Principal forgiveness must be coupled with equity recapture to avoid moral hazard

Millions of people are underwater on their mortgages, and many of those borrowers have payments straining their ability to pay. The favorite solution of pandering lefties is to simply forgive the debt and lower the borrower’s payments. Of course, the solution would bankrupt the banks and cause significant future problems with moral hazard because borrowers would have a strong incentive to borrow imprudently in hopes of obtaining free money. Principal forgiveness is not the answer, and despite loanowner’s false hope, no significant principal forgiveness is forthcoming.

Excessive mortgage debt is a drain on our economy as too much money is diverted to debt service, but the real problems with loanowners is their immobility. Loanowners are trapped by debt in their homes unable to move to take a better job. This causes resale transaction volumes to suffer which in turn puts less money into the economy through agent commissions and new home sales. The economy struggles due to the existence of the excessive mortgage debt.

Back in April of 2007, I first proposed a workable solution to alleviate the debt problem in the post: How Homedebtors Could Avoid Foreclosure.

As much as it pains me to write this, there is a short to medium term solution to the foreclosure problem: convert part of the mortgage to a zero coupon bond. For those of you not steeped in finance, a zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. You don’t pay either the interest or the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.

Here is how it would work for our typical homedebtor: Assume our financial genius utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Let’s further assume his real income (not what he reported on his liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homedebtor can now make their payment, and they get to keep their house. But here is the catch: when they sell their house, they will owe the bank a lot of money. If they sell the house in 20 years, they will owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home will go to the bank.

This would solve a multitude of problems: First, it would provide a mechanism whereby people who were victims of predatory lending could keep their homes. This would make the homedebtor happy, and it would get government regulators out of the bank’s business. Second, it would make the banks more money in the long run because they are still making their interest profit even if they don’t see it until the homedebtor sells the home (many may not be aware of it, but lenders book income on the increase in principal on a negative amortization loan). Third, since foreclosures would be the primary mechanism facilitating the crash, it would keep home prices from crashing by reducing the number of foreclosures.

Today I want to discuss a similar proposal that’s even more favorable to loanowners. Instead of converting the excessive debt to a zero-coupon second mortgage, make it a zero-interest second mortgage. Basically, you take the “forgiven” debt, freeze it so it doesn’t get larger, and hold it against the property to be recovered by future appreciation similar to the zero-coupon idea described above. Lenders won’t be quite as excited about the idea because they will not be earning interest on their money, but at this point, it’s better to get a return of their capital even if they must sacrifice a return on their capital. This solution also solves some of the other problems I noted with the zero-coupon solution.

The borrowers get to stay in their homes, but they still pay a price. They must give up the appreciation between today’s market value and their original loan balance. Borrowers are no worse off than they are today, and although most would be better off selling and buying a less expensive comparable property so they could keep the appreciation, most won’t do this. Most borrowers will stay in their homes even if they are basically paying an extra 30% to do so.

To really unfreeze the resale market, this zero-interest second must have automatic short sale approval written into the agreement. If the seller wants to get out before the house has appreciated to the point the zero-interest second is no longer underwater, the sale should require no further approval. This wouldn’t have worked years ago, but first mortgage holders are no longer holding up short sales anyway. The existing second mortgage holders are the ones causing problems with short sales today.

Compelling existing second mortgage holders to play along is more problematic. The second mortgages that are currently underwater and delinquent would be delighted to participate in the program. Right now, they have nothing, so if they have the chance to get paid back 10 years from now if the combined mortgage balance is no longer underwater, they are better off than they were today. The second mortgages that are not delinquent is a more difficult sell. As long as the borrowers are paying, second mortgage holders have no reason to participate. These second mortgage holders will benefit from the first mortgage converting part of their principal to a zero-interest loan because the borrower will have greater ability to pay on the still-current second.

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Proprietary Irvine Housing News home purchase analysis

17571 WAYNE Ave Irvine, CA 92614

$594,900 …….. Asking Price
$695,000 ………. Purchase Price
3/30/2004 ………. Purchase Date

($100,100) ………. Gross Gain (Loss)
($55,600) ………… Commissions and Costs at 8%
============================================
($155,700) ………. Net Gain (Loss)
============================================
-14.4% ………. Gross Percent Change
-22.4% ………. Net Percent Change
-1.8% ………… Annual Appreciation

Cost of Home Ownership
——————————————————————————
$594,900 …….. Asking Price
$118,980 ………… 20% Down Conventional
3.56% …………. Mortgage Interest Rate
30 ……………… Number of Years
$475,920 …….. Mortgage
$110,027 ………. Income Requirement

$2,153 ………… Monthly Mortgage Payment
$516 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$149 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$25 ………… Homeowners Association Fees
============================================
$2,842 ………. Monthly Cash Outlays

($337) ………. Tax Savings
($741) ………. Equity Hidden in Payment
$136 ………….. Lost Income to Down Payment
$94 ………….. Maintenance and Replacement Reserves
============================================
$1,994 ………. Monthly Cost of Ownership

Cash Acquisition Demands
——————————————————————————
$7,449 ………… Furnishing and Move In at 1% + $1,500
$7,449 ………… Closing Costs at 1% + $1,500
$4,759 ………… Interest Points
$118,980 ………… Down Payment
============================================
$138,637 ………. Total Cash Costs
$30,500 ………. Emergency Cash Reserves
============================================
$169,137 ………. Total Savings Needed

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Cost of Ownership Analysis

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Nearby Foreclosures

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Comparative Market Analysis

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	$659,500 17501 TEACHERS Ave		0.09 miles 5 bd / 2.25 ba 2,067 Sq. Ft.
	$715,000 42 GILLMAN St		0.53 miles 4 bd / 3 ba 2,280 Sq. Ft.
	$850,000 8 TERRAZA		0.59 miles 4 bd / 2.5 ba 2,372 Sq. Ft.
	$886,000 5 PADUA		0.61 miles 4 bd / 3 ba 2,528 Sq. Ft.
	$895,000 4 COMISO		0.65 miles 4 bd / 2.5 ba 2,058 Sq. Ft.
	$839,000 12 MONTELEGRO		0.71 miles 4 bd / 2.5 ba 2,350 Sq. Ft.
	$925,000 15 DAYBREAK		0.78 miles 4 bd / 3 ba 2,366 Sq. Ft.
	$889,000 8 RAINSTAR		0.87 miles 4 bd / 2.5 ba 2,500 Sq. Ft.
	$958,000 21 BAYSIDE		1.13 miles 4 bd / 2.5 ba 2,450 Sq. Ft.
	$699,000 5 HOLLY St		1.15 miles 3 bd / 2.25 ba 2,456 Sq. Ft.