Originally published in U.S. New & World Report's "The Home Front" blog on April 17, 2012.

With four million homes lost to foreclosure since the housing crisis began, and another 11 million borrowers underwater on their mortgages today, housing policy is focused on keeping current homeowners from losing their homes. This year, Washington housing wonks have fought over “principal reduction”: reducing mortgage loan balances for underwater borrowers to help them stay in their homes. The fight has turned nasty and personal with Edward DeMarco, acting director of the Federal Housing Finance Agency (FHFA)—the regulator of Fannie Mae and Freddie Mac—at its center.

It’s an insiders’ fight, hardly registering on Main Street or in the election campaign, and that’s no surprise. The election campaign turned to housing only in January and February, when states suffering most from the housing bust—Florida, Nevada, and Arizona—held their Republican primaries and caucuses.

However, the fight over principal reduction hits all the big themes in the national debate over housing policy that will resurface as the presidential election draws near.

As with all housing policy during this recession, the debate over principal reduction is one small piece in a big, messy puzzle. There are many government policies in place or under discussion that try to help homeowners stay in their homes. Each policy or proposal focuses on some types of borrowers and not others. The key criteria for whether a borrower is eligible for these programs are:

  1. Whether the borrower is current on their mortgage payments;
  2. Whether their mortgage payments are more than 31 percent of their pre-tax income;
  3. How far underwater the borrower is;
  4. Who owns, guarantees, or insures the loan

The fourth piece—who owns, guarantees or insures your mortgage—makes housing policy a confusing mess. Only borrowers with Fannie- or Freddie-backed mortgages (60 percent of all mortgages) are eligible for refinancing under the Home Affordable Refinance Program (HARP). If that sounds unfair, take heart: President Obama thinks so, too, proposing in his State of the Union address a plan to make refinancing widely available to borrowers with mortgages not backed by Fannie or Freddie.

The Home Affordable Modification Program (HAMP), which modifies loans using various tools in order to reduce monthly payments, is different: unlike HARP, HAMP isn’t just restricted to Fannie- or Freddie-backed loans. In fact, HAMP loan modifications can go further for borrowers who don’t have Fannie or Freddie loans.

Here’s why: the FHFA allows Fannie and Freddie to modify loans under HAMP by lowering the interest rate, extending the term of the loan and deferring principal interest free, but not by reducing principal. Other mortgage servicers do use principal reduction as a tool to modify non-Fannie or Freddie loans (though only in 30 percent of loan modifications, so even when allowed it’s not the number one tool).

That’s what the big fight in Washington is about: getting the FHFA to add principal reduction to the list of approved tools in HAMP loan modifications. You wouldn’t know it from the fighting, but the stakes are actually pretty small—the FHFA allows Fannie and Freddie to use several other tools for loan modification, so it’s not as if the FHFA is choosing between principal reductions and doing nothing. The reason why it’s a big fight is because of the FHFA’s reluctance on the following:

  • First, the FHFA has argued that principal reduction would cost Fannie and Freddie—and therefore taxpayers—more money than other tools like principal deferral. But the administration has sweetened the pot for principal reduction by tripling the subsidy they would give Fannie and Freddie (and other mortgage investors) for principal reduction, deflating the argument that principal reduction will cost Fannie and Freddie more than other loan-modification tools.
  • Second, the FHFA is concerned that principal reduction might encourage some borrowers to fall behind on their payments in order to try to get a principal reduction. In other words, it gives borrowers an incentive to become “strategic modifiers.” Those who want the FHFA to allow principal reductions—including the Obama administration and many Democrats in Congress—think that concerns about borrowers trying to game the system as “strategic modifiers” are overblown, and that principal reduction is crucial for stemming defaults and foreclosures.

Regardless of what the FHFA decides in the coming weeks, the fuss over principal reduction underscores the three big lessons about US housing policy:

U.S. housing policy is a sloppy patchwork. Eligibility for government mortgage-relief programs depends on who owns, guarantees, or insures your mortgage. That’s true not just for HAMP and HARP; it’s also true for the robo-signing settlement, which calls for $25 billion in principal reductions, other loan modifications, refinancing, and compensation for those who lost their homes to foreclosure—but only for borrowers whose mortgages are serviced by the five banks in the settlement. If your mortgage is serviced by someone else or owned by Fannie or Freddie, no money for you.

This is obviously inequitable: people in similar financial straits with similar mortgage balances get treated differently based on who has their mortgage. It also means that most new housing policies are incremental, affecting some borrowers and not others, rather than being holistic. Ultimately, it’s hard to solve a big problem like 11 million underwater borrowers in small steps.

It’s all about who pays. Most housing policies—including refinancing and loan modifications—will cost somebody something, and that somebody is usually taxpayers or investors. In the FHFA principal reduction debate, “who pays” is front and center because the FHFA’s acting director is responsible for the financial health of Fannie and Freddie. Boosting the government subsidy for principal reductions shifts “who pays” from Fannie and Freddie to the Treasury, which might soften the FHFA’s objection to principal reduction. Of course, since the government bailed out Fannie and Freddie, ultimately “who pays” is the taxpayer regardless of whether the Treasury (i.e., the taxpayer) is subsidizing Fannie and Freddie.

Part of the game of “who pays” is to make it harder for financial overseers and budget-watchers to object. Make no mistake: “who pays” is a partisan issue. Republicans care more about reducing the federal deficit than Democrats do, but Democrats are more eager to help homeowners avoid defaults and foreclosures, according to Trulia’s survey on housing policy and the 2012 presidential election. That’s one reason why Democrats are coming down harder on DeMarco than Republicans are.

Moral hazard is a political landmine. Here’s where housing politics get ugly. If you help people in financial trouble, it’s really hard to distinguish who had unavoidable bad luck from who made foolish or risky choices. Worse, policies can create “moral hazard” if they encourage people to take risks or game the system because they believe someone else will pick up the tab. Reasonable people can have different views about how big a problem moral hazard is: no one really knows how many borrowers will purposely fall behind on their payments in the hopes of getting an FHFA-approved principal reduction.

But what’s clear is that accepting moral hazard is a partisan issue. Trulia’s survey revealed that 61 percent of Democratsagreed that “helping people keep their homes is the right policy even if it helps some undeserving homeowners,” but only 38 percent of Republicans agreed. By focusing on moral hazard and on the cost to taxpayers, the FHFA has taken stances that fit better with the Republican view of housing policy.

No wonder DeMarco has been getting an earful—at least on this issue—from the Democrats.