Is Mortgage-Debt Forgiveness Worth the ‘Moral Hazard’?

It’s been one of the most vexing problems of the mortgage crisis: Do policies to restructure loans for underwater borrowers encourage homeowners who don’t need help to default?

The federal regulator for mortgage-finance giants Fannie Mae and Freddie Mac said creating such a “moral hazard” is one of his top concerns now that the Treasury Department has offered to subsidize the costs of debt forgiveness for loans backed by the firms.

“What I’m really worried about is what happens if you put an incentive shift out there that says, ‘If you can demonstrate hardship, you can have your debt forgiven,’” said Edward DeMarco, the acting director of the Federal Housing Finance Agency, in an interview with The Wall Street Journal.

Right now, about three-quarters of homeowners who are deeply underwater on mortgages backed by Fannie and Freddie are still making payments. (“Underwater” borrowers owe more than their homes are worth.)

There’s been little research on the subject, in part because the speed and depth of the housing price-crash of the past five years has little national precedent.

One study suggests such concerns aren’t without reason. In 2008, Bank of America agreed to modify mortgages in a settlement related to allegedly predatory lending practices at Countrywide Financial Corp. A study published in January 2011 by economists at Columbia University concluded that Countrywide’s relative delinquency rate “increased substantially…during the months immediately after the public announcement of settlement.”

Moreover, the borrowers most likely to default after that announcement “were the borrowers least likely to default otherwise.”

Christopher Mayer, an economist at Columbia Business School and one of the study’s authors, says the risk of those strategic defaults is “certainly something to be worried about.” But he adds: “You can’t point to this and say, ‘Well we can’t do any modifications.’”

Most modifications today reduce monthly payments by lowering the interest rate, extending the loan term, and offering forbearance, where payments aren’t required on a portion of the loan balance. So far, Mr. DeMarco says the performance of modified mortgages depends most heavily on how much a borrower’s monthly payment has been reduced—not the extent to which a borrower is upside-down on the mortgage.

“We’re just not seeing the borrowers’ willingness to pay vary by their loan-to-value,” said Mr. DeMarco.

But advocates of write-downs say banks can design programs that help limit their appeal to only the most desperate homeowners. “You need to introduce frictions to achieving principal write-down so that those who really need it, get it, and those who don’t really need it will see that the other guy is getting not a windfall,” says Laurie Goodman, senior managing director at Amherst Securities Group LP.

One potential “friction,” for example, could limit the program only to borrowers who were delinquent at the time the program was announced. Others have suggested a debt-for-equity swap that would allow Fannie and Freddie to share in any future appreciation.

Bloomberg News
William Dudley, president of the Federal Reserve Bank of New York

The program under consideration by Fannie and Freddie would only modify loans for homeowners who are already behind on their payments or highly at risk of default—and not all of those borrowers would receive write-downs under complex formulas that haven’t been made public. In other words, borrowers who default in order to receive help could end up getting nothing.

Some advocates of principal write-downs say that lenders may actually be creating a moral hazard today by failing to craft adequate solutions for deeply underwater homeowners. William Dudley, president of the Federal Reserve Bank of New York, earlier this year spoke out in favor of principal reductions for borrowers who are current on their mortgages.

I am uncomfortable with the notion that “underwater” borrowers who owe more on their mortgages than their homes are worth should have to go delinquent before they have a chance of securing a reduction in their mortgage debt. I believe we should also develop a program for earned principal reduction for borrowers who are underwater but keep on making their mortgage payments…

It is admittedly challenging to predict how underwater borrowers will ultimately perform and this performance will be sensitive to the path of home prices. Nonetheless, analysis by my staff that looks at likely borrower behavior over an extended time horizon suggests that without a significant turnaround in home prices and employment, a substantial proportion of those loans that are deeply underwater will ultimately default — absent an earned principal reduction program.

Readers, what do you think: Should policy makers bite the bullet and encourage more loan forgiveness to prevent a big uptick in strategic defaults in the coming years, or is that only going to invite a greater moral hazard?

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