Edward DeMarco Threatens Action Against Communities Weighing Principal Reduction Proposal

WASHINGTON -  FEBRUARY 25: Edward DeMarco, acting director of the Federal Housing Finance Agency testifies during a Committee
WASHINGTON - FEBRUARY 25: Edward DeMarco, acting director of the Federal Housing Finance Agency testifies during a Committee on Financial Services hearing on Compensation in the Financial Industry - the Government Perspectives on Capitol Hill February 25, 2010 in Washington, DC. The hearing focused on the pay practices of both private and public financial entities including AIG, Fannie Mae and Freddie Mac where the federal government plays a role in reviewing and approving compensation. (Photo by Ann Heisenfelt/Getty Images)

Edward DeMarco has opened up a new front on his war against principal reduction.

On Thursday, the Federal Housing Finance Agency, which DeMarco oversees as acting director, threatened to take action against local governments considering using the power of eminent domain to write down the value of some underwater mortgages in their communities. The move comes a week after DeMarco ruled out principal reduction on loans controlled by Fannie Mae and Freddie Mac, the bailed-out mortgage giants he effectively controls as conservator of the companies.

The Federal Housing Finance Agency "has significant concerns about the use of eminent domain to revise existing financial contracts," the agency said in a notice filed in the Federal Register. "FHFA has determined that action may be necessary on its part to avoid a risk to safe and sound operations at its regulated entities and to avoid taxpayer expense."

The notice, which includes a request for public comment on the issue, comes as a handful of hard-hit communities in Southern California, Chicago and on New York's Long Island weigh a proposal by a venture fund, Mortgage Resolution Partners, that would have them seize underwater home loans held in private mortgage trusts. The local governments would then write off that debt, and help the homeowners refinance at the new, lower price.

Though just 10 percent or so of home loans are held in private trusts, they typically include those made in the years immediately proceeding the housing bust, and are thus the most likely to be deeply underwater and in danger of failing. Estimates vary, but somewhere around one quarter of all borrowers in the United States owe more on their home loans than they are worth. In the communities weighing the plan, including San Bernardino County, Calif., the percentage of underwater borrowers is close to 50 percent.

Officials in San Bernardino and Chicago could not be immediately reached for comment on the FHFA's warning about the proposal, but John Vlahoplus, chief strategy officer at Mortgage Resolution Partners, characterized the move "as another attempt by a bond holder trying to use its position to stop local governments from fixing the crisis."

Fannie Mae and Freddie Mac purchased private-label home loan bonds in the run-up to subprime crash, just like other investors. Fannie and Freddie, and by extension DeMarco, therefore have no greater say over what happens to these loans than any other bondholder that made an investment, Vlahoplus said.

"You cannot by dint of being an investor in a private entity control that entity," Vlahoplus said. "They made a bad deal, invested in these securities and the loans fell in value. The right approach is to go to court, but they know they will lose in court."

FHFA did not immediately return a request for comment for this article.

It's not clear what kind of action the agency might take if it decides to intervene in preventing local governments from using eminent domain to seize mortgages. That seizure would happen through a court action, which is typically when any entity opposed to the claim would register an objection. Nor is it clear why DeMarco would choose to wade into another politically heated battle over principal reduction, though his objections to debt relief more broadly center on what he sees as a risk of contagion, and lasting harm to the market that finances home loans.

In ruling out last week -- once and for all, it seems -- principal reduction on any Fannie or Freddie loan, DeMarco cited the risk of "moral hazard." His point, essentially, is that offering debt relief to a targeted group of borrowers -- the up to 500,000 that might qualify for debt relief under a Home Affordable Modification Program -- might encourage others to strategically default in order to obtain the same benefit, in the same way that feeding a neighbor's cat poses the risk that you will soon be setting up a kitty buffet for the whole neighborhood.

Moreover, writing down loan values would spook the mortgage markets and make it more difficult for borrowers to buy and refinance homes, he said. This fear outweighed new findings by his own agency that found that taxpayers would likely actually benefit from targeted principal reduction, to the tune of up to $1 billion.

Critics of this view say there is no evidence that struggling homeowners will intentionally stop paying, and thus risk their home and their credit, in order to potentially benefit from debt relief. DeMarco's shutting the door on principal reduction last week ratcheted up the calls from many in the housing community for him to step down, or for President Barack Obama to use a recess appointment to name a permanent director.

Public hearings on the use of eminent domain to seize mortgages are set for next week in Chicago and in San Bernardino County, in California.

Below are the people who love and hate Ed DeMarco:

Who Is For And Who Is Against Principal Reductions