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Tuesday, January 5, 2010

Loan Principal Reductions Will Trigger a New Economic Catastrophe

A new study from the New York Fed announces that reducing mortgage principal is the most effective way to keep homeowners in their homes, rather than simply reducing their monthly payments.

This seems to make sense, to a degree.  (Fairness -- that's another issue.  Keep reading.)  Real mortgage debt reduction equates to the creation of equity.   It is the loss of equity -- leading to homeowners being "underwater" -- which prompts many "homeowners" to just send the keys to the bank and walk away from their homes.   However, if this Fed idea is implemented, the real world effects will be catastrophic.

As for fairness, consider that responsible debtors who pay their bills on time, whether it be mortgages, school loans, car loans or business loans, will now be subsidizing the outright giveaway of equity to a select group of "homeowners."  Reducing the principal on mortgages is the same as creating equity in those homes, and is the same as someone handing these people a check.

Now, who is writing that check?   That's right -- it's you and me.   No one is reducing our debts.   But someone is saying that we should pay out of our own pockets so that others can keep "their" homes.   There you have it:  The reward for our responsibility is to pick up the responsibility of others who were not responsible.

There are basic fairness questions regarding the propriety of offering partial loan forgiveness to a select group of debtors -- which group may be particularly irresponsible -- instead of anyone, or everyone else.   While not every "underwater" homeowner is irresponsible, the facts remain that these people willingly made economic decisions when buying these homes.   They overpaid for these homes.   And it's not as if no one was talking about a "real estate bubble" back in 2003 or 2004 -- because industry and finance commentators were already sounding the alarms.   This group of homeowners made bad economic decisions, and now the New York Fed is saying that the rest of us -- who were much more risk-averse if not totally responsible -- should bear the burden for the risky, losing bets of these other people.

Here's a question:   If these homeowners saw their houses double in value, instead of decline in value by up to one-half, would the Fed be shouting for the newly-created largesse to be "shared equally"?   No.   Not on your life or mine.

A proposal to forgive loans en masse will force banks to realize losses immediately rather than trying to use various accounting rules to claim that certain declines in value are just "temporary" in order to avoid loss recognition.   Crime, Politics and Policy is all about confronting reality, and running towards it in fact when possible. 

However, the prospect of loan forgiveness for some, when the rest of the responsible borrowers get no relief while paying for the relief of others, is so unfair that it threatens to subvert the basic social compact of our society.   Once fairness ceases to be a bulwark of our society, people will feel emboldened to act callously and according to the "law of the jungle."   Civil order will be weakened, the rule of law will become mocked and increasingly disrespected, and those who play by the rules will be increasingly disadvantaged -- while being mocked by those who harbor no moral qualms about "working the system."  In such a society, those with capital will become much more hesitant to lend it out, on any terms, because they will be far less confident of being paid back, of having courts enforce contracts, of basic agreements and conventions being honored.   The end result, in the not-too-distant future, of a massive loan forgiveness / principal reduction program will be the significant tightening of bank credit on top of the tightening that has been occurring since 2007.   A new round of credit arterosclerosis will make all manner of financing much harder to obtain, at any rates or terms.   This in turn will have adverse consequences for every sector of our economy.  

Eric Dixon is a practicing attorney in New York and New Jersey and engages in select legal, economic and legislative analysis for clients on a professional, fee-for-service basis.   Inquiries of Mr. Dixon may be directed to and by phone at 917-696-2442. 

 new study from the New York branch of the Federal Reserve Bank announces that the most effective way to modify mortgages is to reduce the principal on those loans.

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