Congressman Mel Watt (D-NC) has been nominated by President Obama to take over the Federal Housing Finance Agency (FHFA), which is the conservator for Fannie Mae and Freddie Mac. As FHFA head, he would have vast oversight over the housing market, given that roughly 90% of the mortgages currently originated in the United States are either government-guaranteed or government-sponsored (read: guaranteed).
This nomination has been a political football in that Democrats support principal reduction for underwater Fannie Mae and Freddie Mac loans (mortgages that have a higher balance than the property is worth) and Republicans believe principal mods would cost the taxpayer money. Last Thursday, June 27, Watt had his confirmation hearing in front of the Senate Banking Committee. Suffice it to say nobody changed their mind in the hearing.
The issue of FHFA
The political issue of what to do with underwater loans has fallen predictably along partisan lines, with Democrats embracing principal reduction in order to increase aggregate demand while Republicans worry about the cost and the unintended consequences, particularly moral hazard.
Democrats argue that underwater homeowners aren’t spending, and since consumption is 70% of the U.S. economy, that’s hurting the economy. They would reduce principal to the value of the house, which would reduce the homeowner’s monthly payment and give the homeowner some equity, which would increase their wealth. This would hopefully spur spending, which would stimulate the economy. Many of these loans are already owned by the government, so few investors would take losses (aside from the taxpayer). Their view is that these loans are already impaired, so why not get what we can out of them, and maybe help the borrower and the economy in the process?
Republicans argue that the vast majority of underwater borrowers are current on their mortgage. In other words, they’re making their payments. Republicans fear that the Democrats’ proposed program would cause a wave of strategic defaults, where people would stop paying their mortgage in hopes of getting a principal reduction. We saw a wave of strategic defaults in the beginning of the housing bust, where professional investors simply tossed the keys to the bank after the value of the property fell below the mortgage amount. If the same sort of thing happened again, it would be very costly to the taxpayer.
This analysis continues in Why Mel Watt gained no new fans at the Senate Hearing — Part 2.
© 2013 Market Realist, Inc.