A Mortgage Deal With the Wrong Incentives

This week Bank of America announced that it will contact 200,000 mortgage customers to see if they qualify for reduced principal and interest payments under a February Justice Department settlement. The settlement required five large banks to pay $25 billion to address mortgage loan servicing and foreclosure abuses.

BofA, 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.

Banks should follow the law and repay clients who have been harmed. But the global deal uses government power to dissolve existing legal contracts between banks and customers who may not have not been victims of any deceptive bank practice.

If the government wants to help homeowners in distress, it can improve programs such as the Home Affordable Modification Program, put in place in March 2009. HAMP is due to expire at the end of 2012, and was paid for with $50 billion from the Troubled Asset Relief Program and $25 billion from Fannie Mae and Freddie Mac.

The global mortgage settlement is indeed good news for homeowners who qualify for lower mortgage payments. But hard-working and thrifty homeowners who have kept up their payments, and who have taken lower-paying jobs, won't qualify. If they feel disadvantaged, they may be on good ground.

The government is punishing banks, a ready target, and investors in mortgage-backed securities, whose assets will be diminished. And, as with many Administration programs, there's a cut for public sector unions, because $3.5 billion is allocated to states to hire more state and local employees, who represent the only growing segment of the steadily shrinking union sector.

In addition, although intended to help people who have fallen behind in their home loan payments through no fault of their own, the settlement may also attract people who seek to game the system.

In order to qualify for help from the BofA, homeowners have to owe more on their loan than their property is worth. That's called being "underwater." They must have been at least 60 days behind on payments at the beginning of the year. Their monthly principal and interest payment, plus home insurance, property taxes and homeowner fees, must exceed 25 percent of their gross household income.

As well as the problem of abrogating existing contracts, requiring banks to help people who genuinely need assistance invites others to cut corners so that they too, can qualify for help, either this time or next time. Known as "moral hazard," this is an incentive for dishonest or anti-social behavior. Homeowners behind in payments get loan modifications, while others who pay on time don't get help.

As people come to know that the government will require banks to bail them out, some may be less likely to make their payments or take a job that is offered.

So homeowners gain by turning down offers of employment, or dropping out of the labor force. The labor force has shrunk dramatically over the past three years, and labor force participation rates are now at 1981 levels. Some people may be delaying returning to work to avail themselves of the 99-week period of unemployment benefits, up from the standard 26 weeks, and supports such as Medicaid and the Supplemental Nutrition Assistance Program, formerly Food Stamps.

The settlement creates an incentive for fraud, because homeowners only get help if their payments exceed 25 percent of their income. How does BofA know if someone is working? When people are applying for mortgages, they need to show pay stubs to prove their income, and past years' tax returns to show a steady income. With this type of loan modification, the incentive is to show enough income to pay the new mortgage, but not an amount that will disqualify them from the BoA's offer.

The program penalizes hard work and thrift in another way, too. Banks have to stay in business, so the interest rates of those who are not bailed out will rise in order to pay for reductions in principal and interest rates for those who receive help. Further, if banks know that the government will require them at some point in the future to change the contract, they will offer initial higher rates to account for that possibility.

The program punishes investors in mortgage-backed securities, a type of bond, because reducing the principal on outstanding loans lowers the value of bonds backed by these mortgages. This discourages investments in mortgage-backed securities, both new and old, and will curtail the flow of new money into home loans.

However, the settlement does not reduce second loans on homes, such as home equity loans. These are entirely held by banks, and not by investors in mortgage-backed bonds. By reducing the value of the principal, but not the home equity loan, banks gain to the extent that they can get bondholders to bear a share of the write-down.

This settlement is another case of the federal government using its power to harm the private sector.

The resemblance to the new Affordable Care Act is uncanny. Just as large banks are required to write down loan principal, large employers are required to offer health insurance. Just as homeowners will get help if their incomes are low, so Americans will only qualify for government subsidies of expensive premiums if their incomes are lower. Just as the settlement discourages investors in mortgage-backed securities, so Obamacare discourages innovation in health care with its medical device tax and the rationing of its Independent Payment Advisory Board.

Under the February Justice Department settlement, banks have to spend $20 billion to modify loans, whether or not they have not harmed those individual borrowers. According to the Justice Department press release, "Servicers must reach 75 percent of their targets within the first two years. Servicers that miss settlement targets and deadlines will be required to pay substantial additional cash amounts."

Another $5 billion in bank payments goes-no surprise there-to federal and state governments. States will get $3.5 billion to fund housing counselors, legal aid, and "other similar public programs determined by state attorneys general," according to the Justice Department.

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. AFSCME president Gerald McEntee said in October 2010, "We're spending big. And we're damn happy it's big. And our members are damn happy it's big - it's their money.''

If the government wants to bail out homeowners, it should organize programs and pay for them. As well as HAMP, recent mortgage modification programs include IndyMac's loan modification program in August 2008 and the Federal Housing Finance Agency's Streamlined Modification Program in November 2008.

Yet 52 percent of the 2.4 million loans modified between January 1, 2008 and September 30, 2011, were delinquent or in foreclosure, according to the Office of the Comptroller of the Currency.

Former Federal Housing Commissioner John Weicher, a Hudson Institute senior fellow, told me that HAMP was supposed to help 3 million households, but has only reached 522,000. Eligibility is limited, the application paperwork is cumbersome, and it's staff-intensive for lenders. Mr. Weicher said, "I haven't seen so much criticism of a program since urban renewal (enacted 1949, terminated 1974)."

We have had a housing crisis for several years now. Builders, lenders, homeowners, and the rest of us have suffered. The only way to make this bad situation worse would be to turn America into a country where homeowners have an incentive to cheat and turn down work, where lenders have an incentive to get out of lending, and where all of the rest of us can only look on in dismay. Regrettably, that is exactly what the Department of Justice and its settlement have done.