Fannie Mae, Federal Reserve: Moving on Loan Modifications

In a major policy shift, the Federal Reserve announced that it would start doing loan modifications through mortgage writedown strategies, which includes reduction of loan principal.  Fannie Mae may also be poised to adopt similar loan modification plans to help homeowners.

The Federal Reserve has decided to keep interest rates at their near-zero levels.  At the same time, the institution is pursuing more aggressive efforts to stop foreclosures through such tools as mortgage writedown loan modification.

The Fed recognizes that despite the fact that the key rate is at a historical low, retail credit is still difficult to get.  Banks are reluctant to lend to many consumers who have damaged credit as a result of financial problems exacerbated by a poor economy.  While other lenders are starting to allow loan modifications that include lower rates, extended repayment schedules, or flexible refinancing, the Federal Reserve is going much further by doing significant writedowns of principal balances on existing mortgages.

For now, the new initiative will only apply to those mortgages that are controlled by the Federal Reserve, namely, the portfolio of home loans that it inherited a few months ago following the collapse of Bear Stearns and AIG. In the wake of those failures, about $75 billion of assets came under Federal Reserve control.

Fannie Mae: Crucial to economy

That represents only a tiny fraction of the trillions of mortgage dollars invested in the U.S., however, and most of the bad mortgages are held by Fannie Mae and Freddie Mac. The twin agencies also fell apart last year and had to be taken over by the government.  Many economists believe that doing successful mortgage loan modifications at Fannie Mae-which is by far the largest holder of mortgages-is vital to saving the economy. And while Fannie Mae hasn't yet resorted to mortgage writedowns, it has increased its efforts to perform loan modifications.

More loan modifications needed

Fannie Mae is apparently working behind the scenes to come up with an effective program for reworking troubled loans, although any details of what practical steps that might involve have not been disclosed. But President Obama and his administration have made many public statements regarding their intention to aggressively pursue ways to assist distressed homeowners and relieve the burden of bad loans from banks.

In the past, investors have balked at attempts to do mortgage writedowns, for fear of losing potential profits or incurring even greater losses. The Bush White House was reluctant to intervene, and instead called for voluntary compliance. That passive approach failed, and as the housing market and financial sector continues to hemorrhage, it's expected that the new president will insist on some form of loan modification at Fannie Mae involving substantial mortgage writedowns. Otherwise, it's difficult for economists to see a way out of the foreclosure crisis.  Unless it's cured, the banking industry may never recover from its own deepening freefall.