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Moral Hazard and Mortgage Modifications

posted by Adam Levitin

Bring out the Vice Squad--we've got a Moral Hazard.  Yup, some of the reluctant AGs have now expressed concerns over principal write-downs in a servicing fraud settlement because it might create....moral hazard. Some bank CEOs and other predictable voices jumped on the moral hazard bandwagon.

Yes, there's some moral hazard in doing principal reduction mods if you only offer them to defaulted borrowers and the borrowers no that. That's hardly surprising. But so what? Just because something creates a moral hazard doesn't mean it's the wrong thing to do. There's more to that equation. 

Larry Summers showed pretty handily why too much belly aching over moral hazard is silly. As Summers argued, when there's a fire next door, you help put out the fire; you don't first ask if the fire was caused by lightning or by your neighbor smoking in bed. Yet putting out the fire irrespective of cause creates a moral hazard by bailing out in-bed smokers. The reason why we do this (and why we have fire departments) is that concerns over externalities can trump moral hazard concerns--if my neighbor's house catches fire, mine is at risk. So too if my neighbor's house goes into foreclosure, my property value is going to plummet.

Basically, we're looking at a Type 1 vs. Type 2 error problem--too many mods (some go to the undeserving) or too few. There are costs either way, but too many mods is not as likely to cause further downward pressure on housing prices as too few mods.  Laurie Goodman, the leading MBS analyst around, didn't miss this. In a recent research report, she writes:

Principal reductions are clearly the most effective type of modification. This makes sense, as equity is the most important determinant of default. There are many ways to both effect a principal reduction and contain the moral hazard issue. All our ideas boil down to one simple notion—create a series of frictions such that only those borrowers who need this type of modification will take advantage of it. The frictions ensure that fairness issues are minimized, as the receipt of a principal reduction entails other penalties.

 We applaud the Attorneys’ General proposal, as principal reductions are at the heart of their recommended course of action. Indeed, principal reduction is the single most important supply side measure that can be taken. [Laurie goes on to state that principal reduction alone, however, is not sufficient.]

Laurie also makes short shrift of the moral hazard argument:

First, the current modification program [HAMP] already has a moral hazard issue; borrowers are clearly defaulting to get a rate reduction.

Second, we can introduce a series of frictions so borrowers who need the principal reduction are able to obtain it, and those who don’t need principal reduction are not envious of those who receive it.

Third, the moral hazard problem only extends to underwater borrowers, of which there are a finite amount, and the overhang can be sized.

We actually have a pretty easy solution to moral hazard concerns about principal reduction--it's called bankruptcy. A critical reason for using bankruptcy to do principal reductions (cramdown) is to impose some costs on the homeowner beneficiary so that only those who need help will seek it. Bankruptcy provides the "frictions" that Laurie Goodman writes about. Somehow, I suspect that all of those crying moral hazard now also opposed cramdown.  (Certainly Stumpf and Moniyhan were opposed.) If so, the issue really isn't moral hazard. Moral hazard is just an argument being made to avoid principal write-downs, not because of genuine concern over the issue. 

Comments

Adam,

Always focusing on the key points!

Moral Hazard...

Just one more example of how dysfunctional our financial systems have become. Federal regulations and a handful of banks create debt instruments designed to bleed the Middle-class American homeowner dry and then discuss the moral hazard of bleeding to death. Honestly sounds like a joke coming from the lips of half the guys you mentioned.

The newest weapon in the war for the middle class is going to be the Personalized Debt Settlement… leveraging all the pesky little tricks the bankers hate most like due process and strict rule of law. American Homeowners are (as much as I hate the word) entitled to a fair settlement under fair housing, debt lending laws, and a host of other state and federal regulations. http://diligencegroupllc.net/

Good attorneys are beginning to understand the opportunity to negotiate/litigate using basic design flaws in the financial systems created to secure and unsecure asset backed debt. Do the math on every single debt burdened family in America, and the banks will pay one inappropriate debt instrument after the other! With the right leverage in the Debt Negotiation Middle-class America, living in asset poverty, actually has a chance to reach a sustainable settlement without declaring bankruptcy… as any good old American Bank/Company/State does.

The American Middle-class had better wake up and rally against the financial bureaucracy or they will be gone. Adam Thanks again for keeping us focused on the moral imperatives.

American (Middleclass) Homeowner

-AH

Adam is quite right to point out the Type 2 error problem - that NOT doing principal reduction prevents necessary deleveraging for deserving borrowers.

When opponents of writedowns invoke moral hazard, they also ignore the moral hazard of doing nothing. Most of the good empirical research on moral hazard is actually about the risk that underwater borrowers will walk away because they are not getting modifications. For details, see http://pubcit.typepad.com/clpblog/2010/04/moral-hazard-strategic-default-and-debt-reduction.html.

