By James Sterngold
August 8, 2012

FORTUNE — Is the agency in charge of Fannie Mae and Freddie Mac working for taxpayers or homeowners looking for help?

That’s the question being debated after Edward DeMarco, the acting director of the Federal Housing Finance Agency, rejected the Treasury’s proposal for a mortgage principal reduction program last week. His critics, from Treasury Secretary Timothy Geithner to columnist Paul Krugman, protested what some regarded as DeMarco’s heartless decision. The policy, the Obama administration argued, would keep troubled borrowers in their homes, avoid a further wave of distressed home sales and thus revive the sluggish economy. For DeMarco, the reasoning seemed clear – he was protecting taxpayers, not a few homeowners.

When Congress created the FHFA at the height of the financial crisis in 2008 to bail out the failing mortgage giants, Fannie Mae and Freddie Mac, the aim was to halt a cataclysmic meltdown, not fine-tune a national housing strategy. But four years into the stumbling recovery, that is what he’s being asked to do, and he is resisting, highlighting a critical, unresolved question – who DeMarco works for.

A career civil servant rather than a policy architect, DeMarco thumbed his nose at the Treasury and even many members of Congress when he said he was answering directly to taxpayers. He is officially the “conservator” of Fannie and Freddie, and he has made clear he sees it as his role to conserve assets for taxpayers rather than just conserve homes for a limited number of troubled borrowers, and certainly not veer off in new policy directions. Geithner protested that the program would be a net plus while Krugman suggested he was aligned with right wing ideologues and demanded that DeMarco be fired.

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In an analysis, the FHFA noted that the mortgage agencies actually could profit from a well-crafted principal forgiveness program. The problem, it said, was that taxpayers might bear some cost because the Treasury promised to subsidize part of the immediate losses from the principal write-downs.

The law that created the agency “requires FHFA to consider not just cost to the Enterprises.” The Treasury had offered to cover as much as 63% of the losses from principal reductions, and that would come from money already appropriated years ago under the TARP rescue program. But it’s still taxpayer money.

The FHFA analysis “absolutely makes no sense,” said Laurie Goodman, a housing analyst and senior managing director at Amherst Securities Group. Private mortgage lenders have been experimenting with various types of principal reduction quite successfully, she said, and in the long term any costs to the taxpayer will be returned when the economy improves. “We’re just frozen in place” in housing policy because of DeMarco’s narrow reading of his mandate, she said.

The boards of Fannie and Freddie have debated these issues, but have decided “they don’t do social policy,” said a person who has worked closely with the agencies. The only way to change that, he said, would be for Congress to amend DeMarco’s mandate and eliminate or redefine the “conservator” function, and that’s not likely to happen in an election year.

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The Federal Reserve estimates that $7 trillion in value has been wiped out since the subprime mortgage-fueled meltdown and housing prices are still down about a third overall. But a major issue now is “shadow inventory” – the millions of homes either in or moving toward default, which will probably lead to massive numbers of forced sales.

The Treasury has initiated a series of programs for modifying loans or helping under water borrowers – those with homes worth less than the outstanding principal of their mortgages – to refinance at lower rates. But the government says there are more than 11 million homes that are under water. Goodman says as many as 9 million homes could be pushed into distressed sales in the next few years. But in the first five months of this year only 78,000 borrowers were able to refinance under the government program, which is why some experts feel principal reductions are essential.

DeMarco stressed that all taxpayers would, in effect, be subsidizing a smaller number of homeowners, an unfair benefit for the few. If a homeowner gets a principal reduction, lowering his monthly costs, and then the home value appreciates in the future, “all the upside goes to the individual borrower,” not taxpayers, he said.

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That’s why some have argued for what is called forbearance rather than outright forgiveness of some loan principal. Under this approach, the borrower stops paying interest on a portion of the mortgage principal, but if he later sells the house at a profit, he must repay the sum that had been set aside. If the homeowner does sell at a loss or loses the property through foreclosure, that portion of the loan principal is essentially written off. (Update: The FHFA says it has been using some forbearance; in the first quarter of this year, 32% of its modifications, or 19,311 cases, included principal forbearance. Some experts say the tactic should be used more.)

“What’s obscured by this debate is we already have a piece of the puzzle and we know that principal reduction through forbearance is working,” said Susan Wachter, a housing finance expert at the University of Pennsylvania’s Wharton School. She said some private lenders are already doing it with good results. The approach should be expanded. The problem for DeMarco, she said, is that “in his head, he’s just acting as a conservator.”

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