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Principal Reduction and Strategic Default

posted by Adam Levitin

Moral hazard, moral hazard, moral hazard....  How often have we heard that as a reason for why principal reductions can't be done.  As if it were the worst thing in the world.  

As an initial matter, we don't have to do principal reduction in a way that creates moral hazard, such as making principal reduction contingent on default and no strings attached. (To put it another way, we don't have to be stupid about the way we do principal reduction.) One solution would be principal reductions contingent on level of negative equity, not on default. Another would be to offer principal reductions only to those who have already defaulted (I don't like this because it penalizes those who kept paying, but the point is that it avoids moral hazard inducement). Another possibility would be to make principal reductions contingent upon paymentshared appreciation, which doesn't have to be a 50-50 split. Instead, it could be that initial appreciation goes all to the lender and then it starts to shift to the borrower. 

But let me suggest something counterintuitive and heterodox. Principal reduction is a case in which we WANT to encourage moral hazard. To understand why, you need to start with the understanding that our goal here is macroeconomic, not moral. The goal is stabilizing the housing market and the the economy, not balancing the moral cosmos and bringing harmony to the Force (not that there's anything wrong with that).

Making principal reduction contingent upon default means that there will be a bunch of people who default just to get the principal reduction. That's a "ruthless" group of people who are quite likely to be strategic defaulters otherwise. They are precisely the people who need to get principal reductions to incentivize them to stay in their homes in order to stabilize the market. We might not like rewarding people who would act opportunistically like this, but if you accept the issue as macroeconomic, not moral, then the results are what matter:  fewer foreclosures and a stabilized housing market.  


moral cosmos and bringing harmony to the Force (not that there's anything wrong with that).

Agreed, and I see nothing counter-intuitive about it. The current housing crisis is such that there *will* be "winners and losers." The bottom line now is to restore the economy ... without the money that has disappeared to Wall Street, probably for good.

As to your good sentiments for balancing the Cosmos, which I share, maybe with a restored economy America can move on to becoming a more equitable nation.

Considering that our entire capitalist system is predicated on the idea that everyone acting in their own economic self-interest produces the best allocation of resources, why would we suddenly be concerned with fairness?

What really irks me is that we already bought into the idea that economic security is more important than fairness when we bailed out the banks, but now that "they got theirs" we're done with it.

We made the classic mistake of half assing two objectives instead of whole assing one objective. Which, coincidentally enough, is my biggest complaint with damn near everything that has come out of the Obama administration--no public option with healthcare reform, haphazard prosecution of medical marijuana dispensaries, a war in Afghanistan whose entire purpose is to mitigate the damage of a war in Afghanistan.

It's okay, though; we might figure it out when the student loan bubble bursts.

"Moral hazard" makes me want to reach for my revolver. It is almost impossible to think of any public policy or private act that does not contain the seeds of moral hazard: creating adverse incentives that tend to undercut the purpose of the private policy or public act.

Consider police, for example. Police create moral hazard--you're somewhat less likely to take care of your own personal safety. Or consider the decision to set up a shop. You are creating incentives for people to steal your goods. The attorney-client privilege creates all kinds of socially perverse incentives. Think of the moral hazard created by the abolition of debtors' prison!

The only serious question is whether the perverse incentives (or consequences) outweigh the intended benefits, or can be significantly mitigated while retaining the benefits. The answer is usually somewhere between "no" and "hell no."

Ocwen has been offering an interesting modification. They give a principal reduction, but you agree that if the property gains equity, you pay a percentage of that equity back to Ocwen at the time of refinance, sell, or completion of the loan. This protects Ocwen from losing future appreciation and gives the homeowner the break he/she needs now. The only problem as I foresee it, is that it potentially locks the homeowner into the loan with Ocwen.

For example, if the client goes to refinance in 10 years and the property has appreciated by $50,000, the homeowner would have to pay a lump sum of cash to Ocwen in order to refinance (under the terms of the modification). If the homeowner doesn't have the lump sum of cash, he/she will not be able to refinance.

