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Tuesday, October 5, 2010

Deadbeats Get Mortgage Principal Cuts: It's Called -- Winning!

UPDATE MARCH 28, 2011:  The Wall Street Journal reports that over 100,000 homeowners have in fact gotten principal reductions on their outstanding mortgage balances -- in essence, free money, which is coming from the rest of us -- while the banks resist wrongheaded, strongarm tactics from many state attorneys general to implement a formal principal reduction system in the hope of stopping the foreclosure tsunami and the residential housing meltdown.

The true nature of our dysfunctional society, in which Charlie Sheen can profit from his meltdown (and which I believe to be entirely contrived) and deadbeats can game the system to get paid by their responsible fellow business owners and neighbors, has never been more apparent.  The societal moral authority to compel obedience to the rules, and to traditional authority, has never been weaker -- at least not in the last three decades.  One should not be surprised to see a significant increase in crime over the next few years, regardless of economic conditions.

Here we go again.  Another proposal to save the residential real estate market by having the government subsidize the reduction of the principal owed on outstanding mortgages.  Wrong again!
A principal reduction is the equivalent of giving cash back to the owner.  If the government is involved in any way, whether through a direct subsidy to homeowners or indirectly through the lenders, understand what this proposal represents: The redirection of taxpayer money from other homeowners -- who are already paying their own mortgages and property taxes and utility bills -- and towards a different subset of homeowners who will be deemed entitled to a special "protected class" status as victims because they are not paying their mortgages on time or at all.

This is the essence of unfairness and poses a severe moral hazard.

Here is the Eric Dixon proposal:  Allow homeowners who have significant cash on hand to make a one-time balloon prepayment of a substantial portion of their outstanding principal -- say, a minimum of five or ten percent of the outstanding amount.  In return, the bank forgives an amount of the principal in addition to, and which is substantially greater than, the prepayment.  I propose the bank forgive an amount which is double the prepayment amount.  Finally, I propose that this loan forgiveness be a tax-free event (unlike other loan forgiveness).

Here are the advantages:
  • The homeowner comes out ahead, because he enjoys what is essentially a 100% return on his money.  Under my plan, a prepayment of $25,000 yields a principal reduction of $50,000.
  • Instead of having the taxpayer bear the full burden of the mistake, my proposal costs the taxpayer nothing.
  • My proposal promotes a very efficient use of capital, because homeowners who can afford these balloon prepayments are likely the ones who will be the most able to stay in their homes.  As what I will call "bedrock" homeowners who are the foundation of their towns and neighborhoods, they are the homeowners who should be the most encouraged to remain...not the homeowners who are the least likely to stay and the least likely to contribute positively to their community.
  • Banks get to reduce their exposure to loans.  I admit that their exposure to "bad" or "toxic" loans from those most likely to default remains.  However, I am making the value judgment that this is preferable to having responsible taxpayers give money to other homeowners who are likely to eventually default anyway, in a transfer that is essentially as useful as giving more liquor to an alcoholic.  Besides, I don't believe that taxpayers should be forced to buy the garbage from the banks at what is essentially the banks' yard sale of junk -- and junk is precisely what you find at yard sales.
  • Banks also increase their cash on hand, but suffer an overall loss in their paper assets as represented by the outstanding mortgage principal.  I admit overall assets will decrease, but the quality of these assets will improve as paper assets will be replaced by cash.  This is like replacing accounts receivable with cash.  Most businesses will take a discount on their receivables in exchange for cash, because cash is essential to their survival.  Banks should do the same. It will prevent future illiquidity and keep some banks more solvent. If this is too painful for the banks, the amount of premium to give homeowners could be adjusted; for example, the banks could reduce principal by an additional one dollar for every three dollars of prepayment, such that a $30,000 prepayment would result in a $40,000 principal reduction (with the homeowner still realizing a 33% tax-free return.
  • The likelihood of another investment bubble is reduced, because this plan gives investors with cash the incentive to plow their capital into something personally useful and which benefits the banks (see above), as opposed to having investors chase ever-more-elusive return (or what professional investors call, "alpha") in ever-more-speculative asset bubbles like corporate bonds, junk bonds, commodities and so on.
What are your thoughts?

Eric Dixon is a New York small business lawyer and president of Eric Dixon LLC in New York City.  Mr. Dixon is a 1994 graduate of Yale Law School and admitted to practice law in New York and New Jersey.  He represents small businesses and individuals in litigation, negotiations, investigations and other legal matters, and in management matters involving strategic analysis and consulting.  He can be reached at 917-696-2442 and via e-mail at

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