, and length of loan term.  Various methods were used to control for
these variables including excluding loans from the sample.

It is acknowledged that LTV ratios have
a significant correlation with default and the authors did test and confirm
this relationship.   The next step was to estimate the impact of a
26 percent payment reduction on the average default rate.  The authors used estimated ARM default and
prepayment hazards to do a five-year cumulative default forecast holding the
local employment rate and home prices stable. 
At five years the models imply that the expected cumulative default rate
would be 17.3 percent. When the payments are reduced by 26 percent the expected
default rate is reduced to 13 percent a 24.8 percent reduction.   The same analysis was run for borrowers with
prime conforming fixed-rate mortgages obtaining a cumulative default rate of
15.2 percent which refinancing reduced to 11.4 percent, a decline of 3.8
percentage points. 

These figures were used to conduct a
simple pricing exercise to measure the difference between a refinancing fee
that maximizes fee income for a certain category of borrowers and a fee that
maximizes the combination of the fee income and the reduction in the expected
future credit losses using the GSE pricing categories for their loan level adjustments.  It was found that FICO score strongly impacted
both payment reductions and default rates ultimately resulting in reductions in
the default rate of 1.9 percentage points for a high FICO borrower and 9.1
points for a low one.  This implies that
incorporating the impact of expected credit losses into the pricing decision
should generate higher price discounts for weaker credit borrowers as measured
by FICO score and LTV.

The authors found that incorporating the
impact of expected credit losses after refinancing on average lowed the desired
pricing by 17 basis points.  Looking at
the averages by LTV intervals shows an impact of 15 basis points for mortgages
with a current LTV of 80 to 85 and increases to 14 basis points for mortgages
with a current LTV of 105 or higher. 
Basing fees on FICO scores involves a much more complicated set of

The authors conclude that the average
HARP refinance would result in an estimated 3.8 percent lower default
rate.  Assuming a conservative average
loss-given default of 35.2 this indicates an expected reduction in future
credit losses of 134 basis points of a refinanced loan’s balance.

The paper concludes that the impact
of refinancing on future default risk is important to the current debate of the
GSE fee structure for HARP loans.  “These
results suggest that refinancing can be fruitfully employed as a tool for loss
mitigation by investors and lenders.  The
optimal refinance fee will be lower if this reduction in credit losses is
recognized.”  Reducing fees, the authors
say, will increase incentives to refinance but at the cost of fee income to the
GSEs.  “Our analysis shows, however, that
there is an offset to this lower fee income today which is lower credit losses
in the future.”

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