Millions of Americans lost tens or even hundreds of thousands
of dollars of net worth during the housing bust, as the value of
their homes plunged. Yet as well-intentioned as government
initiatives are in trying to address the financial impact of the
mortgage crisis, the newest program to help struggling mortgage
borrowers seems to encourage exactly the behavior you'd want
homeowners to avoid.
More options for delinquent homeowners
On July 1, the Federal Housing Finance Agency's Streamlined
Modification Initiative (link opens PDF file) took effect.
As FHFA Acting Director Edward DeMarco said back in March when
the initiative was first announced, the "new option gives
delinquent borrowers another path to avoid foreclosure."
Under the program, eligible homeowners who are 90 days or more
behind on their mortgage payments will automatically receive an
offer that includes a reduced mortgage payment based on a fixed
interest rate. Payment terms will be extended to 40 years, and
for some of those who owe more on their loans than their homes
are currently worth, the program will provide limited reductions
of the amount of principal they owe on their mortgages.
The FHFA hopes that this program will succeed where others
have failed. In particular, because the Streamlined Modification
Initiative doesn't require homeowners to complete an application
or provide evidence of financial hardship, the agency is
optimistic that more eligible homeowners will participate than
have used similar programs in the past.
Will the FHFA catch strategic defaults?
The danger with the new program, though, is that it provides no
incentives for homeowners who've kept current on their payments.
Indeed, it arguably gives homeowners a reason to
making mortgage payments in the hope that by doing so, they'll
become entitled to favorable benefits that wouldn't otherwise be
available to them.
Indeed, previous programs designed to help homeowners avoid
foreclosure raised similar concerns about moral hazard. Back in
earliest attempts to provide for mortgage loan
resulted in far fewer benefits than expected, because the banks
involved chose not to grant modification in many cases.
Bank of America
were among the slowest of the big banks to modify loans early in
the program's existence, moving forward with just 4% to 6% of
eligible mortgages within the first half-year or so of the
program. Even giving lenders incentives to modify loans didn't
keep bankers from concluding that they'd often be better off
modifying and counting on homeowners to find ways to cure their
a modification. In other words, banks chose not to reward their
customers automatically for being late and seeking
To its credit, FHFA specifically addresses the moral hazard
involved in the Streamlined Modification Initiative. The agency
notes that "because many borrowers who miss one or two payments
have a temporary hardship and often reinstate their mortgage to
current status, it is most effective to target borrowers who are
at least 90 days delinquent." Moreover, in its efforts to curb
abuse of the program, the FHFA notes that
, which the FHFA oversees, have "existing proprietary screening
measures to prevent strategic defaulters from taking advantage of
a Streamlined Modification."
Still, the danger with this program is the same as with past
attempts to help potential victims of foreclosure: It's hard to
help deserving homeowners while avoiding giving unneeded help to
those who are simply trying to game the system. In particular,
principal reduction introduces a whole new element to moral
hazard, as the government has to consider the costs that Fannie
and Freddie have to bear under total-default scenarios compared
to the more limited costs of principal reduction. According to
projections by the Congressional Budget Office (link opens
PDF file), extending principal forgiveness under another program,
the Home Affordable Modification Program, could result in net
in the budget deficit of between $2.2 billion and $2.8 billion.
Yet the CBO analysis acknowledges that strategic defaults would
lead to cost reductions that would be "less than costs would fall
if borrowers whose modifications were costly could be excluded."
Moreover, because HAMP involved having to document financial
hardship, the potential for gamesmanship in the Streamlined
Modification Initiative is arguably more substantial.
Is there no solution?
In the end, any government program will struggle to identify
those who most need help. Rather than focusing on decisions
within homeowners' control, such as becoming late on payments,
programs should choose objective criteria that limit manipulation
and truly find those in need.
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