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How to Help Homeowners, Without Creating Moral Hazard

The foreclosure crisis and housing market collapse have been a significant burden for homeowners, for lenders and for the economy as a whole. Policymakers are frustrated that foreclosure relief efforts such as HAMP, HARP, and Hope for Homeowners have, by and large, failed. Government officials decry the fact that the housing market "is so severely out of balance that it is hampering the economic recovery," as Federal Reserve Governor Elizabeth Duke said in a speech in September.

To some, the answer is simply to let the markets sort it all out. But this could take many years, during which time enormous continuing pain is inflicted on our economy and its citizenry. Some experts say that the problem will not be resolved until lenders begin to reduce mortgage principal. But there is no fair or equitable way to selectively reduce the unpaid balance of a mortgage without creating moral hazard, and to reduce all mortgage debt is economically unfeasible.

Are there no other possible solutions or approaches which could be undertaken by policy makers to provide relief? While there may not be a single, broad panacea for this intractable problem, there may be several partial solutions which, taken together, could provide some measurable help to struggling homeowners. The key to avoiding "moral hazard" is to make sure that the homeowner is giving up something of value in return for relief of some portion of the mortgage obligation. Here are some examples:

1. In an instance where the borrower has a steady source of income, but the income falls short of what is required to meet the mortgage payments, the borrower could convey the property to the lender in return for a lease to remain in the property for a reasonable period of time (say 18 to 30 months), paying a rent of 35% of monthly income. There is no "inequity" because the homeowner has given up ownership of the property. But, at the same time, the former owner can remain in the property for a long enough period of time to find other suitable rental housing, arrange for the schooling of children, etc. In the meantime, all of the social, economic and community damage of a foreclosure and possibly an eviction are avoided. The lender, now the landlord, would be free to recoup its investment as the lease matures and dispose of the property under more normal market conditions, presumably mitigating losses.

Fannie Mae has had a rental program called "Deed for Lease" since late 2009 which has had some success, despite not being actively promoted, and the recently released Fed white paper on the housing crisis suggests a potentially important role for the conversion of homes to rental units.

2. A second example of foreclosure relief deals with the problem of unemployed, underwater borrowers not being able to move because of their negative equity. If an underwater borrower can demonstrate that he or she has a bona fide job offer in another community at a distance of more than 50 miles, the lender would be required to accept the property as full payment of the loan in a deed-in-lieu-of-foreclosure. The "payment in full" designation is crucial so that the borrower's creditworthiness and therefore ability to finance the acquisition of a home in the area of the new job is not impeded. Again, inequity or moral hazard is avoided because the homeowner is giving up the property and moving to a new location.

3. A third example of foreclosure relief could come in the manner in which a lending institution is encouraged to negotiate short sales, meaning a sale of the property for less than the loan amount. The real estate industry reports that many, if not most, short sales never go to settlement because lengthy delays in the approval process cause the buyers to walk away. Thus, preapproval is essential. The lender would first have to approve the borrower as qualified by establishing that nothing improper occurred in the loan application process such as overstating income, assets or employment. The lender would then establish an acceptable price through an independent appraisal and agree, in advance, to release its lien on the property in return for a sale at that price. Any shortfall from that price would require a deficiency payment by the borrower. It is believed that an aggressive short sale process would multiply the number of such sales, thereby helping to clear the market of excess inventory.

4. Yet another example of foreclosure relief would be to suspend required mortgage payments for an unemployed borrower. Freddie Mac has recently announced such an extension program of up to 12 months. The suspended payments are not forgiven; they are added to the principal balance of the note and a new amortization schedule is issued. Such a program, if expanded throughout the mortgage lending community, could eliminate a significant number of foreclosures.

These are but a few examples of creative steps which could be taken to help move the housing crisis behind us. Special concern needs to be given to loans which have been sold to investors, particularly where the servicer's range of options is constrained by the securitization documents.

