According to the latest reports, housing prices continue to fall in many areas of the country, in some cities falling to pre-2000 price levels. Sinking home prices come on the back of continued fallout from the excesses of the housing boom: the recent announcement that New York State’s attorney general has begun a new round of home loan industry probes, the lawsuit by the federal government against Deutsche Bank under the False Claims Act, and the ongoing negotiations led by Iowa Attorney General Tom Miller and Elizabeth Warren, Obama administration special assistant for consumer credit issues, between state attorneys general and mortgage servicers related to “robo-signing” and other irregularities.
As housing prices fall and enforcement actions rise, something else will rise as well: calls to use current and prior misdeeds to force banks to write down the principal on underwater mortgages - those where a homeowner owes more than his home currently is worth - to the market value of the house. While coerced principal reduction is a tempting political gambit for politicians, requiring it as part of a settlement for previous bad acts by lenders would be illogical and unfair, both as part of this settlement as well as a general response to the continued housing crisis.
To be clear, the behavior of mortgage servicers has been outrageous and the allegations in the various civil investigations disturbing. But coercing lenders to write down the principal on delinquent mortgages is the wrong solution to lenders’ misdeeds. For lost among the legitimate outrage about “robo-signing” and other improper practices is another uncomfortable truth: Paperwork bungling has not resulted in innocent and responsible borrowers being thrown out of their homes. The homeowners subjected to foreclosure actions haven’t made payments in months and not a single one has proposed catching up on payments in order to cure default. One lender reported last fall that 33 percent of its homes in foreclosure were vacant and 80 percent of the foreclosed properties’ owners hadn’t made a payment in more than a year. In fact, the Martin Act - the New York State attorney general’s main tool against the mortgage industry - doesn’t even require him to prove that the lenders were trying to defraud anyone.
Nor would writing down mortgages provide a real solution to the housing crisis - in fact, it would make it worse. Forced principal reduction might alleviate foreclosures crisis in the short run by reducing the incentives borrowers face to walk away from an underwater home. In that sense, we’ve learned that houses fundamentally are no different than any other financial asset. Each month, the borrower has a financial option. He can treat it as a call option and make his payment on the mortgage for that month and retain the option of making 30 years worth of payments, at which point he will have purchased the asset. Or he can instead treat it as a put option and instead of making the payment, he can instead default on the mortgage and put it back with the bank through a foreclosure process. Unsurprisingly, economists find that where the value of exercising the put option rises (such as when the house falls in value) or the cost of exercising the option falls (such in states that have so-called “anti-deficiency” or “nonrecourse” laws that limit the lender’s remedies in the event of default), foreclosures tend to rise.
So forcibly reducing principal would likely reduce the foreclosure rate - temporarily. But this would exacerbate the foreclosure problem in the long run. According to a recent study by Zillow, 28 percent of all American homes are currently underwater. And that was before the recent reports that housing prices continue to sink in many parts of the country. If government officials force principal reductions because of shoddy paperwork or previous misdeeds, then they are inviting a moral hazard problem on a nuclear scale. Homeowners all over the country would face a temptation to stop paying mortgages just to find out if the paperwork was in order, which recent experience suggests it most likely isn’t. Who wouldn’t consider going delinquent if the prize was a principal write-down of 60, 80, or $100,000? Banks, uncertain of their ability to enforce the terms of agreements, likewise, would jack up mortgage rates sky-high or stop making mortgage and home equity loans altogether. Another serious recession could result. Even if the most extreme, recent allegations against the mortgage lenders are entirely justified - and that’s far from clear - it still wouldn’t provide grounds for policies that potentially could collapse the entire country’s housing market.
Nor is it fair to reward delinquent borrowers with principal reduction. The failure of loan servicers to properly document their loans is inexcusable but it makes no sense to provide a windfall to borrowers who are in foreclosure because they have made an economic calculation to walk away from a bad investment. If it does, why limit relief for bad investments to homes - why not give everyone who bought stocks at the height of the dot.com bubble a refund for overpaying for Pets.com stock?
What of the borrower who bought a home with nothing down and an interest-only mortgage, never planning to pay a penny in principal but instead to flip it in a few years for a tidy profit - and then decides to walk away once the investment went south? It isn’t clear that it is even meaningful to call that person a “homeowner” as opposed to a real estate speculator living in his investment. Why should he receive a bailout denied to a real homeowner who has responsibly built up equity over time and so chooses not to walk away?
Lenders and loan servicers should pay the price for whatever wrongs they have committed. But their punishment should not result in a windfall to delinquent borrowers at the expense of responsible consumers and setting back a housing market recovery.
Todd Zywicki is a law professor at George Mason University and scholar at the university’s Mercatus Center.