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Moral Hazard and Mortgage Modifications

By Adam Levitin

Bring out the Vice Squad--we've got a Moral Hazard.  Yup, some of the reluctant AGs have now expressed concerns over principal write-downs in a servicing fraud settlement because it might create....moral hazard. Some bank CEOs and other predictable voices jumped on the moral hazard bandwagon.

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 reason why we do this (and why we have fire departments) is that concerns over externalities can trump moral hazard concerns--if my neighbor's house catches fire, mine is at risk. So too if my neighbor's house goes into foreclosure, my property value is going to plummet.

Basically, we're looking at a Type 1 vs. Type 2 error problem--too many mods (some go to the undeserving) or too few. There are costs either way, but too many mods is not as likely to cause further downward pressure on housing prices as too few mods.  Laurie Goodman, the leading MBS analyst around, didn't miss this. In a recent research report, she writes:

Principal reductions are clearly the most effective type of modification. This makes sense, as equity is the most important determinant of default. There are many ways to both effect a principal reduction and contain the moral hazard issue. 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.

 We applaud the Attorneys? General proposal, as principal reductions are at the heart of their recommended course of action. Indeed, principal reduction is the single most important supply side measure that can be taken. [Laurie goes on to state that principal reduction alone, however, is not sufficient.]

Laurie also makes short shrift of the moral hazard argument:

First, the current modification program [HAMP] already has a moral hazard issue; borrowers are clearly defaulting to get a rate reduction.

Second, we can introduce a series of frictions so borrowers who need the principal reduction are able to obtain it, and those who don?t need principal reduction are not envious of those who receive it.

Third, the moral hazard problem only extends to underwater borrowers, of which there are a finite amount, and the overhang can be sized.

We actually have a pretty easy solution to moral hazard concerns about principal reduction--it's called bankruptcy. A critical reason for using bankruptcy to do principal reductions (cramdown) is to impose some costs on the homeowner beneficiary so that only those who need help will seek it. Bankruptcy provides the "frictions" that Laurie Goodman writes about. Somehow, I suspect that all of those crying moral hazard now also opposed cramdown.  (Certainly Stumpf and Moniyhan were opposed.) If so, the issue really isn't moral hazard. Moral hazard is just an argument being made to avoid principal write-downs, not because of genuine concern over the issue. 

Full post as published by Credit Slips on March 28, 2011 (boomark / email).