Last summer, Federal Housing Finance Agency chief Edward DeMarco made a fatal mistake: He flatly refused to consider principal reduction on underwater mortgage loans backed by Fannie Mae and Freddie Mac. Perhaps DeMarco thought an Obama reelection wasn't in the cards, or maybe he really was concerned about the use of public funds toward such an endeavor. At any rate, rumors of his ouster were prescient, as President Obama has just nominated a replacement, Representative Mel Watt, a Democrat from Charlotte, North Carolina.

Mortgage REITs begin their plunge
It didn't take long for investors to show their concern, and by mid-afternoon yesterday, Annaly Capital (NLY 1.33%) and fellow agency players American Capital Agency (AGNC 0.99%) and Armour Residential (ARR 2.60%) had dropped sharply after the opening bell. By the market's close, each fell by 0.69%, 0.87%, and 1.23%, sequentially.

Investors may feel that Watt will be much more open to the principal-reduction scenario -- which would unleash a rash of prepayments possibly never seen before, as owners of troubled home loans not previously eligible to do so rush to refinance under more amenable terms.

Are they right? Could be. Watt has a history of consumer-protection leanings, having co-sponsored the Credit Card Accountability, Responsibility and Disclosure Act of 2009, in addition to advocating for the revamping of mortgage lending procedures. Despite these activities, he hasn't alienated Wall Street, and has been a recipient of healthy campaign contributions from both banks and insurers, according to The Wall Street Journal. 

Not a shoo-in
Watt faces a tough nomination process, however. Obama's previous effort to replace DeMarco ended in failure two years ago, when Republican hostility caused that candidate to withdraw. Watt's left-of-center views, including his support of making home loans more available to low-income and minority borrowers, will likely not endear him to the political right. Senator Bob Corker, R-Tennessee, has already been quite vocal in his dismay regarding Obama's plan to nominate Watt, labeling the choice as "political" and comparable to "the fox...guarding the hen house."

Despite these roadblocks, the Obama administration will certainly be better positioned to fend off opposition this time around, and Watt's nomination has already gotten the thumbs-up from several influential politicians, including Erskine Bowles and Alan Simpson, co-chairs of Obama's Deficit Commission. 

If Watt emerges victorious, mREITs will be in a more precarious position than they were last November, when banks were inundated with refinance work, and were therefore unlikely to take on more even if it came their way. With the mortgage business drying up, though, this threat looms larger than ever.

Still, the agency would need changes to its charter to pave the way for principal forgiveness for loans backed by Fannie and Freddie, and that surely wouldn't happen overnight, giving the industry time to come up with options. The mREIT sector managed to survive quantitative easing, after all. For Annaly and the others, a change at the FHFA may very well turn out to be just another surmountable obstruction on the well-traveled road to double-digit yields.

Editor's note: A previous version of this article stated that NLY, AGNC, and ARR dropped 90% from the opening bell. The Fool regrets the error.