The Potentially Negative Effect of Mortgage Principal Reductions

by 17 May 2012
(TheNicheReport) -- The mortgage principal reduction provision of the 2012 foreclosure settlement agreement between state attorney generals and major American mortgage lenders has been generally well-received by homeowners, politicians, and some economists. There are, however, some valid concerns about the potentially negative impact that this provision could have on some sectors of the economy. The concerns about the negative do not point to worst-case scenarios; instead, the concerns are mostly related to long-term economic effects and the possibility of some homeowners taking unfair advantage of the principal reduction process, a situation that can be compared to strategic defaults whereby borrowers stop paying for mortgages they do not consider to be financially sound.

The Moral Hazard One of the problems associated with the mortgage principal reductions is that some borrowers who might be underwater on their home loans, but have not fallen into default, will not qualify for a write down offer from their lenders. This could be considered as unfair to homeowners who have not considered strategic default, even in the throes of the global financial crisis that essentially eroded their home values in relation to their mortgages. Analysts who believe that the mortgage principal reduction program created a moral hazard mention the probability of homeowners willfully falling behind on their payments just to qualify.

The fact that this principal forgiveness gives an advantage to delinquent borrowers has not been entirely lost on the mortgage lenders involved, but since these banks essentially agreed to something they would not have done on their own, it is unlikely that they will extend the mortgage reduction benefit to borrowers who are current on their payments –even if the appraised values of their homes have taken a dive in the last few years. The moral hazard concept comes from the difficulty that financial institutions would endure if they had to place their borrowers into categories; for example, homeowners who ended up in default due to hardship or just because market forces turned against them.

The Cost to American Taxpayers Edward DeMarco, acting director of the Federal House Finance Agency (FHFA), has voiced his opposition to allowing government-sponsored mortgage giants Fannie Mae and Freddie Mac participate in the principal forgiveness program. His rationale has been that since Fannie and Freddie are essentially owned by taxpayers at this time, reducing the values of their mortgage portfolios boils down to demanding more assistance from taxpayers in order to keep them afloat.

DeMarco’s reasoning for shutting out thousands of Americans who could benefit from mortgage principal reductions has been widely criticized, but the losses he mentions could extend beyond taxpayers. Pension fund managers whose portfolios include investments in mortgage securities could also see some losses; something that in the end will affect their clients who invest in retirement accounts. This would be a long-term effect that could grow to very negative proportions if the overall economy does not improve.


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