But, for the modification offers I've been seeing, the interest rate is low (usually 2%), so really the property owner might be better off with this loan for the long haul.

Cudos to Ocwen for at least putting an offer out there that really helps property owners instead of knocking off a few hundred dollars for a few years and requiring a huge balloon payment at the end of the loan.

With all this ‘moral’ discussion I wonder if we have taken our ‘eye off the prize’ which is operating your home as one would a business. If the business that you are engaged in at the time is not doing well for whatever reason it becomes a write-off before the owner(s) lose everything in a futile attempt to keep it afloat. Society has been treating consumers as disposable commodities and concern for others, by others, has disappeared on the moral landscape. Reduction of principle on tremendously underwater mortgages is not a ‘new idea’. In the last Great Depression this was accomplished. From Yahoo Finance, by Morgan Korn – Daily Ticker| Robert Shiller, a professor of economics at Yale University and co-creator of the Standard & Poor's/Case-Shiller Index, says the market has "a chance" of rebounding even though the downward momentum in the real estate market has accelerated in the past five years…Before housing can bottom, the problems facing mortgage giants Fannie Mae and Freddie Mac must be resolved, Shiller says in an interview with The Daily Ticker. There is speculation that Fannie and Freddie could sell bundles of foreclosed homes to hedge funds; NPR and ProPublica reported last week that both Fannie and Freddie are leaning toward principal mortgage write-downs and loan forgiveness. As economists and housing insiders continue to analyze every grain of housing data, most would agree that housing will continue to drag down the overall economic recovery in the near future. Many young people are choosing to live at home for a longer period of time instead of buying. Moreover, would-be homebuyers are settling into modern apartments and condominiums, further hindering a housing rally. Shiller says the shift toward renting and city living could mean "that we will never in our lifetime see a rebound in these prices in the suburbs."

This is one of the best posts I've seen on this issue in a long time, and I really like that you touched on incentives in your concluding paragraph. I read a book in grad school by Douglass North called "Institutions, Institutional Change and Economic Performance" and it influenced me profoundly. Now that I'm out of grad school, it seems that everyone is incentivized to behave in a certain way.

If you give people an incentive to change their behavior, usually they will do so. We're wasting valuable time trying to punish people (the wrong people, in my opinion) instead of fixing the problem. Arbitrary decisions are made all the time in these types of situations, and this needs to be one of them. We should focus on fixing the problem. If that means giving the ruthless strategic defaulters principal reductions, then so be it.

One related point. The major concern about moral hazard is not a fairness argument; rather, it is an argument that rewarding certain bad behavior will encourage future bad behavior. So the concern here is that by rewarding overleveraged homeowners now, we will encourage excessive leverage and risk-taking by homeowners in the future.

But does anyone actually think that future homeowners will behave in a way that ASSUMES another unprecedented housing crisis in which we experience a national 30% home price decline? This housing crisis was universally acknowledged as a catastrophic "black swan" type event. If we assume that homeowners are rational-- i.e., they are going to strategically default because they can get a principal reduction that is greater in benefits than the costs (damaged credit rating, reputation, etc.) they would incur-- then we must also assume that they would not behave in a way that assumes another 100-year flood is on the imminent horizon. Because that would be insane.

I don't really understand how the moral hazard argument applies at all to homeowners here. I would love to hear a good argument, but as far as I can see, claims of moral hazard are basically now a form of Tea Party-type rhetoric, and not grounded in actual facts or logic.

Can someone help ME out? Ive raised an enormous amount of money to refinance through working three part time jobs and one full time. Im constantly working and saving, despite financial and physical setbacks from an accident. Ive never been even an hour late on any payment ever. As fast as I save, the lower my house goes. The LTV refi rate here is 90%. I dont qualify for HARP. I wont be able to keep my home. I hear banks say to me, I feel for you, youre in a tough spot. Yes, is that all I can do? You're not going to be able to sell it for what Im willing to buy it for. I can afford my payment clearly, but they wont let me keep my house in the long run. The rate will keep adjusting and the bottom is about to fall out from the settlement and upcoming foreclosure flood. How am I not the one deserving if help? I am not asking for favors. The favors are not set up for people who spend all their free time working odd jobs to the point they feel guilty breathing without working. I do, I feel guilty when Im not working. I have no quality of life. What message is all this sending to people like me? Truly. Before this is over my credit will be destroyed and I will be kicked out of my house with no savings. This is the other side if the picture. Everyone needs to look at it, everyone.

