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Should Fannie, Freddie Write Down ‘Underwater’ Mortgages?

California Attorney General Kamala Harris became the latest elected official on Thursday to call on Fannie Mae and Freddie Mac to write down loan balances for borrowers who owe more than their homes are worth.

Ms. Harris on Thursday didn’t specifically address the settlement talks, which have not included Fannie and Freddie. Instead, she called on the agency’s acting director, Edward DeMarco, to “step aside” if he “is unwilling to support principal reduction for these home loans in crisis.”

Why won’t Fannie and Freddie write down loan balances? There are three broad reasons. First, the firms guarantee $5 trillion in mortgages, of which around 20% are underwater. But the vast majority of those underwater mortgages—around 87% for Freddie Mac—are current. The companies are reluctant to write down loan balances because of a concern that will create a moral hazard that induces other borrowers to default.

Second, Mr. DeMarco has said that the firms’ current efforts to modify mortgages are successfully reducing borrowers’ monthly payments to affordable levels without the costly step of forgiving debt. Fannie and Freddie are supported entirely by taxpayers and have run up a $145 billion tab so far, and the FHFA is charged with conserving the firms’ assets. In a recent interview, Mr. DeMarco said that principal forgiveness isn’t justified given that mandate.

Third, many underwater loans often are covered by mortgage insurance, which reimburses Fannie and Freddie for part of the loss when those loans default and go through foreclosure. The upshot is that even in cases where it might make economic sense for the loan to be written down, it still isn’t in the economic interest of Fannie or Freddie to write down certain loans.

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