The current fascination with a recent trial balloon proposing eminent domain as a seemingly cost-free solution for the mortgage crisis ignores the reality that it won’t solve the underlying problem.
Why not? There are likely more reasons than there is room on the page. To start, eminent domain can’t be implemented fairly. It ignores the original legal agreement with the investor by forcing a change to the mortgage note without the presence of imminent default. And more critically, it may upset whatever semblance of order still exists in what remains of the private-label securitization markets.
But let’s put the eminent domain argument aside for now. Leave it to the lawyers, legislators and the investor community to fight over whether a municipality – under the guise of constitutional law – can turn a hefty profit while condemning individual mortgage contracts simply because they are underwater.
Once again, the mortgage industry seems to be taking its eye off the ball. There is finally a constituency within the senior ranks of policymakers who are focusing on negative equity. The question that remains, however, is what needs to be done about it? The terms negative equity and mortgage default would never be spoken in the same breath if the former weren’t the primary cause of the latter.
Negative equity has always been the main driver of default. The solution, however, cannot be allowed to compound the problem by violating contract law, or disrupting the orderly transfer of risk into the capital markets.
The current strategies employed have amounted to nothing more than fitting a series of square pegs into round holes. Lowering a monthly payment, for example, when a borrower is deeply underwater is somewhat helpful, but largely irrelevant in the long run.
The fact remains that the underwater homeowner is much more likely to default than the homeowner who has equity. The difference is almost entirely explained by one word: Incentive. When equity has been eliminated, a homeowner’s incentive to pay becomes diminished. Moreover, as the incentive is reduced, the probability of default increases. And when the default becomes discretionary, the idea of incentives becomes relevant. Finally, rising loss severity levels across the U.S. have made it clear that something must be done to reduce the amount of negative equity on the consumer’s balance sheet.
Recent history has taught us that negative equity is the main driver of default. So why not replace that incentive through an alignment of interests among all relevant risk holders? Instead of simply lowering the principal, why not make principal forgiveness contingent on paying the loan until maturity? We have been testing this theory for nearly three years with noteworthy results: a greater than 50% reduction in delinquency rates.
The carrot will almost always trump the stick – especially when the penalties for contract violations are becoming difficult to enforce. Second, the size of an incentive will always be significantly smaller than what would be required through a principal reduction to achieve comparable results.
Third, when the incentive is properly spelled out in writing, it can be designed to motivate the consumer to earn an interest rate reduction if necessary, lowering overall risk even further. The message must be credible, and explained so that the consumer understands the terms by which the incentive can be earned, monetized and forfeited.
The laws of mathematics dictate that lowering the loan balance should be no different than replacing lost equity. As such, replacing that lost incentive through a mechanism designed to change payment behavior is the answer to widespread default caused by negative equity. In order to be successful in the long run, the incentive scheme must be executable in a way that does not violate contract law or change the terms of the mortgage note. It must also not seek to benefit one or more parties, at the disproportionate expense of another. Finally, given the fragile state of servicing and increased regulatory oversight, the program must be structured so that it can be launched quickly, justly and in scale.
The use of financial incentives in the U.S. housing market is not new. Unfortunately, most past strategies were created to the long-term detriment of the industry. What is truly needed is policy which involves an alignment of interest, with positive and lasting implications for housing. But we must make certain we’re not causing our Founding Fathers to roll over in their graves.
Save the use of eminent domain for those instances where the “public good” does not include 33% unlevered returns at the expense of the taxpayers, pension funds, and retirement accounts.