Preventing ‘Moral Hazard’ Issue for Principal Reduction

They say foreclosure harms everyone â€" the lenders, the borrowers, and even the neighbors. While avoiding foreclosure has been established as an unwavering goal for the benefit of everyone, the question that is creating tension between policy makers, advocacy groups, and analysts is how to best prevent foreclosure.

With numbers from a CoreLogic report revealing 22.8 percent of borrowers are underwater, principal reduction has been eyed as a key solution to keep borrowers in their homes.

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For Fannie Mae and Freddie Mac, the FHFA has not given the go ahead to apply principal reduction, despite reports that the GSEs are in support of the foreclosure prevention measure.

The ""Wall Street Journal"":http://blogs.wsj.com/developments/2012/03/28/geithner-fannie-and-freddie-favor-loan-write-downs/ reported that Treasury Secretary Timothy Geithner, during a Senate subcommittee hearing, said, ""I think Fannie and Freddie themselves are actually pretty supportive of this,"" Geithner said. Their regulator, he said ""has been a little more conservative.""

Recently, to encourage the GSEs to apply principal reduction, the Treasury tripled incentives it will pay them. According to a ""Capital Economics"":http://www.capitaleconomics.com/ report released Friday, this means the Treasury will raise incentives from between 6 and 21 cents for every dollar of principal reduced to between 18 and 63 cents.

""So in theory, the direct cost to Fannie and Freddie of reducing its $100 [billion] of negative equity has fallen from a midpoint of $87 [billion] to $60 [billion]. No wonder the FHFA might now be keener on the idea,"" Capital Economics stated.

According to a report from the Office of Comptroller of the Currency (OCC), the two mortgage giants made up 59 percent of the overall portfolio of mortgages during the 2011 fourth quarter, a figure that has further fueled the argument that it is important that the GSEs also be allowed to apply principal reduction to help the housing market recover.

At the same time, the percentage of GSE mortgages that were current and performing at the fourth quarter's end was 93.1 percent, according to the OCC. And, according to the FHFA, about three out of four underwater Fannie and Freddie borrowers are still making their monthly payments.

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However, Capital Economics points out that those delinquent negative equity loans at Fannie and Freddie could add up to 600,000 homes to the visible inventory if they end up in foreclosure.

But, if the GSEs maintain a high percentage of current loans and most of their underwater borrowers seem to be making their payments, opponents of principal reduction argue that borrowers who could afford their payments might purposely default just so they can qualify for principal reduction. Also, principal-reduction could be viewed as discriminating against those who were conservative when borrowing funds for their mortgage, according to a ""white paper"":http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf issued by the Fed.

The Center for American Progress (CAP) released a ""report"":http://www.americanprogress.org/issues/2012/03/pdf/principal_reductions.pdf Thursday detailing solutions to the ""moral hazard"" issue regarding borrowers who would go into default on purpose.

John Griffith and Jordan Eizenga, policy analysts with CAP, offered three solutions.

""The simplest solution would be to make this a one-time program open to borrowers that are already delinquent when the program begins. Such a rule limits the borrower's ability to default intentionally just to be eligible,"" the report stated.

The second option is to open the program up for current borrowers who are at-risk and about to go into default.

The third suggestion in the report is to have so-called ""shared appreciation"" modifications, where the GSEs write down a portion of principal in exchange for a portion of the future appreciation on the home.

""The borrower has a reason to keep paying, while the lender benefits when home prices eventually stabilize and rebound,"" the report stated. This could make principal reduction less attractive to borrowers who don't actually need it.

The report also suggested targeting certain types of borrowers. More specifically, principal should be applied towards borrowers that are most likely to benefit from a reduction, such as those with a mortgage that's worth at least 115 percent of the home's current value; are either delinquent on their mortgage payments or about to be; face a long-term economic hardship; and do not have private mortgage insurance or a second lien.

With $700 billion in negative equity, Capital Economics stated that the GSEs could remove $100 billion of the total negative equity at best.

The research firm also added that ""the scale of the principal reductions and the resulting decline in foreclosures are unlikely to be sufficient to make a major difference to the immediate housing outlook.""

When assessing the overall impact of principal reduction on Fannie and Freddie mortgages, Capital Economics said, ""It won't solve the foreclosure problem in one fell swoop, but it certainly won't hinder the housing recovery that is already underway.""