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Mortgage Principal Can Be Cut Without Moral Hazard

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At the end of October, the Obama Administration announced changes to the Home Affordability Refinance Program that conceivably will make as many as 2 million more homeowners eligible for refinancing over the next two years. This will lower the default risk for the government sponsored entities and their ultimate backers, the American taxpayers, and should provide some level of economic stimulus.

But it will help housing only indirectly, because it doesn’t address the two strongest headwinds that are depressing housing prices: negative equity and shadow inventory. Addressing these challenges will require new thinking on the strategic use of principal reductions. Although the cost of this approach would be significant, it could be far less than the $699-billion price tag usually associated with negative equity and could save as many as three million more at-risk homeowners.

The drop in mortgage rates to record lows in 2011 has not resulted in the expected surge in refinances. The reasons for the lack of refinance activity include: the prevalence of negative equity; insufficient borrower credit quality or income; GSE hurdles, such as loan-level price adjustments, and investors' unwillingness to give up their rights to require lenders to repurchase loans that did not meet GSE guidelines. Repurchase risk makes lenders less willing to take on more liability and due diligence risk (although Harp II attempts to address some of these concerns).

There already have been many government efforts to aid borrowers in refinancing, which include version one of Harp, Hope for Homeowners and the FHA Short Refinance program. They have not produced sufficient volume to dramatically influence housing market conditions because the eligibility criteria were too tight, the rates offered were too high, or borrowers had qualification constraints.

We have seen adjustments made to Harp, but only time will reveal the full economic stimulus effect of increased refinance activity.

It's important to note that a bond investor’s interest income is a borrower's interest expense. That means that refinancing millions of borrowers and offering them lower rates would reduce household mortgage expenses, but it would also reduce investors' interest income by roughly the same proportion.

History, as a guide, shows that in prior large refinance waves, with only one exception, there was no real discernable impact on consumer spending. The only exception occurred in 2003, when the mortgage market experienced the largest refinance wave ever recorded. Even then, the impact on consumer spending was small and transitory, and the potential refinance wave this time would be smaller. In any case, refinancing existing mortgage balances does not address the fundamental issue of negative equity.

The large number of homes with negative equity is holding back purchase demand for homes by reducing household mobility and elevating the risk that seriously delinquent borrowers will move into foreclosure because they don’t have enough equity to refinance or sell their homes.

As of the third quarter, 22 percent of U.S. homes — nearly 11 million borrowers — were upside down. The average such borrower was upside down by $65,000 and aggregate negative equity was more than $699 billion. If negative equity diminishes, it will greatly aid the housing market recovery by unlocking pent-up demand and reducing foreclosure risk. As would be expected, re-default rates for modifications with principal reduction are much lower than other modification.

There are many concerns with principal reduction, but moral hazard and costs to banks and taxpayers are the two that stand out.

Moral hazard occurs when individuals behave differently when insulated from risk than they do when fully exposed. If servicers give principal reductions to borrowers who are delinquent and in a negative equity position, which insulates them against negative-equity risk, borrowers who are current may purposely become delinquent so that they can also receive a principal reduction.

However, there are many ways to deal successfully with moral hazard:

  • Servicers can offer borrowers a principal reduction, but at some cost. This would be similar to a car insurance deductible and could be structured in different ways. For example, servicers could reduce principal in exchange for the borrower giving up a portion of future appreciation.
  • A shared-appreciation mortgage that reduces principal could be taxed as a capital gain rather than as ordinary income as is the case today.
  • Servicers could also change mortgage terms to include recourse in the event of a default, such as the right to non-housing assets in addition to foreclosing.

Basically, servicers could address the moral-hazard risk associated with principal reduction through appropriate loan terms.

The cost of principal reduction is another large hurdle. It's certain that not all $699 billion dollars in negative equity needs to be forgiven. There are 6.3 million borrowers with first liens only who are current on their mortgage payments and underwater by an average of $52,000, representing $314 billion in total. Within that segment, servicers could target moderately upside down borrowers (110% to 150% LTV) who are most likely to respond to principal-reduction offers. That would help nearly 3 million borrowers (or nearly one third of all negative equity borrowers), at a cost of $118 billion. Although $118 billion is clearly not trivial, it is much more manageable than $699 billion.

Streamlined refinance plans will improve household monthly obligations but it remains to be seen if the will create meaningful economic stimulus. Plans to reduce principle are more likely to greatly aid the housing market recovery by unlocking pent-up demand and reducing foreclosure risk. It is important that these plans also have features that address the moral hazard risk. Targeting principle reductions as described above would aid the greatest number of borrowers for the least amount of money, reduce current and future distressed shadow inventory and put less downward pressure on prices today and in the future.

Mark Fleming is the chief economist of CoreLogic, Inc.

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Comments (6)
In every month, you will be able to experience paying a lower rate with "123 Refinance". That will be a big blessing especially for a family that has a tight budget. The money that you will be able to get from this can be used to improve household conditions.
Posted by bud l | Wednesday, November 23 2011 at 12:16AM ET
I didn't use my house as an ATM machine and now I need to write a check to pay down the balance of people who did? No thanks. You reap what you sow.
Posted by Amaulsby | Wednesday, November 23 2011 at 9:53AM ET
There are alot of people that didn't use their house as an ATM. However, if you loose your job and are forced to take a job with a 50% cut in income,then it throws families in a tail spin. If the banks helped with a principal reduction, then it would help individuals sustain their independance, keep family in the home, give confidence to the economic spending. This of course comes with everyone having to buckle down and play within their means. I believe people have had a hard lesson in living within their means today. Foreclosure cost the institutions additional money, keeps the economy down, and the confidence of future is prolonged. The housing market and LTV's will not see an upswing for at least 10 to 15 years. Help America and the cash flow for the investors will come.
Posted by emanuel@balalis.com | Wednesday, November 23 2011 at 11:46AM ET
"Moral hazard occurs when individuals behave differently when insulated from risk than they do when fully exposed."

Is it also possible that moral hazard might occur because banks are fully capable of behaving differently when insulated from risk? How much money did the banks get handed by the government, and then they just turned around and handed out big bonuses?
Posted by Mark N | Tuesday, November 29 2011 at 4:18PM ET
There are also lots of people whose homes were stuck in the immediate gridlock trigger by unavailable funding for purchasers, followed by nothing but TUMBLING home values, forcing them to reide out the storm as unplanned Landlords or default as the home on the market could not sell, this is also not a "home ATM" scenario. In addidtion, if you research state and local areas the DROP was not of an equal percentage throughout the United States - some areas soming out so crippled due to the growth wave in their area from 2004-2008 and others only mildly or moderately affected as the area was more established, or the economic function of the area not being as hard hit. Who truly received the 'handouts'? Who is really being punished? This is not a passing phase as a generation of young americans are being moved to the thought process that homeownership is too risky, not a long term investment of personal goal worth achieving and renting may be their best option - the investors will not be hurting in the end as they go behind and buy up the foreclosures and short sales then force the market's machine back into full swing to recover their money through resale after they rent what the 'situational landlords' and 'underwater delinquent homeowners' cannot at that rental rate without taking hundreds of dollars a month out of pocket to make up the difference.
Posted by Cherub C | Thursday, December 15 2011 at 9:02AM ET
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