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Democracy Likely Defeats Moral Hazard

Posted by Larry Doyle on April 20, 2009 7:06 PM |

As part of Obama’s proposal to support housing, the administration pushed the application of principal reduction via bankruptcy proceedings. This process, known as a mortgage cram-down, was pushed hard by the administration and many Democrats. Virtually all Republicans and mortgage investors viewed the mortgage cram-down as another in a long line of moral hazards.  In short, the mortgage cram-down would violate the implicit and explicit terms of a written contract. 

I wrote What Is a Mortgage Cram Down? on January 1st. While the Obama administration pushed hard for this legislation to be approved, ultimately those with a longer term vision prevailed. What are the concerns about principal reduction? As I wrote:

I personally find it difficult to swallow the concept of government funding for this program. At this juncture, though, the horse is so far out of the barn that we are trying to prevent the illness from becoming a full blown epidemic, if not a plague.

Home prices are down 18% year over year in the top 20 cities in the country and foreclosures have increased by approximately 40%. Both of these figures are certainly headed further in those directions with continued losses for the holders of the underlying mortgages, whether those mortgages are already pooled into securities or held in whole loan form.

The unintended consequences of a principal reduction program will likely be an increase in mortgage rates over the longer term along with a more stringent credit review for those applying for a mortgage. Why will this happen? Very simply, investors in mortgage securities will demand those concessions if they are to purchase mortgages that have the chance of being “crammed down.” Additionally, this program may actually incentivize some borrowers to intentionally become delinquent in their mortgage payments, and actually risk personal bankruptcy in an attempt to be “crammed down.” Where does the madness end?

The FT reports Critics Scent Blood on Obama Mortgage Bill. I fully empathize with homeowners in trouble on their mortgages. The immediate beneficiary of this proposal not becoming law are the entities holding these mortgages (banks and investors).  The long term beneficiaries are future homeowners who will not have to pay higher rates and increased fees due to the potential of the mortgage being crammed down by a judge in a bankruptcy. The FT highlights:

The industry used the potent threat that the legislation would force lenders to raise the cost of mortgages in order to insulate them from the added risk of losses. The fear that responsible borrowers could be hurt has swayed moderate Democrats, who forced a weakening of the bill in the House of Representatives last month. 

The Obama administration pushed very hard for this mortgage cram-down legislation.  It viewed the cram down as the last opportunity for mortgage holders to gain relief. The adminstration seemingly does not take into account unintended consequences of this legislation as well as the costs of increased moral hazards. The FT sheds further light on this:

The Obama administration sees the bankruptcy measure as providing a crucial final resort for people unable to refinance or modify their mortgages through other means. It would also act as a threat to intransigent lenders, encouraging them to modify mortgages where possible.

“I believe that the package is important to keep together because all elements are needed,” said William Apgar, senior adviser to the secretary of the department for housing and urban development. “On the other hand, we live in a democracy. The Senate runs on its rules, they count the votes, and we move from there.”

It is heartening to see that the rules of democracy will likely carry the day over the veil of threats and increased moral hazards. 


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