Principal reductions also address the risk that a borrower will default on their loan after it has been modified, which is referred to as re-default. This suggests that a significant campaign of principal reduction, particularly in areas with widespread negative equity, would curb strategic defaults and the resulting losses. As more homes fall more deeply underwater, it’s likely that the stigma of walking away from your home is not as potent as it once was. The study found that borrowers are more likely to consider walking away from their underwater homes if they believe that many of their peers have done so. However, when negative equity reaches 50 percent or greater, economic benefits of default and moral constraints loosen, raising the likelihood that the borrower will default. For example, if negative equity was at 10 percent, no homeowners would choose to default because of economic costs associated with foreclosure and moral constraints. The study finds that that borrowers largely do not consider strategically defaulting on their loans until negative equity reaches a tipping point. A body of research on borrowers’ incentives to pay demonstrate that negative equity is a strong predictor for default.Ī study by researchers at the University of Chicago and Northwestern University, cited by Alan White at Public Citizen, examines the relationship between negative equity and propensity to strategically default, or walk away from your mortgage even if you can afford the monthly payments. While it’s not clear how many homeowners would choose to default in order to cure their negative equity, it is clear that NOT addressing negative equity will cause defaults-and significant losses for investors.
The concerns about moral hazard are twofold: there’s an economic concern, where moral hazard would trigger a wave of countless dollars lost to forgiven principal and an ethical issue, where critics believe that principal writedowns would violate the spirit of fairness by protecting borrowers from losses on an investment that inherently includes an amount of risk.
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