Five years into a housing crisis that never seems to end, a dispute over offering homeowners assistance has come down to morality.
Edward DeMarco, the acting director of the Federal Housing Finance Agency, will not permit targeted debt relief for underwater homeowners -- also known as principal reduction -- because he said doing so would threaten the covenant between borrowers and lenders, and encourage those making their payments on time to default and cash in.
In taking this stand, DeMarco, responsible for overseeing oversees mortgage giants Fannie Mae and Freddie Mac, puts himself in an increasingly lonely position. The Obama administration, along with housing activists and many economists, says the "moral hazard" of debt relief is less dangerous to the economy than the foreclosures and suffering that will happen if nothing is done. The fear that writing down loan values for one set of borrowers encourages others to quit paying their mortgages is overblown, they say, and the argument about morality is way out of date.
"There is no evidence that people would rush to strategically default," said Brent White, a law professor at the University of Arizona who has written extensively about housing policy. "If homeowners needed an incentive to default they would be doing so already."
The FHFA estimates that principal reduction could benefit taxpayers to the tune of up to $500 million, though the benefit could be much less. The Department of the Treasury's estimate is higher, possibly up to $1 billion.
For many of the 11 million borrowers who owe more on their mortgage than their home is worth, the economically logical next step would be to walk away, White argues. Some have, but most are unwilling or afraid to break their contract -- even if it means unloading tens of thousands of dollars in bad debt, he said. So why would they default to obtain a smaller and much more uncertain, measure of relief?
Thressa Walker is one homeowner who probably would be better off walking away from her San Jose, Calif., townhouse, and her deeply underwater home loan.
She owes $538,000 now on a home worth $256,000. She received an interest rate reduction through the Home Affordable Modification Program, or HAMP, but because her first mortgage is owned by Fannie, she did not qualify for principal reduction. When she inquired about principal reduction for her smaller second mortgage, she was told she would need to stop making payments, she said.
But Walker doesn't want to abandon her home, and she also doesn't want to intentionally default, for fear that she will lose her only credit card and damage her credit, she said. Even if she did, DeMarco's decision ensures that she will remain on the hook for most of the negative equity in her home loan.
"I am stuck," she said.
If anything, DeMarco's decision increases the odds that she will walk away -- sticking Fannie Mae -- and by extension taxpayers that bailed out the mortgage giant -- with a home worth half of what was loaned out.
Up to 500,000 homeowners could qualify for principal reduction through HAMP if Fannie and Freddie got on board, according to government estimates.
Luigi Zingales, a University of Chicago economist, said he agrees that offering targeted principal reduction to some underwater borrowers would probably not trigger a tidal wave of intentional defaults. Most homeowners aren't that savvy or cynical, he said.
But, he said, it is also a little late in the game to be arguing moral hazard now. The Obama administration's response to the housing catastrophe -- including programs that DeMarco supports, such as interest rate reductions and forbearance plans -- has created a moral hazard, he said.
"Every sort of intervention can create legal uncertainty and moral hazard," he said.
If the phrase moral hazard sounds familiar, it is because Bush administration officials, including then Secretary of the Treasury Henry Paulson, used the phrase frequently in 2008 to explain why they failed to throw a lifeline to Lehman Brothers, the investment bank that gorged on subprime mortgages, then melted down.
When that decision threatened to ruin the economy, Bush officials quickly pushed a massive $700 billion bailout through Congress. Since then, banks have received hundreds of billions in taxpayer support. Homeowner aid, however, through a collection of Treasury initiatives, has totaled just $4.5 billion of the $50 billion set aside by Congress -- and much of that was used for incentives to encourage banks to modify loans.
Moral hazard didn't stop Congress from rescuing banks, but it is enough for DeMarco.
"I'm a free market guy, but there is a clear difference in treatment between the banks and homeowners," Zingales said. "It seems as though they remember moral hazard in one case and not in the other."
CORRECTION: A previous version of this story incorrectly said that the Obama administration views the moral hazard of principal reduction as more dangerous to the economy than foreclosures. The administration, in fact, sees the hazard of debt relief as less dangerous.
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