Liberals have been jumping on Federal Housing Finance Agency (FHFA) leader Ed DeMarco for not allowing principal reduction for mortgages held by Fannie Mae and Freddie Mac. Such a policy would bring many homeowners above water and allow them to refinance at lower interest rates and afford their mortgages. Here’s Krugman:

In any case, however, deciding whether debt relief is a good policy for the nation as a whole is not DeMarco’s job. His job — as long as he keeps it, which I hope is a very short period of time — is to run his agency. If the Secretary of the Treasury, acting on behalf of the president, believes that it is in the national interest to spend some taxpayer funds on debt relief, in a way that actually improves the FHFA’s budget position, the agency’s director has no business deciding on his own that he prefers not to act.

I don’t know what DeMarco’s specific legal mandate is. But there is simply no way that it makes sense for an agency director to use his position to block implementation of the president’s economic policy, not because it would hurt his agency’s operations, but simply because he disagrees with that policy.

That’s 100% correct and it’s terrible that DeMarco is overstepping his bounds. However, DeMarco also made one good point:

Perhaps the greatest risk of the Enterprises’ allowing principal forgiveness is one with far more significant 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. Longer-term, this view could lead to higher mortgage rates, a constriction in mortgage credit lending or both, outcomes that would be inconsistent with FHFA’s mandate to promote stability and liquidity in mortgage markets and access to mortgage credit.

I’ve talked about this before in using eminent domain for principal reduction. It’s a real issue that many economic bloggers are overlooking. Here’s Felix Salmon’s response:

Higher mortgage rates? Um, fine: no one is exactly complaining that mortgage rates are too high right now. A constriction in mortgage credit lending? That’s fine too: it was too-lax credit lending that caused this whole problem in the first place. Both together? Even that’s fine: it would help bring homeownership rates down from their current too-high levels, and encourage more people to rent rather than own, creating a more flexible national labor force.

Over at Free Exchange, Ryan Avent wrote, “Over the long term, it’s no bad thing to make homeownership in America a little more difficult and expensive.” But this is the wrong way of looking at it. Right now, the American mortgage system is filled with inefficiencies that incentivize homeowners who cannot afford homes to purchase them. Principal reduction just uses  greater, unnecessary risk to offset these inefficiencies.

Consider a perfect free-market system: people buy homes at the exact level they can afford them. The market is stable with no market failures or inefficiencies. Now, consider the past decade of home ownership. The mortgage interest-rate tax deduction, sleazy bankers, shady rating agencies, lack of information and other market incentives skewed the market and led to the housing bubble. Interest rates (or teaser rates) were too low. The correct response to this is to eliminate these market failures: get rid of the mortgage rate deduction, regulate the banks, clarify mortgage rate information, etc etc. Doing so correctly would bring us to that perfect free-market system with a correct level of housing supply and home-ownership.

But increasing risk in a different sector of the market just puts another market inefficiency in place to offset the ones already there.

Let’s say we go through with principal reduction and interest rates rise a bit. At the moment, it brings housing supply back to a level near optimal level since supply was too high already. But now let’s say we eliminate all those other inefficiencies (as we should strive to do). Now the only inefficiency in the system is the extra risk from principal reduction. Interest rates are now slightly above the optimal level.

Thus, now we want to correct this as well? Too bad. The risk is part of the system. We’re forever left with slightly higher rates for homeowners and slightly fewer homeowners than under a perfect free market system.

Now a few years ago, I would have said this would be a worthwhile trade-off. Housing was so bad that it was worth using principal reduction to spur on the market and try to avoid an ugly, nasty recession. But we didn’t do so and we got that recession. Now, however, the housing market is recovering! Principal reduction would certainly spur it along and help underwater homeowners, but it would no longer be worth the cost of permanently higher housing prices.