Lending institutions and loan servicers must begin to realize that they are in the real estate business and must become expert in all aspects of property management, appraisal, leasing and sales. The federal government, utilizing funds still available and unexpended in the TARP program, can provide additional incentives to push the lending industry in the direction of these and other recommendations.  

Firmly worded guidance by the banking regulators could clearly establish that these more creative solutions are to be utilized rather than simply relying on the old foreclosure-and-liquidate model.

It's time we faced up to the incredible challenge of the housing collapse and foreclosure crisis with a more focused and innovative approach.

Alexander R. M. Boyle is the retired vice chairman of Chevy Chase Bank. He has worked in mortgage lending and consumer banking for 30 years.


(6) Comments



Comments (6)
The old foreclose and liquidate model had been working fine for decades. Why not get out of the way and let it work again. There are buyers our there for these houses at the right prices. The current occupants aren't going let themselves become statistics. They'll do what they have to do to take care of themselves. Politicians so underestimate American's ability to take care of themselves.
Posted by Amaulsby | Thursday, January 19 2012 at 6:23PM ET
Some good thoughts BUT it seems that the author is more concerned with helping the banks --- that caused the economic problems than the screwed over homeowners. Screw the unemployed -- that are UNEMPLOYED because of the banks.

Why are we worried about the moral hazard towards homeowners when the BANKERS WERE IMMORAL TO BEGIN WITH???
Posted by Ronald L | Thursday, January 19 2012 at 9:32AM ET
The inventory needs to be cleared. Let banks do what they have done well for over 100 years; foreclose. All these theatrics are merely drawing out the process and causing people to default when if this were allowed to bottom, say 2 years ago, they may not have. Things were going well when the subprime was being liquidated. Now, things have become so bogged down that it is now taking over 2 years to foreclose instead of the 6 months it used to. this is a big loser, and because of the way things are being done, thanks mainly to government interference, many more people will get hurt than need be. Cancelling principal will most certainly anger many and cause more strategic defaults.
Posted by JOHN V | Thursday, January 19 2012 at 12:05AM ET
The economy will not recover and grow at a succicient pace until confidence recovers. Regulators have not been enforcing safety and soundness policies so bank portfolios are full of non-performing loans which have been continually extended. The first loss is always the best route. Face the facts. Short sales, accomodating foreclosures as described are all good, humane ideas but the fact remains we have hundreds of billions of dollars of loans which are not properly reserved.
Posted by tedmeylor | Wednesday, January 18 2012 at 6:02PM ET
That is an incorrect statement. The partial claim process from old FHA days could be used to manage the principal reduction. Reduce the principal and create a second lien for the amount. It would be nominal interest carrying. It would stay until the borrower paid off the home or sold it. If sold then it becomes part of the settlement with any upside split between the borrower and the investor until the lien is paid off. Any short fal to be handled just as a short sale. You know you are getting better than you would with a forced short sale or an REO sale because the borrower is trying to maximize proceeds.If held to maturity then the second lien becomes a manged note at that point.

There is a lot more that could be done but until consistent communications is established it will not happen. There still is a need for the borrower facing portal and Default Mitigation management LLC has provided it. That is why the court systems are using it for their mediation processes.
Posted by Joseph S | Wednesday, January 18 2012 at 3:52PM ET
Generally good ideas. But the short sale "pre-approval" idea is not. First, it is incorrect - at least in Oregon - to say that short sale never go to settlement. The reverse is correct. Secondly, per-approval is unrealistic because comps can change radically very quickly. If the bank pre-approves a sale at $250,000 for a condo today, a foreclosure or short sale of a similar unit tomorrow for $200,000 changes all that. Time waiting for pre-approval, etc. is better spent marketing the property for the current FMV and track the comps if they go down. Once an offer is received, the bank can do a BPO or appraisal, and verify then that the price is reasonable based on the comps.
Posted by Querp | Wednesday, January 18 2012 at 3:46PM ET
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