By Phil LeBeau, CNBC Correspondent
NEW YORK (
) -- Despite strong pressure from the Obama administration, a federal regulator will not allow Fannie Mae and Freddie Mac to reduce mortgage principal. The Federal Housing Finance Agency's Ed DeMarco has previously opposed the program, which uses taxpayer money to pay lenders to reduce loan balances of severely troubled borrowers, but had not made the final decision until now.
"After much study, I have concluded that Fannie Mae and Freddie Mac's adoption of HAMP PRA [the government's Home Affordable Modification Program Principal Reduction Alternative] would not make a meaningful improvement in reducing foreclosures in a cost effective way for taxpayers," DeMarco wrote in a letter to the chairman and ranking member of the Senate Committee on banking, Housing and Urban Affairs.
DeMarco concludes that the program presents the risk of more losses to taxpayers, not to mention operational challenges to the GSE's. He cites moral hazard, suggesting that as many as 19,000 borrowers who are current on their mortgages could strategically default in order to qualify for debt forgiveness. Even more significant, he goes on, could be long-term consequences for mortgage credit availability.
"Fundamentally, principal forgiveness rewrites a contract in a way that other loan modification programs do not. Forgiving debt owed pursuant to a lawful, valid contract risks creating a longer-term view by investors that the mortgage contract is less secure than ever before," writes DeMarco in the letter to lawmakers.
Treasury Secretary Timothy Geithner responded immediately in a letter to DeMarco:
"I do not believe it is the best decision for the country, because, as we have discussed many times, the use of targeted principal reduction by the GSEs would provide much needed help to a significant number of troubled homeowners, help repair the nation's housing market, and result in a net benefit to taxpayers."
A study of the program by Treasury's Michael Stegman showed that mortgage modifications that included principal reduction had a far lower re-default rate than those without the debt forgiveness.
"Fannie Mae's analysis suggests that using principal reduction to reduce the loan-to-value- (LTV) ratio not only increases a borrower's ability to pay, but for these selected borrowers, it also increases the likelihood that they will continue to pay," writes Stegman in the analysis.