Mark Zandi as new FHFA head could usher in principal mods for conforming loans

Numerous Sources have reported that Moody’s Chief Economist Mark Zandi could replace Ed DeMarco as the head of the Federal Housing Finance Agency

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 FHFA’s mandate is to ensure stability and liquidity in the housing finance system and to minimize costs to taxpayers.

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. 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.

Mark Zandi is supportive of principal mods

Mark Zandi has been quoted as saying “Principal reduction works. If someone gets a reduction in their principal amount, it gives them a real powerful hook to really fight to try and hold onto the home, even if things aren’t going financially right for them.” The problem with mass principal mods is the issue of moral hazard, where people who are able to afford their mortgage payment may stop paying in order to qualify for a principal modification. By allowing principal modifications, FHFA could end up making a bad problem cost a lot more than originally anticipated.

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.

Impact on mortgage REITs

Any mass principal forgiveness will affect only agency REITs like American Capital (AGNC) and Hatteras (HTS). Agency REITs do not bear credit risk because the loans are guaranteed by the government, but that 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 is in the context of the HARP program. This means that a MBS with a 6% government guaranteed coupon rate will trade significantly above par since most of the loans cannot 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 writedown would be negative for the mortage REITs.