With nearly one-fourth of Americans underwater on their mortgages and home prices still on the decline, homeowners who resist the temptation to strategically default and make efforts at meeting their obligations should be applauded. But should they be paid for it?
Loan Value Group, a firm in Rumson, N.J., has been experimenting with the idea. It has a program, called RH Rewards, through which banks, mortgage servicers, hedge funds, insurers—pretty much any institution that carries mortgage risk—can offer a financial incentive to their underwater customers, mainly targeting those who remain current on their mortgage.
Once a customer accepts the invitation to the program, every time an on-time mortgage payment is made, the reward grows, up to a predetermined maximum, typically no more than $20,000. When the loan is paid off, either through refinancing or a sale, the homeowner gets the reward.
Rewarding people just for doing the bare minimum, for following through on promises made of their own volition, feels unsettlingly un-American somehow. But RH Rewards also borrows from that most American of ideas—using financial incentives to drive desired behavior. That's a concept that has been used in programs to encourage everything from good grades to healthier lifestyles.
In the case of underwater homeowners, establishing rewards for on-time payments is a way to replace incentives for a group whose original payment motivation has been lost.
"It's a clever way to create a mutual benefit between all parties involved," says Sayta Thallam, director of the financial markets group at the free markets-leaning Mercatus Center at George Mason University. "It's essentially changing the terms of the mortgage, and people do that and refinance all the time. You can't begrudge your neighbor because he refinanced and got a better deal."
While the reward will not be enough to make up for the negative equity a homeowner has, Frank Pallotta, a managing partner of Loan Value Group, is confident that that the program, particularly the extra $100 or so up for grabs each month, is enough to make someone rethink a strategic default. "The reward is not intended to put someone 'in the money,' but is more of a 10-year light at the end of tunnel," Pallotta says.
While Loan Value Group operates all aspects the program, it does not provide the cash incentive. That's where partner companies come in. There are eight so far, with the latest one, PMI Group, signing up in early July. The Walnut Creek, Calif.-based insurer says it will role out the RH Rewards program to customers in the Florida and Arizona first, and will decide from these results whether to offer the program on a larger scale.
Loan Value Group touts that RH Rewards is used in 40 states, offering more than $113 million in rewards covering $1 billion of mortgages. Pallotta says that partner mortgage holders have been able to reduce defaults rate by 50 percent through RH Rewards, with nearly all the invited homeowners agreeing to participate in the program. The default rate among those in the program is "under 5 percent," he says.
Still, this is a very small piece of the $14 trillion mortgage pie. And it provides rewards to only a select group of underwater homeowners, leaving millions of others dutifully paying their mortgages with no cash incentive.
But Alex Edmans, the Wharton finance professor who developed RH Rewards, hopes the program will gain traction with some of the larger banks and mortgage servicers, and that the most distressed homeowners will be moved to the head of the line.
"With anything, you first offer the program to those who have the greatest need for it," Edmans says.
In his paper last summer outlining the RH Rewards concept, Edmans referenced a statistic from the National Bureau of Economic Research showing that 31 percent of foreclosures in March 2010 were strategic, up from 22 percent a year earlier. More recently, a report from Moody's in July noted that the risk of strategic default is rising among performing mortgages as loans-to-value ratios, a strong predictor of future default, "are now approaching the LTV of loans that have defaulted since 2009."
Dean Karlan, an economics professor at Yale University, says that with such unusually high rates of strategic defaults, banks are acting like any other troubled retail business, scrambling to find a way to keep some wayward consumers (homeowners) interested in their product (mortgages). "They are just tinkering with price to find the profit maximizing point," Karlan says.
"Consumer firms do that all the time with coupon and sales," Karlan notes. "We do not live in a world in which everyone pays the same price for the same service."