Bailouts push the moral dilemma envelope

Fannie Mae and Freddie Mac announced plans Tuesday to ease the mortgage modification process for troubled homeowners. As reported in the Los Angeles Times:

Under the program announced Tuesday, a homeowner who lives in the home in question and misses at least three loan payments could qualify for a streamlined workout designed to reduce the monthly payment to 38% of the borrower's gross income.

That would be accomplished by doing one or more of the following: extending the term of the loan to 40 years; lowering the interest rate temporarily or permanently; or excluding part of the loan balance when calculating the monthly payment.

With the last option, known as principal forbearance, the amount owed by the borrower would not change and would have to be paid back when the house was sold or refinanced.

The Times' Tom Petruno looks at the issue at the Money & Co. blog:

Is there really a big moral-hazard risk in this plan?

If you believe that many people will try to cheat their way to a modification, you will be interested in the views of the well-known libertarian investment manager Peter Schiff of Euro Pacific Capital.

Here's his take, which he sent by e-mail Tuesday:

By offering to reduce mortgage payments to 38% of household income for homeowners who are 90 days delinquent, the mortgage program announced today will spark a new wave of delinquencies. In a classic case of unintended consequences, the plan will encourage homeowners to rearrange their finances to qualify for the benefit. Those who could conceivably economize to meet their existing obligations will now have a strong reason to forgo such sacrifices.

The intentional reduction of income is also a possibility. In many cases dual-income families may decide to eliminate one job altogether as reduced mortgage payments combined with lower child care and other work-related expenses will likely exceed the after-tax value of the lost paycheck.

It may also be tempting for some homeowners to temporarily quit high-paying jobs, or delay job searches, and accept low-paying jobs while the creditors consider their fate. Once their mortgage payments have been modified to fit their diminished incomes, these homeowners would then be free to pursue better-paying jobs. With mortgage payments reduced to a fraction of their prior payments, these workers will have much more employment flexibility than those foolishly struggling to meet non-modified mortgages.

L.A. Land readers have been pointing out similar concerns since the get-go.

-- Lauren Beale

Thoughts? Comments?

Photo: Freddie Mac's corporate offices in McLean, Va. Credit: Pablo Martinez Monsivais / Associated Press

Comments

[Cal]

People really have to think about how much of a bailout this ISN'T.

They aren't forgiving principal and are getting the bagholders to keep paying for their overpriced assets.

Gee, let me trash my credit to sign up for that plan!

It is a non-event.

[Tim K.]

It's also highly unlikely any of the people who are this deeply underwater will want to get ANY loan modification that doesn't involve principal reduction.

Seriously, if you were told you are underwater by $200K, would you want someone to help you figure out how to pay that off in nicer monthly installments, or would you prefer to just take a hit on your credit and not pay the $200K at all?

That's why this strategy is flawed - nobody *wants* to pay back the money.

[MyLessThanPrimeBeef]

From now on, I am doing business only with the United States government.

I will only borrow from the Fed and The Tresury.

I willl only deposit with the same.

Why go through the middleman, as they say. Forget about Fannie Mae, Freddie Mac, FHA, or whatever.

In fact, after they bailout/buy a stake in GM, I am buying my car from the government directly as well.

[anonymous]

This administration is dumb as dirt. All they are doing is rewarding fraud with our tax dollars. Now Paulson is switching the "goal" of the 700B bailout away from bank credit and focusing on credit cards and other types of loans. Too little too late.
There are a LOT of small business owners who rely on credit cards during hard times. Their credit card limits have been reduced to nothing and the interest rates have doubled or tripled.
Hello, out there, they are laying people off and NOT ORDERING stock for the holidays.
The current administration really doeasn't have a clue what the middle class is going through right now.

[Kevin]

Peter Schiff has a good point, but only if it applies to a forgiveness and actual bailout of a portion of the loan. I don't believe them when they said it's only a deferment, but if that were true, I'm much more satisfied with this approach. It made me sick to my stomach thinking that they were going to do a free mortgage giveaway to idiots, which of course would be joined by all other homeowners.

[Rational Renter]

I don't even care about the moral hazard argument anymore. That bridge was crossed a long time ago. The problem with these plans is THEY WILL NOT WORK.

NOTHING can stop house prices falling until they hit affordability levels. Short of a dramatic increase in incomes (virtually impossible in this economic climate), prices are falling to 2000 levels (and they will overshoot before eventually settling there).

[Robert in Palm Springs]

The best thing the government can do is get out of the way and let the market stabilize itself. Their interference is only prolonging the agony and delaying recovery.

After three years of shopping in Palm Springs my partner and I are finally seeing houses we both like and can afford. However, we are renting a house that suits our needs fine at a fraction of the cost of buying. We plan to wait it out until 2010 and then buy having a larger down payment and being able to buy more house for less money.

With layoffs increasing, more ARM resets coming and credit still scarce, even with the government interference we see little upside to the housing market. Yet many sellers still refuse to face reality asking premium prices and, of course, not selling.

In the broader scope, we see many small businesses closing in addition to the chain stores (i.e. Linens and Things), more homeless people or people living in cars, and are constantly hearing of layoffs. With all that, plus all the deserted developments, the images are increasingly looking like the 1930s. I expect it only to get worse and see no reason to commit to long-term debt at a time when cash is king.

[Steve]

This is how you get ahead in America, get in as much debt as possible and then flake out. These are the ones that have always won. You save for the 20% down payment and play it conservitive you loose. Just like the liars in politics we will expereince inflation that will make the 70s look like chump change. Get in total debt and pay back with dollars that will be worth half in 5 years. Do not save and be a chump.

[TrojanDLA]

Why people trust the government to do anything efficiently is beyond me. From airport screeners to immigration agencies to medicare oversight, it's all been a complete FAILURE in terms of execution.

I have yet to see ANY government run a business more efficiently (without tax subsidies) than a typical private company. France took over one of the largest banks in its history (Credit Lyonnais) and pretty much ran it into the grand in less than 10 years.

[Carl Heldmann]

"The blind leading the blind"

[tew]

Guys like Schiff only hit the tip of the iceberg.

What about folks with extended families and family businesses? They will gladly shift income to other family members and get their mortgage mods for some of them.

How about folks with dual citizenship and connections to other countries? Another easy way to shift money and income around.

How about folks that work in positions that have access to under the table income? If part of the family income is waiting tables you tell the boss to stop paying you and you just work for tips which you don't report at all for example.

You can forget about working that second job too. Maybe most folks don't know what the term "marginal income tax rate" means, but they know that they are working extra hours for exactly $0.00/hr if it keeps them from getting the mortgage mod.

This will be gamed beyond recognition.

[Nelcisco]

Interesting comment by Jim Cramer of CNBC's Mad Money who thought bailing out deadbeats was a great idea contrary to what he or any of us believe, saying that its our best hope because by not doing it it'll prolong what we see today, basically do it get it out of the way so that home prices can be stablized which will get the economy back on track.

[Fourth Generation]

No program can stop the inevitable correction that we are experiencing. At best they only slow it down. And that only prolong the economic instability. The best alternative is to let prices reach affordability for each market.