Hmmm... So the "moral hazard" of principal write-down outweighs any moral "hazard" a borrower may have suffered at the hands of unscrupulous brokers steering them into 2-28s when they could have had 30y fixes, artificially inflated appraisals, etc. and any other "tricks" to get the loan to fly?

Do people truly think that 10 million borrowers got together and collectively decided to game the system all at once? Correct me, but I believe the last time a large group of American people got together to do anything collectively was roughly 1963 in D.C. For the purposes of this statement Woodstock, First Night and the Super Bowl, unfortunately, don't count.

I would also add to Ms. Goodman's first point in that, in many cases, borrowers are being INSTRUCTED to default on their mortgage in order to get a rate reduction. That shouldn't count as a ding against the borrower.

Adam, I assume you've seen this:
http://realestateresearch.frbatlanta.org/rer/2011/03/seductive-but-flawed-logic-of-principal-reduction.html
It made the rounds a few weeks ago, but didn't get much critical attention -- which is a shame since it's got some pretty obvious flaws from a policy perspective (some of which you touch upon here). As in your conclusion here, my first thought on reading it was that these sorts of arguments make a good case for "cramdown".

Please consider endorsing the Unitedinprosperity.org petition that will provide a consistent and similar financial benefit (modification) to every negative equity homeowner as capitalism and the law dictates. It is not a demand for principal reductions changing the concept and principles of capitalism for selected or targeted homeowners but a viable working solution protecting ALL homeowners and investors within capitalism and the law.

I really need everyone's help in forwarding the Unitedinprosperity.org petition via email, Facebook, articles, blogs or by whatever means you can, to stop the illegal and unnecessary foreclosures occurring harming our economy. I have been sending the Negative Equity Streamlined Uniform Modification System to the government for over 2 years with very polite responses that essentially state thank you but they know what they are doing. The only way to change the governments and Wall Street's attitude of "business as usual" to end the Negative Equity Housing and Foreclosure Crisis is with the combined voices of the American public, please join.


Home page of Unitedinprosperity.org
Did you know that every negative equity homeowner is legally entitled to the same modification? Why because when Wall Street changed a standard mortgage clause found in every mortgage loan pertaining to the standard operating practice of "don' pay, be foreclosed on" to "modifying instead of foreclosing " if modifying would avoid the investors guaranteed financial loss from the difference between the distressed sales price of a potential or possible foreclosed negative equity property and the outstanding mortgage amount due, Wall Street was fully aware that changing a legal clause had to be legally applied across the board to all similarly situated homeowners if the modification avoided the investors guaranteed financial loss within the provisions of existing law.

Instead Wall Street denies that the clause or policy was changed but that they are just following the governments directive to modify mortgages for affordability purposes. Their denial is "hogwash" when the financial industry physically issued almost 3 million modifications that weren't within the governments affordability standards to avoid the investors negative equity financial loss in addition to the 630,000 modifications that were issued for affordability purposes to avoid the investors negative equity financial loss.

Regardless, the legal consequence of issuing 3.5 million modifications set an industry wide precedent reaffirming the equal entitlement of every negative equity homeowner to a consistent similar financial incentive, benefit, compensation, reward, reimbursement, subsidy or advantage to remain a paying negative equity homeowner if the financial benefit avoided the investors negative equity loss.

*Sign the Unitedinprosperity.org petition to stop the bias and misleading "misrepresentation" being portrayed that affordability is why a modification is issued allowing the holdings of the government and Wall Street to violate the principle of "honest and good faith dealings" using "predatory mortgage servicing practices" and "unfair and deceptive business practices" by taking "undue financial advantage" of similarly situated homeowners who are paying or can afford to pay by restricting or denying them the same moral, ethical and legal entitlement of a modification violating numerous consumer, banking, civil, tort and business laws to maintain Wall Street's profits.

*Sign the Unitedinprosperity.org petition to provide every negative equity homeowner a consistent similar financial benefit as outlined in the attached Negative Equity Streamlined Uniform Modification System by demanding that the government lead by example starting with the mortgages of the Government Sponsored Enterprises by enforcing the rules of capitalism, existing laws and the industry wide precedent set creating a six billion dollar monthly taxpayer free stimulus for Wall Street to follow. Let's stop the policy of playing on the homeowners sense of moral obligation to remove themselves from receiving what is legally theirs to receive.

*Sign the Unitedinprosperity.org petition to stop paying for your neighbors mortgage and Wall Streets' unregulated capitalistic actions being paid thru back door deals, subsidies and guarantees. United we have the power for change we can believe in.

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