Immoral Hazard: How Helping Homeowners Avoid Foreclosure is Good for Everyone

Last Updated Mar 29, 2011 10:43 AM EDT

Banks that object to reducing mortgage principal as a way to help homeowners avoid foreclosure contend it would create "moral hazard," encouraging other borrowers to default on their loans. Some people also think this amounts to rewarding deadbeats for their irresponsible borrowing.

That's the wrong way to think about it, explains Georgetown University law professor Adam Levitin:
Yes, there's some moral hazard in doing principal reduction mods if you only offer them to defaulted borrowers and the borrowers no that. That's hardly surprising. But so what? Just because something creates a moral hazard doesn't mean it's the wrong thing to do. There's more to that equation.
Larry Summers showed pretty handily why too much belly aching over moral hazard is silly. As Summers argued, when there's a fire next door, you help put out the fire; you don't first ask if the fire was caused by lightning or by your neighbor smoking in bed. Yet putting out the fire irrespective of cause creates a moral hazard by bailing out in-bed smokers.
The fire in this case, obviously, is the raging foreclosure epidemic, which banks have worsened by doing everything possible to avoid modifying people's home loans. Thing is, any homeowner concerned about plunging real estate prices should favor principal reductions. Why? Because as Levitin notes, while it's true that some people will get mortgage relief who don't deserve it, offering too many modifications is less likely to further depress home prices than offering too few.

The virtue of "cramdowns"
Besides, there are ways to address moral hazard, adds Amherst Securities analyst Laurie Goodman, among the country's experts on housing finance:
All our ideas boil down to one simple notion -- create a series of frictions such that only those borrowers who need this type of modification will take advantage of it. The frictions ensure that fairness issues are minimized, as the receipt of a principal reduction entails other penalties.
One effective friction -- bankruptcy. An excellent way to stem foreclosures is to let bankruptcy judges "cram down" mortgage balances. That's because bankruptcy hurts. It wrecks your credit, makes it hard to get a loan and can even complicate getting a job. As Levitin notes, such effects are a powerful disincentive for homeowners to seek mortgage relief who don't genuinely need it.

Unfortunately, banks also oppose this form of legal remedy. They helped scuttle cramdown legislation in 2009. Their objection? That it would induce homeowners to declare bankruptcy.

What that tells us is that moral hazard, as invoked by financial firms, is a fig leaf for their economic interests. And it turns the problem exactly on its head. Because the main obstacle to solving the foreclosure crisis isn't the morality of homeowners -- it's the morality of bankers.

Thumbnail and image from Wikimedia Commons, CC 2.0
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    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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