It never ceases to amaze me how successful policy-makers and policy-influencers have been in changing the subject to benefit never-to-be prosecuted fraudulent loan originators and taxpayer-funded accomplices, Fannie & Freddi.

Bravo to all of you American Bankers and Fearful of crossing American Bankers out there! So what if the statute of limitations has run on those millions of juiced appraisals, fabricated loan applications, botched and forged securitizations! Nobody who has their job because they are supposed to care cares, so let's move on.

Yes, let's change the subject... let's pretend the most important thing is to appear compassionate for all those responsible, albeit idiotic homeowners who bought into the bubble and have been (waterboarded) drowning ever since. (And while we're at it... let's figure out ways to suck more of their blood along the way.) Let's talk about adding principal reduction into a new and improved HARuMPh program.

In the name of "moral hazard" (not applicable to immoral loan originators and their eager accomplices), let's make the idiot-responsible borrowers give us half of any price appreciation from the date they HARuMPh themselves.

You may ask - why would any homeowner who was so grossly abused now be expected to give that same team of complicit parasites a slice of future "appreciation"?

Will the parasites have to share future "depreciation?" No.

What if the homeowner finally opens his wallet to pay for deferred maintenance... does he get that investment back before the parasites start calculating their share of "appreciation?" No, half of that would go straight into the bloodsuckers' pockets.

So why would any homeowner do this to himself?

The answer is simple... He is desperate and no one is telling him the truth about the impact of his choice to participate with HARuMPh. Not even the CFPB will warn the hopelessly underwater homeowner queing up for HARuMPh that quicksand lurks there for all who are in the GSE pool. If not the CFPB, who will explain to him that DeMarco has regulated debt collection in such a way that pre-conservatorship mortgages automatically become explicitly federally guaranteed upon refinancing? And who will tell him that means he has just assumed the same status as those unfortunate student loan borrowers - unforgivable in all circumstances, putting even his federal entitlements, including social security, at risk should he ever default on his refinanced loan?

I would like to see Tim Geithner's and Paul Ryan's projections on the potential long-term deficit reduction impact of this back-door "entitlement" reduction strategy, wouldn't you?

Besides North Korea, name 5 other countries (excluding EU members) where government and institutions have so effectively collaborated to siphon the net worth of the middle class?

Here's what should happen: the grand bargain should be struck where the underwater bubble-days borrower neither admits nor denies that he was an idiot (for borrowing and patriotically staying current and thereby facilitating recapitalization of the financial services industry); the raters, MIs, originators and their successors-in-interest neither admit nor deny their amply documented frauds and/or gross negligence; and the GSEs, federal legislators and regulators neither admit nor deny their complicity in aiding and abetting the consequential economic catastrophe, knowing it would be at the expense of America's middle class taxpayers (the saps who gave them their jobs, providing their children with the best education that money can buy).

In exchange for this mutual plenty of nothing, every bubble-days mortgage gets written down to 80% of FMV; originators, MIs, raters and the GSEs should - over a reasonable number of years - be entitled to mark to market; and be obligated to share the burden of compensating 2005-2009 investors for the losses realized on these faulty mortgages.

The alternative - to perpetuate the partisan stalemate for no ostensible purpose other than the provision of campaign fodder every four years (Clinton-Reese-Rubin, now Obama-Reese-Geithner, next Obama-Reese-Dimon) is cynical in the extreme, and confirms the players worthy of eternal comforts contemplated by Dante for the economic genocide they wreck upon us.

May God have mercy on all of us who neither admit nor deny our sins. And thusly let's move on.

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