The federal agency that regulates Fannie Mae and Freddie Mac is expected any day now to update its position on so-called "mortgage principal reduction," lowering the amount owed on a home loan in exchange for a higher likelihood of repayment. The Federal Housing Finance Agency is reluctant to allow principal reductions at Fannie and Freddie, even though many private banks write down principal for delinquent borrowers that are deeply "underwater," meaning they owe more than their home is worth.
At the center of this debate is concern over moral hazard. According to FHFA and other critics of principal reduction, the prospect of a writedown for borrowers on the verge of foreclosure may encourage homeowners who don’t need financial help to purposely stop making their monthly payments.
While this concern is legitimate, it’s easily mitigated. As FHFA reconsiders whether to allow principal reductions on some of the 2 million deeply underwater mortgages backed by Fannie and Freddie, here are three reasons why moral hazard should not be a deal breaker.
First, there are ways Fannie and Freddie can structure a principal reduction program without creating skewed incentives for borrowers. Mortgage expert Laurie Goodman of Amherst Securities recently offered one simple solution: Make it a one-time program open to borrowers that are already delinquent when the program begins. This would limit the borrower’s ability to default intentionally just to be eligible.
Another solution is to impose some sort of fee on program participation, ensuring the borrower has to give up something valuable before receiving a principal reduction. For example, in exchange for a writedown now, the borrower can give up a meaningful portion of any future price appreciation on the home, known as "shared appreciation." As a result, deeply underwater homeowners have reason to keep paying, while the modification is not particularly attractive to borrowers that don’t absolutely need it. The Center for American Progress recently laid out how the shared appreciation model could work at Fannie and Freddie.
Second, the moral hazard argument assumes homeowners have the option to default at little to no cost, making principal reduction a windfall for any underwater borrower that’s proven willing and able to make their monthly payments. That’s simply untrue.
In reality, borrowers give up quite a lot by choosing to default. Delinquent borrowers see a blemish in their credit history, making it much more difficult to take out a loan in the future, and they’re typically unable to refinance to today’s record-low interest rates. That doesn’t even account for the risk of losing their home if the modification doesn’t come through – and with it, access to schools, parks, law enforcement and other community services.
Finally, there’s little evidence underwater borrowers actually act this way. When the nation’s five largest mortgage servicers began offering more principal reductions in compliance with a recent settlement with state attorneys general, the credit ratings agency Fitch Ratings found no "material change in the behavior of underwater borrowers attempting to strategically default to qualify for a reduction."
To be sure, studies have shown the sudden availability of any mortgage modification options that reduce monthly payments for delinquent borrowers – usually by extending terms, lowering interest rates, deferring payments or reducing principal – can lead to an increase in defaults. But Fannie and Freddie already offer most of those options, with principal reduction as the lone exception. Based on available evidence, it's unclear whether adding writedowns to that list will meaningfully influence borrower behavior.
When the federal government stepped in to save the country's largest financial institutions in 2008, a shared sense of urgency trumped concerns over fairness and skewed incentives. Nearly four years later, in the midst of what is arguably the worst foreclosure crisis in U.S. history, it's time we put banks and American homeowners on the same moral footing.
If done carefully, targeted principal reductions can give hundreds of thousands of deeply underwater homeowners a strong incentive to keep paying their mortgages, saving Fannie, Freddie and the taxpayers supporting them billions of dollars. This is not a "moral" issue; it's a matter of smart economic decisions and sound business practices.
John Griffith is a policy analyst with the housing team at the Center for American Progress.