This key news item got overlooked earlier this week, but it’s worth flagging now.  The Obama administration had hinted that they might use their leverage through the Federal Housing Finance Agency (FHFA) to reduce principal amounts on home loans that are currently underwater, ostensibly as an economic stimulus but mostly as a political stimulus to Barack Obama’s re-election hopes.  FHFA chief Edward DeMarco put the kibosh on that plan, arguing that it would set up perverse incentives that could inflict a lot more damage than it would repair.  The Washington Post notes the rebuke to the White House in this decision — and that the White House didn’t take it lying down, either:

The federal regulator for government-backed mortgage giants Fannie Mae and Freddie Mac said Tuesday that he will not allow the firms to reduce loan balances of struggling homeowners, frustrating the Obama administration as it looks for ways to boost a floundering economy.

Edward J. DeMarco, acting director of the Federal Housing Finance Agency (FHFA), said the agency’s analysis showed no sure-fire financial benefit to letting some mortgage holders reduce their loan amounts. He also warned that such a move could cause some borrowers to default intentionally in hopes of getting taxpayer aid. …

Treasury Secretary Timothy F. Geithner chastised DeMarco for his decision in a letter Tuesday, even as he acknowledged DeMarco’s right to forbid principal reduction in his role as independent regulator for Fannie and Freddie.

“Five years into the housing crisis, millions of homeowners are still struggling to stay in their homes and the legacy of the crisis continues to weigh on the market,” Geithner wrote. “You have the power to help more struggling homeowners and help heal the remaining damage from the housing crisis.”

Geither argued that a principal-reduction plan might save taxpayers $1 billion, and Fannie Mae and Freddie Mac close to $4 billion.  DeMarco responded by saying that was true — under the most optimistic scenario possible.  DeMarco decided that the incentive to default and rely on government aid for principal reduction would be too attractive an incentive for more homeowners than necessary, and that the damage done to the market might be incalculable:

DeMarco reiterated his concern about the potential long-term consequences of principal forgiveness, saying that rewriting valid contracts could spook investors, encourage bad behavior on the part of homeowners and increase mortgage costs in the future. “It’s an important thing for us, the policymakers, to weigh,” DeMarco said, even as he acknowledged that such effects are “not readily measurable.”

Diana Olick noted the reasoning in more detail for CNBC:

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.

Not only that, DeMarco and Olick noted, but the supposed savings are mostly a shell game:

The FHFA estimates that up to 500,000 Fannie and Freddie borrowers could have been eligible for principal reduction. The Treasury’s current program pays lenders large incentives to write down loan balances, using unspent money from the $700 billion TARP (Troubled Asset Relief Program). But FHFA says despite a positive financial benefit to Fannie and Freddie, it is really just a transfer of taxpayer funds, adding “to the over $188 billion in taxpayer support the Enterprises have already received.”

Olick also hears grumbling on Capitol Hill in reaction to DeMarco’s decision, and we may yet see legislation to force DeMarco’s hand.  Of course, this is exactly what the lending markets don’t need — more instability for investors, and more government interventions to change the terms of their investments ex post facto. If the government insists on forcing a write-down on existing mortgages, fewer investors in the future will put their capital at risk in this market, which will make lending much more difficult and further discourage any risk-taking.  Washington politicians have already been complaining about reluctance on the part of lenders to make loans except under minimal-risk scenarios, and an intervention will only reinforce those strategies.

DeMarco got this right, but don’t expect him to get any credit for it with the same people who brought us the 1998-2008 housing bubble in the first place.