Over the past six months, it has become clear that the banking industry and its regulators recognize that the problem of strategic default is both real and growing. They understand not just the notion of what it is, and how to begin to identify it, but also the need for a preemptive solution.
Strategic default is not just a problem for banks, however. In every traditional mortgage transaction, there are at least five constituencies that benefit from timely and consistent mortgage payments. It's not merely the borrower and lender/servicer, but the investor, mortgage insurance providers, state and local municipalities and the U.S. taxpayer (by way of our indirect ownership of the government-sponsored enterprises that guarantee timely payment of principal and interest).
What this means is that a solution to strategic default cannot truly succeed unless it addresses the interests of all parties to the transaction. Simply put, widespread principal forgiveness is not the answer. A principal reduction, whether earned over time or not, is designed almost exclusively to help the borrower. While helping the borrower is a big step toward a long-term solution, it cannot happen in a vacuum without buy-in from all risk holders. What's more, the moral hazard and fraud that are likely to accompany widespread principal forgiveness has the potential to cripple an already-fragile system.
Principal forgiveness has long been advocated by distressed investment funds — less due to their altruistic yearning to help the U.S. homeowner than to their desire to secure healthy returns for themselves and their investors at the expense of the U.S. taxpayer.
A recently announced program by Bank of America to reduce principal also looks to have some inherent flaws. First, the borrower must be delinquent in order to qualify, so the unavoidable temptation to commit fraud becomes greater. Additionally, because the program targets mostly subprime loans originated by Countrywide Financial, it may potentially "shut out" homeowners who may be at an even greater risk of strategic default. Furthermore, the driving force behind the B of A program looks to be a settlement with the Massachusetts Attorney General. As a result, it may not be the model program for the banking industry that many may have initially expected.
For a solution to be effective and lasting, all parties must ultimately benefit. Or at least it must not benefit the few at the expense of the many. The solution must also preserve the integrity of a seamless and efficient future transfer of risk into the capital markets while being mindful of contract law, securitization practices, GAAP accounting and predictive financial modeling.
So, now to the question of what the banks should do about strategic default. The easiest solution — to dramatically increase the value of the nation's housing stock — is clearly out of their ability to achieve. The default solution is to do nothing, and hope that the problem will go away. The ideal solution is to create a tangible incentive to keep borrowers who are at risk of strategic default current on their loans, without the need for a costly loan modification or widespread principal reduction — and without raising the specter of moral hazard. If we can keep underwater homeowners current, the strategic default problem will solve itself.
You need only to look at the explosive growth of alt-A origination between the late 1990's and 2007 to come to the conclusion that financial incentives in the U.S. residential markets work. When given the opportunity, borrowers and lending institutions will almost always do what is in their short-term best interest (a lower rate, less money down and lower documentation, for example). The alignment of short-term goals and long-term incentives is necessary for a successful and lasting housing recovery.