Must-know: Why Mel Watt will be bad for mortgage REITs

Market Realist

Mel Watt's nomination will impact mortgage REITs and originators (Part 3 of 5)

(Continued from Part 2)

Mel Watt takes a pass on supporting or not supporting principal mods

Mel Watt had been very supportive of principal mods in the past, and several Senators asked him if he still stood by that. Watt’s answer basically said that as a Congressman, he was representing his constituents, many of whom were underwater homeowners. As such, he had a responsibility to look out for them. As the head of FHFA, he would have to reconsider his stance because he’d now be a regulator and have the responsibility to look after the taxpayer as well. So he said he would revisit the issue, but he refused to come down on either side.

The problem with principal mods

There’s one additional issue with principal mods that politicians need to deal with, and this one falls along bipartisan lines. While many of these underwater loans are held by the government, many are not. They’re securitized in mortgage-backed securities, which are held largely by pension funds. This is a big sticking point. Pension funds have been hit by a confluence of problems—high healthcare inflation and low interest rates. Since pension funds invest in securities to meet future obligations, if the rate of return available in the market is lower than the expected growth rate of their obligations, they’re in trouble.

Think about an underwater Fannie Mae loan that’s performing. The borrower may have paid top dollar in 2006, and the home is now worth a lot less. Yet they keep paying. Their mortgage rate may well be 6.5%. They can’t refinance because the loan is underwater. However, the government is guaranteeing the principal and interest for that loan. With interest rates at these levels, a mortgage with an above-market interest rate is worth more than par. It may be worth 109% of par. What happens in a principal mod? The government effectively prepays the loan. The price drops from 109 to par. That causes a capital loss—and makes the already shaky pension funds even shakier.

Politicians on both sides of the aisle are getting whispers in their ears from their state pension funds, asking them not to approve principal mods. This is why the issue is more nuanced than simply economic growth versus moral hazard. Finally, virtually every politician participates in the government’s pension program. Guess where the government pension fund has a lot of its money.

Continue to Part 4

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