Finessing 'Moral Hazard' Is Tough in Housing Plan

By RUTH SIMON and NICK TIMIRAOS

The Obama administration is trying to ensure its $275 billion housing-relief program will help only genuinely needy homeowners, but some critics say that it will also aid those who don't need -- or deserve -- the help.

"It's going to encourage everyone under the sun to try to qualify for this," warns Chris Mayer, senior vice dean at Columbia Business School.

Other critics balk at the idea of providing help to borrowers who used their houses as cash machines, or who bought much costlier homes than they could afford.

 

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Administration officials say it is impossible to help large groups of borrowers without introducing some degree of what has come to be known as "moral hazard." In other words, in its effort to help homeowners who behaved responsibly but wound up in trouble, the Obama plan will likely help some who didn't, which some say encourages more risky behavior.

The guidelines for loan modifications, part of the overall housing-relief program, are scheduled to be released early next month. Administration officials stress that they are carefully designing them to make sure borrowers can't game the system. For example, investors and homeowners who can afford their mortgage payments won't qualify for help, officials noted.

The announcement of the administration's program is already producing a flurry of calls to mortgage companies. A Wells Fargo spokeswoman said that interest in refinancing had contributed to a 20% increase in call volume at its retail-mortgage call center Thursday.

Steve Walsh, a mortgage broker in Scottsdale, Ariz., says his phones have been "ringing off the hook." But he says he is frustrated that the provisions weren't more detailed. "We don't really know what to tell people," he says.

Moral hazard has been a key issue in the debate over how the government should respond to financial distress, whether among homeowners or corporate titans. Critics have assailed the bank bailouts for helping businesses whose mistakes contributed to the financial crisis in the first place. And some homeowners who have stayed current on mortgages don't like the idea of helping borrowers who refinanced homes and pulled out cash for vacations, cars and other things, or submitted loan applications that falsified their income.

Another concern is that borrowers are stopping making payments in order to get help. That's because mortgage companies often won't modify the loans of troubled borrowers until they're delinquent.

The Obama plan addresses this issue by making it more likely that borrowers who need help will get a modification before they become seriously delinquent. Under the plan, mortgage companies and investors will receive incentive payments for helping borrowers who are "at risk" of defaulting because of a loss of income or an interest-rate increase, for instance.

"The Achilles' heel" of many previous efforts to stem foreclosures is that they have required borrowers to default in order to get help, says Susan Wachter, a professor of real estate at the University of Pennsylvania's Wharton School. Providing aid to borrowers who haven't yet defaulted "is an unrecognized and powerful component of this plan," she says.

The loan-modification guidelines that will be released next month also will be designed to weed out borrowers who don't need help, administration officials say. For example, they are likely to require that mortgage companies verify borrowers' incomes or claims of financial hardship to make sure they can't afford their payments.

Some homeowners who borrowed more than they could afford, either when they bought the house or refinanced, also may not qualify for assistance. That's because mortgage servicers are likely to use a "net present value" test to determine the losses that would result from a modification, and how they would compare with a foreclosure. If the losses are too great, the modification wouldn't be likely to happen.

But some borrowers may slip through the cracks. Someone working two or three jobs to make ends meet, for instance, may decide to give up one job in order to show a lower income. "Five years ago, if you really wanted to buy a house, you would do whatever you could to show every income source to make it as high as possible," says Tom Lawler, an independent housing economist. Now, borrowers seeking help "will want to show a low income." Borrowers with substantial assets but moderate incomes may also be able to get help, he adds.

Mr. Mayer says his "biggest pet peeve" with the Obama plan is that it will pay participating borrowers $1,000 a year for staying current on their mortgages once they are modified. He says, instead, participants should be warned: "If you're not going to make your payments on time, you're going to lose your house, because we just made it affordable."

Write to Ruth Simon at ruth.simon@wsj.com and Nick Timiraos at nick.timiraos@wsj.com