The greatest threat widespread negative equity presents to the U.S. residential markets is not necessarily the negative equity itself, but rather the losses associated with underwater loans that do default.
What's more, the losses suffered in a default are often two to three times more than the total amount of negative equity. In other words, the ultimate loss to the investor (which can be the U.S. taxpayer and pension funds, in many cases) can be as high as $50,000 on a mortgage of only $100,000, even if the loan is only $20,000 underwater. Finally, the industry cannot stop defaults caused by negative equity by using solutions designed to address affordability.
As delinquency rates continue to hover near all-time highs, and home prices show little sign of recovering anytime soon, the window of time to address negative equity is fast closing.
With as many as 12 million underwater homes, and shadow inventory predicted to be as high as three times the number of homes currently on the market, it's no wonder the private sector and regulators are battling over what needs to be done to address the crisis.
While there are plans in place to help homeowners who are struggling to make their monthly payments (HARP, HAMP, etc.) there is no effective plan in place to address negative equity.
Furthermore, whenever there is a discussion over what to do to address negative equity, the conversation invariably turns to principal reduction. The premise is that reducing the homeowner’s balance will solve the problem. However, widespread principal writedowns may not be the answer to the problem, and may actually do more harm to the housing market than good.
What we should be discussing are tools that address negative equity in ways that help the underwater homeowner yet (equally as important) don’t hurt the owner of the underwater mortgage.
The obvious negatives to principal forgiveness aren't the forgiveness itself, but rather the costs, implementation challenges and the potentially disastrous repercussions.
If every underwater homeowner continued to make regular and timely payments regardless of their loan-to-value ratio, there would be no need for loss mitigation strategies or mandated principal writedowns. This however, isn't the case. When a homeowner chooses to default on a debt obligation, even when they have the means to pay, they are choosing to do so because they have lost the incentive to pay. Something should be done to replace that incentive, not reduce principal.
Incentives should be introduced in an effort to realign the interests of loan owner and homeowner in a way that prevents the borrower from defaulting due to negative equity. The incentive should come in the form of contingent forgiveness, which is granted only when the loan is paid off. (This can be done one of two ways – the forgiven amount can be netted out of the balance due at the time of payoff, or it can be granted in the form of a "rebate" shortly after a full payoff.) However, the incentive disappears (or is never paid to the homeowner) if a delinquency trigger is breached.
The solution also needs to be implemented quickly and in scale primarily because many of the nearly 12 million underwater homes in the U.S are serviced by only 8 to 10 servicers. Servicers, by and large, are not equipped to handle new programs or mandates very well. Therefore, the solution must be cost effective, without causing additional burden on the servicer’s operational infrastructure.
Next, the incentive must be administered equitably. A benefit that unintentionally promotes moral hazard or fraud will render that incentive scheme useless. For example, requiring a borrower to be delinquent in order to qualify for a benefit will cause the subject to become delinquent – regardless of the barriers, or perceived penalties.
The solution must be fair. Addressing only loans held within a bank's portfolio while ignoring loans held in a securitization is unfair and politically unpopular.
Finally, and most importantly, the overall solution to widespread negative equity must specifically address the homeowner's personal balance sheet, and not their income statement. The cure needs to address the disease. The homeowner who defaults due to negative equity creates exactly the same loss to the investor (or taxpayer!) as the homeowner who defaults because they could not afford the payment. If the reasons for default are different, so should the solutions.
The solution to negative equity is not widespread forgiveness. The solution is an alignment of interest in the form of an incentive that replaces a portion of the borrower’s lost equity … and is fair, operationally executable, and legally binding.