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New rush to modify home loans raises 'moral hazard' issue

November 11, 2008 |  7:44 pm

How far would people go to get better terms on their mortgage?

Would you feign financial trouble to qualify for a loan-modification plan?

As the government and private lenders face more pressure to aid struggling borrowers in a worsening economy, they’ll inevitably have to deal with the "moral hazard" issue: They may be encouraging applications for help from people who could otherwise scrape by without assistance.

On Tuesday the Treasury announced a new loan-modification effort for mortgages held by Fannie Mae and Freddie Mac, which the government took over in September.

My colleague Maura Reynolds describes the program in this story. Basically, the plan would reduce a homeowner’s payment to no more than 38% of monthly gross income, by cutting the interest rate, deferring payments or extending the loan term.

To pre-qualify, a homeowner would have to miss at least three loan payments and must still be solvent, at least in theory (i.e., you can’t have filed for bankruptcy protection). Apparently, your loan would have to be for at least 90% of your home’s value.

Foreclosuresale See more of the plan's specifics here. (There's a Q&A on pages 4 to 7.)

As usual with these programs, the onus is on the borrower to contact the lender, to see what can be worked out.

Brian Montgomery, assistant secretary of Housing and Urban Development, insisted in a statement that loan modifications under the Fannie Mae/Freddie Mac program "are not a gift." A principal reduction on the front end of a loan, he said, would be repaid at the end of the loan. "This is not loan forgiveness; the loans will be paid, but under terms that are affordable to borrowers."

But if a loan's interest rate is reduced, the loan holder (in this case, Fannie or Freddie, and therefore taxpayers) would be forgiving part of the expected return on the mortgage, unless the interest savings were added to the loan principal.

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.

Way too cynical a view?

And even if some people are going to cheat  -- as some obviously did to qualify for their mortgage in the first place -- do lenders really have any choice but to get more aggressive with loan modifications rather than risk an even bigger wave of foreclosures?

Photo credit: Damian Dovarganes / Associated Press

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