Insight & Thought Leadership on the Global Economy

He really has the ability to put aside any pre-existing agenda and just talk facts to almost everybody — Barney Frank, U.S. Representative for Massachusetts’s 4th Congressional District

Ed DeMarco Could Hasten End to Foreclosure Crisis by Allowing Debt Forgiveness

[This article originally appeared in the Washington Post May 10, 2012]

As an example, consider an underwater homeowner who owes $150,000 on a home worth $100,000. With a 5 percent mortgage rate, his monthly payment is just over $1,000. With an earned mortgage, the bank forebears on $25,000 of the mortgage amount, saving the homeowner more than $100 per month. The homeowner still owes $150,000, but this is reduced by $5,000 a year, or $25,000 over five years. If the homeowner goes delinquent for more than two months during those five years, he owes the entire $150,000. If the homeowner wants to move before five years, his mortgage would be reduced pro rata. Under most scenarios, he would still be underwater, and would go through a short sale. It is possible that the home could appreciate enough so that with the mortgage reduction he would pocket a gain. But this seems unlikely.

An earned mortgage seems well suited for homeowners who are deeply underwater but fighting hard to keep their homes. An estimated 6.5 million homeowners are underwater more than 30 percent, and most have never been more than two months late on their mortgage (see chart). This is a key threshold for default. Even a small financial reversal, such as a roof leak or a busted air-conditioning unit, could discourage these homeowners from holding on. Forbearance would provide them with some relief , but an earned mortgage would offer a real financial hook — making it possible to get back above water and avoid default.

Moral hazard is much less a problem with an earned mortgage. Because a homeowner must earn forgiveness, and even then is unlikely to be above water soon, the program is much less subject to abuse. Also worth noting is that banks have forgiven principal on mortgage loans they own for some time, with good success. Moral hazard has not increased and default rates are low compared with other types of mortgage modifications.There are signs that the housing crash is almost over. Home sales and construction are rising and prices are more stable.It is premature, however, to conclude that the problem is behind us. Millions of homes are stuck in foreclosure; as these go to foreclosure and short sales, the market’s fragile stability is threatened.Policymakers don’t need to do a lot to prevent that, but they should take the opportunities they have to help. Forgiveness won’t come easy for the FHFA and its agencies, but if it helps even a few hundred thousand homeowners, it is the right thing to do. Say yes.
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