Friday, February 20, 2009

Moral Hazard of Loan Modification

One can empathize with Ric Santelli’s widely heard rant and the reaction in the Blogosphere: No doubt the people who played by the book have the short stick in the $75 billion Homeowner Stability Initiative (“HSI”), but unless some way can be found to deal with the twin time bomb of mortgage foreclosures and more importantly, jobs and the threat of further job loss, the economy will continue to disintegrate.

There are people in homes who are employed but who borrowed too much or at terms that they can no longer afford, and who now may be motivated to simply walk away from their home and rent down the block and save a bundle. Hopefully, this group will be the plan’s focus. Yes, if they walk their credit rating will become impaired, but outside of that it becomes a simple business decision. How the HSI deals with principal reduction has a weighty bearing on the moral hazard issue.

Proposals that involve reducing the mortgage principal balance have called for banks or the taxpayer (whoever takes the hit for the lowered principal) having a “call” on the appreciated value of the home (over the new principal amount) if the home is sold in the future. So, if the home’s original mortgage was based on, say, a principal of $300k and the new principal is $200k, the bank/taxpayer would be entitled to the appreciated (assuming there is any) difference between $200k and the selling price in the future up to the original principal value. The problem with that approach is why would the seller bother to hold out for a price above $200k – there is no incentive (unless in the unlikely event the home can be sold for more than the original principal amount) – or would the bank then take it over as a foreclosure? Seems to me the bank/taxpayer needs a phased in participation in the selling price to avoid foreclosure down the road, or to provide incentive for the homeowner to get the best possible price, keeping government and/or the bank out of those logistics.

Thus, as far as principal reduction is concerned, the devil is in the detail, and it is here that the core moral hazard issue seems to lie. Other approaches of lowering the mortgage interest rate or converting adjustable rates to an affordable fixed rate or increasing the loan term are more straightforward and quantifiable and would seem to be easier to deal with – from a moral hazard perspective -- than principal reduction. It certainly makes sense to find a way to help people who are employed and can afford a reasonable monthly payment to stay in their homes.