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Homeowner Moral Hazard


If you were a homeowner who was “underwater” – your outstanding principal on your loan was greater than the assessed value of the house – how would you react if you knew that:

  • The government was going to purchase mortgages
  • The government wants to prevent foreclosure and favours modification of principal/interest rather than foreclosing.

The answer, I think, is: you’d stop paying your mortgage payments, just for the heck of it. If the government has purchased your loan – you know they will do anything to stop foreclosing on you, so you’ll end up being better off by either a reduced principal, reduced interest rate or both.

And if a bank still owns it, the bank could easily sell your mortgage to the government as it is a “distressed” asset; and then the government will do stuff like reduce your principal/interest.

No matter how you look at it – it’s best for even prime borrowers to default on their loan payments, to take things to the breaking point. That is the kind of moral hazard associated with the bill that failed.

I think if you took out just that one clause – basically, no modifications to mortgage principal or interest will be done – I think the bill will be a better one. A moral hazard introduced at the homeowner level will cause absolute financial chaos.

It’s probably moot, because the bill failed. And perhaps that’s a good thing because it gives people time to think some more and make changes that aren’t purely politically motivated. There are problems with other clauses as well, but the mortgage mod is by far the worst one – and I think that removes most means of really making any profit on the deal.

It’s not time to panic. It’s time to sit and think about what has just happened. It is not a big deal. It is not worthy enough for an 8% drop on the S&P.

If the Indian markets panic tomorrow I will be seriously considering some purchases.


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