The concerns about moral hazard are twofold: there’s an economic concern, where moral hazard would trigger a wave of countless dollars lost to forgiven principal; and an ethical issue, where critics believe that principal writedowns would violate the spirit of fairness by protecting borrowers from losses on an investment that inherently includes an amount of risk.
While it’s not clear how many homeowners would choose to default in order to cure their negative equity, it is clear that NOT addressing negative equity will cause defaults—and significant losses for investors. A body of research on borrowers’ incentives to pay demonstrate that negative equity is a strong predictor for default.
A study by researchers at the University of Chicago and Northwestern University, cited by Alan White at Public Citizen, examines the relationship between negative equity and propensity to strategically default, or walk away from your mortgage even if you can afford the monthly payments. The study finds that that borrowers largely do not consider strategically defaulting on their loans until negative equity reaches a tipping point. For example, if negative equity was at 10 percent, no homeowners would choose to default because of economic costs associated with foreclosure and moral constraints. However, when negative equity reaches 50 percent or greater, economic benefits of default and moral constraints loosen, raising the likelihood that the borrower will default. The study found that borrowers are more likely to consider walking away from their underwater homes if they believe that many of their peers have done so. As more homes fall more deeply underwater, it’s likely that the stigma of walking away from your home is not as potent as it once was. This suggests that a significant campaign of principal reduction, particularly in areas with widespread negative equity, would curb strategic defaults and the resulting losses.
Principal reductions also address the risk that a borrower will default on their loan after it has been modified, which is referred to as re-default. Re-default is a real risk that threatens the viability of foreclosure prevention programs: bank regulators found that nearly 24 percent of all modified loans since 2008 (which have largely relied on reducing interest rates and extending loan terms) have become seriously delinquent again, and another 13.6 percent were in foreclosure or have completed foreclosure. A recent Federal Reserve Bank of New York study points out that “modification is only worthwhile if it induces borrowers who would otherwise default to continue paying.” The report found that while both promoting affordability and reducing negative equity lower re-default rates, reducing negative equity impacts re-defaults to a much bigger degree: the authors estimated that “restoring the borrower’s incentive to pay [by writing down principal to current market value] nearly quadruples the reduction in re-default rates achieved by payment reductions through interest rate modifications and term extensions alone” (emphasis mine).
Additionally, negative equity could be exacerbating the unemployment rate: if an unemployed borrower gets a job offer in another state, but can’t sell his or her house because he or she owes more than it will sell for, he or she faces a significant barrier to accepting that new job. One study cited by the New York Fed found that borrowers in negative equity are one-third less mobile than borrowers with positive equity.
As for the criticism that principal writedown is “wrong”? Well, figuring that out is above my pay grade, but there are ways to introduce costs for receiving a principal writedown to make it less desirable to borrowers who don’t really need it. One way would be to allow principal writedowns to happen in bankruptcy court. A borrower would still be able to keep his or her home and would have incentive to continue paying his or her mortgage, but would have to suffer the consequences of a bankruptcy on his or her credit report and pay significant costs to his or her debtors.
In an editorial questioning “moral hazard fundamentalists,” Larry Summers pointed out that the fact that some people smoke in bed does not mean that we shouldn’t put out their fires. We don’t condemn the bed-smokers to suffer the consequences of their risky behavior because the fire can spread. If we want to stop the spread of strategic defaults caused by negative equity, principal writedowns are the most effective option.