NCPA - National Center for Policy Analysis

A Mortgage Deal With the Wrong Incentives

May 17, 2012

Bank of America, JP Morgan Chase, Wells Fargo, Citigroup and Ally Financial (formerly GMAC), are accused of "robo-signing" affidavits in foreclosures, deceptive loan modification practices, and failure to offer alternatives to foreclosure, says Diana Furchtgott-Roth, a senior fellow at the Manhattan Institute.

Settling these accusations, the Justice Department determined in February that the five large banks will be required to pay $25 billion to address mortgage loan servicing and foreclosure abuses.  However, the global deal that this entails is fraught with moral hazard and nepotistic quid-pro-quo deals.

The inherent moral hazard of the settlement can be seen in its structure:

  • The global settlement deal will help mortgage customers obtain lower payments by reducing interest rates and principle owed.
  • In order to qualify for help, homeowners must be "underwater" on their mortgage (owe more on their loan than their property is worth).
  • They must also have been at least 60 days behind on payments at the beginning of the year.
  • Finally, their monthly principal and interest payment, plus home insurance, property taxes and homeowner fees, must exceed 25 percent of their gross household income.

The incentives for neglect and abuse are abundant.  Customers face incentives to hide income or to not work entirely so that they can qualify for the relief provided by the deal.  This moral hazard demonstrates an inherent inefficiency that accompanies indiscriminate global relief.

Furthermore, because banks will take a financial hit on losses from qualifying customers, they will likely respond by raising rates on thrifty customers who have been so responsible as to fail to qualify for relief. 

Additionally, the deal disperses profitable side-benefits to public sector unions.

  • Of the $25 billion in the deal, $5 billion will go directly to federal and state governments.
  • $3.5 billion of this money is allocated to fund housing counselors, legal aid and "other similar public programs determined by state attorneys general."
  • Those hired under this program will be state and local employees, whose union, the American Federation of State, County and Municipal Employees, was the largest single campaign contributor in the 2010 elections, giving $90 million to Democratic candidates.

Source: Diana Furchtgott-Roth, "A Mortgage Deal With the Wrong Incentives," Real Clear Markets, May 10, 2012.

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