Why did Mel Watt fail to get the vote to become FHFA head?

The Obama Administration nominated Rep. Mel Watt (D-NC) to replace Ed DeMarco as the head of the Federal Housing Finance Agency (FHFA)

The Acting Head of the Federal Housing Finance Agency (FHFA) is Ed DeMarco, who has come under fire for not permitting principal modifications on loans backed by Fannie Mae and Freddie Mac. The FHFA is the conservator for Fannie Mae and Freddie Mac. Ed DeMarco asserts that the FHFA’s mandate is to ensure stability and liquidity in the housing finance system and to minimize costs to taxpayers.

Negative EquityEnlarge Graph

In pursuit of his goal to minimize costs to taxpayers, DeMarco has resisted allowing principal modifications on loans backed by Fannie Mae and Freddie Mac. He has permitted term and rate refinances, which allows the servicer to lower the interest rate or to extend the term of the loan. DeMarco’s reluctance to allow principal mods has angered many on the left—particularly Paul Krugman, who has called for President Obama to fire DeMarco. The Treasury has supported allowing principal modifications. While the number of homes with negative equity has been declining since house prices started rising, underwater homeowners are still a major social and economic problem.

Representative Mel Watt is probably in favor of principal modifications for conforming loans

Rep Watt is a member of the Congressional Black Caucus, which has been vocal in advocating principal reductions for conforming loans. While there has been a smattering of criticism on the left, charging that Watt is too cozy with the banks, he’s generally seen as a consumer-focused liberal who pushes hard for affordable housing and CRA lending.

Politically, mass principal mods are a tough sell. In fact, Rick Santelli’s speech (which unofficially launched the Tea Party) was in response to the idea of mass principal mods being forced on bondholders. And while people tend to think of mortgage REITs as the main holders of mortgage-backed securities, the other big holders are pension funds and endowments. These creditors have been whispering quietly into the ears of their representatives, pressing them not to do it. In fact, Rep Maxine Waters (D-CA) has discussed her concerns regarding the impact of principal mods on investors.

In a Senate vote, Mel Watt had 42 nays (one was Harry Reid, who voted no so that Watt could be brought back up for a vote). The Republicans were against a politician taking the job for fear that he would be more interested in furthering political objectives over looking out for taxpayers.

Impact on mortgage REITs

Any mass principal forgiveness will mainly affect agency REITs like American Capital (AGNC), MFA Financial (MFA),  and Hatteras (HTS). Agency REITs don’t bear credit risk like the non-agency REITs Redwood Trust (RWT) and Two Harbors (TWO) because the loans are guaranteed by the government. That said, an absence of credit risk doesn’t mean they won’t take losses. Many underwater homeowners have above-market interest rates on their mortgages and are unable to refinance because lenders won’t underwrite a mortgage with a loan-to-value ratio of over 1—unless it’s in the context of the HARP (Home Affordable Refinance) program. This means that an MBS with a 6% government-guaranteed coupon rate will trade significantly above par since most of the loans can’t be refinanced. If the government pursues a mass principal reduction, those loans will be reduced to a LTV of 1 or below, which makes them all eligible for refinancing.

This means that agency REITs will face a massive increase in prepayment speeds. Their higher-yielding mortgage-backed securities will drop in price as the market factors in higher prepayment risk. They will also face higher reinvestment risk. A mass principal write-down would be negative for the mortgage REITs.