There are plenty reasons to object to the recent groundswell of support for modifying distressed mortgages (badly delinquent or already in foreclosure) by slashing rates, lengthening payback periods, and writing off part of the loan balance if a home is under water (i.e. the loan balance is greater than the market value of the home. The latter provision — forgiving part of the loan because housing prices have fallen is particularly troublesome.
First, there’s the moral issue: when somebody borrows money, they accept both a legal and a moral responsibility to pay it back. Whether or not the collateral they posted retains its value is irrelevant. Brokerage houses don’t write-down clients’ margin accounts because the stock market tanked. Banks don’t write-down auto loans if a borrower totals their car.
If that argument doesn’t carry sway, consider this: under reasonably realistic assumptions, folks who default on their mortgages and get government induced loan modifications may, in effect, get their housing for free for an extended period. Here’s the math.
Assume the Subprime Sam “buys” a home for $150,000 with no downpayment. After making a couple of payments, he stiffs the bank. Property values fall in his neighborhood — say, by 25%.
In the old days, the bank would have simply foreclosed on the loan and booted Sam out of the house. Not so fast these days.
Instead, the Feds “encourage” the lender to modify the loan — say, by lowering the mortgage rate to 4.5%, by lengthen the term to 40 years, and by reducing the loan balance to the current fair market value of the house.
Let’s say that Sam’s house dropped by the 25% neighborhood average and has a current $112,500 fair market value.
The bank writes off $37,500 of the original $150,000 loan, and Sam’s monthly mortgage payment drops to $500 — less than half of what he used to pay. (Trust me on the math).
Now, things get interesting,
If Sam is an typical mortgage loan “modifiee”, then — based on empirical data — there is at least a 40% chance that he’ll default on the loan again — within 6 months. That is, unless housing prices fall more — in which case, Sam is virtually certain to default again and walk away from the home and his mortgage obligation.
Let’s be positive, though, and assume that Sam takes his debt seriously this time, and that real estate prices bottom and start to creep up again.
For the sake of argument, let’s pretend that home values claw their way back up. Let’s pretend that — in around 7 years — Sam’s house is worth the original $150,000 again. (Note: that’s a home inflation rate of less than 5% annually — maybe a bit optimistic, but not wildly so)
And, let’s pretend that Sam sells the house then and walks away with about $40,000 – $150,000 from the sale, less the roughly $110,000 he’d still owe on his loan. (Note: Principal pay-down is minimal during the early years of a 40 year mortgage).
Now, over that time period, Sam made 80 monthly mortgage payments of $500 each — totaling about $40,000
So, Sam pitched in zero down payment and $40,000 in mortgage payments — then, he netted $40,000 on the sale. Presto. Free housing for about 7 years.
Of course, home prices might stay in the dumper and Sam may end up “out of pocket” for his housing.
But, that’s only fair. Especially since his mortgage payments are less than half of his non-defaulting neighbor’s, and since the bank had to write-off $37,500 to get the whacky process rolling.
Talk about unintended consequences and moral hazard …
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