3 ways to write down mortgages without moral hazardMarch 28, 2012: 11:57 AM ET
A plan to offer principal mortgage reductions to struggling homeowners could backfire by encouraging many to stop making their payments. Here are some ways around that.
FORTUNE – Pressures have been mounting to give struggling homeowners financial relief by reducing the principal on their home loans – a key ingredient, many economists agree, to solving America's housing woes.
Over the next few weeks, acting Federal Housing Finance Agency director Edward DeMarco will decide whether he will allow Freddie Mac and Fannie Mae to reduce loan balances. DeMarco is skeptical about the idea. Even as Congress, the Federal Reserve and the Obama administration call on the mortgage companies to write down home loans they own or guarantee, DeMarco points to several reasons why that's a bad idea. His latest argument, as reported by The Financial Times: It would amount to another bailout for the big banks, whose second mortgages are subordinate to the primary mortgages backed by Fannie and Freddie.
That's one way to see it. DeMarco is solely responsible for minimizing taxpayer losses following the government's bailout of Fannie and Feddie in 2008. Ultimately, the overarching worry is that principal reductions would encourage moral hazard, that it would unleash a flood of borrowers strategically stopping payments on their mortgages just so they can weasel their way into lower principals.
That can certainly happen. But here are three ways to provide relief and keep moral hazard in check:
Give lenders and borrowers a stake in the deal
If borrowers have a stake in the deal, that might keep some from trying to score a reduction. Under what's commonly called a "shared equity" plan, underwater borrowers have their principals reduced to their property's current value. In exchange, if the price of the property rises in the future, the lender would have a claim on a portion of the increase.
Using an example from economist Bill Wheaton at M.I.T., here's how the plan could work: Say a borrower bought his house for $100,000 a few years ago. But then the price of the home has fallen by 40% to $60,000. Rather than risk foreclosure, the lender could lower his mortgage's principal to the home's current value. In turn, the lender would have a 50% claim if the home's value rises in the future – capped at $40,000. So years from now when the owner sells the home for – say, $90, 000, the lender would collect $15,000 of the sales proceeds.
This set-up isn't perfect. And lenders would probably endure some losses. Nevertheless, the claim on future appreciation might be enough to attract only those who really need mortgage relief.
Give borrowers incentives
If the fear is that principal reductions will set off a flurry of unpaid mortgages, then it probably makes sense to give borrowers incentives to actually pay down their loans.
In an interview with Fortune, former FHFA director James Lockhart said the agency should move forward with at least a test plan to reduce principals. Lockhart, who stepped down from the agency in 2009 and is currently vice chairman of private equity firm WL Ross & Co., acknowledges the risks of moral hazard.
But a way to avoid that, he says, is by making reductions contingent on borrowers behaving responsibly. A reduced principal wouldn't happen instantaneously. Instead, when borrowers send off a mortgage payment, a percentage of the principal gets knocked off until it gradually falls to the property's current value.
Not all write-offs should be created equal
Economist Dean Baker at the Center for Economic and Policy Research gives the following scenario: A borrower tells his neighbor, 'Hey, I got my lender to lower my principal so I'm no longer underwater. Here's how I did it.' Armed with precise information about how the process works, the neighbor does the same. And then his neighbor, and so on.
"You have to restrict it, and one the ways to restrict it is by requiring borrowers to demonstrate their inability to pay," Baker says.
Of course, borrowers can always manipulate their income. But by implementing a program where the outcome is less certain, and the amount of reductions vary depending on the finances of each borrower could discourage those trying to milk the system. In other words, if it isn't clear how much of a reduction one might get, then it's likely many will not go through the hassle of trying.
And while there are roughly 11 million homeowners underwater on their mortgages, representing about 23% of all residential properties with mortgages, Moody's Analytics chief economist Mark Zandi says only roughly half a million principal reductions are needed to push home prices up again. So any reduction plan could be targeted to a selected few borrowers over only 18 to 24 months.
"Once prices start to rise, that gives other homeowners an even greater hook to hold onto their homes," Zandi adds.