Calling DeMarco’s Bluff? Use the GSEs’ Market Power to Force 2d Lien Write Downs
There’s been mounting pressure on the acting head of the FHFA, Ed DeMarco to order Fannie Mae and Freddie Mac to undertake principal reductions. DeMarco’s pushed back, arguing that it’s not fair for the GSEs to write-down principal when there are second liens on some of the loans that are on banks’ books and the banks aren’t doing write-downs (see here and here and Felix’s critique here). DeMarco is arguing for strict observance of absolute priority. He notes that reducing the GSEs’ first lien balances at taxpayer expense effects a bailout of the banks as it bouys the likelihood that their second liens will be repaid.
DeMarco’s correct about a write-down of the firsts alone being a bailout of the banks. But his argument for doing nothing doesn’t hold up for two reasons. First, there are plenty of GSE loans without seconds. There’s no reason not to do write-downs on those loans. And second, the GSEs have the market power to force the banks to write down seconds as a term of doing business with the GSEs. If DeMarco’s serious about dealing with negative equity, he’ll start running the GSEs’ like the 800 lb. gorilla they are in the housing market.
Not all GSE loans have second liens. It’s not hard to determine if there’s a second lien on a property–a title search and/or a credit report will show that. Those aren’t free, but I hate to think that would be what’s keeping DeMarco from ordering the GSEs to write-down principal on loans that don’t have seconds. The possibility that some might have seconds shouldn’t get in the way of writing down principal on those that don’t have seconds.