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Dukes of Moral Hazard

January 17, 2010


The Treasury Department last Friday released the latest monthly report on its Making Home Affordable mortgage modification effort.  It showed significant growth in the number of trail modifications, to more than 1 million, as well as the number of final modifications, which rose from a measly 30,000 to more than double that, with another 46,000 pending final resolution.  But as heartening as these numbers might be, they must be considered in the context of 2.8 million foreclosures in 2009 and at least another 2 million estimated for 2010.

The rapid deflation of the housing bubble also has left millions of homeowners deeply underwater on their mortgages, eg., they owe more than their homes would fetch if sold.  The GAO this month released a report that 

“estimated that one-quarter of nonprime borrowers with active loans nationwide had negative equity in their homes as of June 30, 2009. We also found that the incidence of negative equity was highest among borrowers who obtained their mortgages in 2005, 2006, and 2007.”

Stubbornly high rates of delinquency and default and negative equity appear to have a growing correlation.  In a recent report, the New York Fed concluded that loan modifications that included a write down of principal, alone or in addition to other moves such as reducing the interest rate, had a much lower likelihood of defaulting again than loans that did not.   

One of the arguments raised most often against principal reductions is the “moral hazard” associated with such moves.  When some owners have their debt forgiven and others do not, the argument goes, the hazard of other borrowers defaulting on their loans to secure similar reductions increases.  Allowing some borrowers to escape their “moral obligation” to pay off debts risks infecting the whole system with a bad case of “walk aways.”  

I don’t want to diminish this risk.  It’s real.  It’s a nightmare for lenders holding loans.  It’s a dilemma for policymakers.  But it’s worth keeping in mind that many of the loans that are so deeply underwater were extended to borrowers without adequate disclosure.  They contained tricks and traps that have made it difficult, if not impossible, for consumers to pay them back.  The broad devastation wrought by unregulated and unbridled asset-based lending has dropped the floor from beneath millions of owners whose only mistake was buying at the top of the market, or in a neighborhood where other buyers got  in over their heads.  

It’s vexing beyond belief to see some of the same policy wonks that approved using TARP money to pay Goldman Sachs and others 100 cents on the dollar for bets they made with the undercapitalized counterparty AIG argue  that hapless homeowners should be held to a higher standard of financial discipline.

Stephen Colbert nails it in this clip from the January 14, 2010 Colbert Report.  Following that is a more straightforward clip featuring analyst Josh Rosner on the same topic.


The Colbert Report Mon - Thurs 11:30pm / 10:30c
The Word - Honor Bound
Colbert Report Full Episodes Political Humor Economy




It is a myth that the HAMP does not “allow” principal reductions.  However, the government subsidy for such a modification is no greater than the government subsidy for a rate reduction mod.  And virtually no banks are doing a HAMP mod via a principal reduction to get the front end DTI down to 31% because the NPV cost is really huge.  Should the government encourage more principal reduction mods?  Maybe.  Should the government (meaning taxpayers) pay for such mods? NO.

By Tom Lawler on 2010 01 18

A number of borrowers did not understand the terms and conditions of the mortgages they took out—including total costs, potential rate hikes from resets, neg am, etc.  But very few borrowers did not know HOW MUCH they were borrowing.  Most borrowers who are upside down are in that position because home prices have fallen a lot in many areas, and the ones most upside down either (1) put little or nothing down; or (2) extracted “equity” from their homes.

By Tom Lawler on 2010 01 18

Tom is right, principal forebearance is a permissible HAMP modification, and the December report notes that 26.6% of the mods so far have included it in some measure.  Treasury could—and likely will—do more to encourage principal write-downs by recognizing the impact such reductions have on redefault rates.

By Barry on 2010 01 18

But if only portfolio lenders are offering principal reductions, which the OCC report suggests, more encouragement is called for.  If the USG could buy the loans at a discount and hold a long term interest if the value climbs, I don’t know why this isn’t a good use of taxpayer funds to stem foreclosures and restore some balance to the market.

By Barry on 2010 01 18

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By JoyncSow on 2012 10 12

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