Posted in the Wall Street Journal by Nick Timiraos:
How do you get borrowers to avoid walking away from homes that are deeply underwater without encouraging more to follow by writing down principal balances? One idea: Pay them to keep paying their mortgage.
The novel approach is being touted by Loan Value Group LLC, a firm selling their idea—and ready-made application—to mortgage investors nervous about the risk of strategic default, where borrowers walk away from their homes even though they can afford to pay their mortgages. The firm says it’s signed up an undisclosed mortgage investor to test a pilot program with a few hundred borrowers.
Here’s how the program works: The mortgage investor (possibly joining with other risk holders, such as mortgage insurers or second-mortgage holders) offers a cash reward to borrowers if they agree to keep paying their mortgage. The incentive amount varies by borrower depending on income, negative equity, geography and other risk factors—those who are more likely to cause steep losses receive a bigger carrot. The “responsible homeowner reward” grows for up to five years as the borrower makes monthly mortgage payments.
The borrower can’t collect that cash payment until the mortgage is paid off (though investors could allow the reward to be used towards paying off the mortgage in a sale or refinancing if the reward amount is enough to close the transaction).
The main goal of the program is to avoid the moral hazard and upfront costs to the investor associated with writing down borrowers loans. “When you make it so a borrower doesn’t have to do anything negative to get the reward, you remove moral hazard,” says Frank Pallotta, a founder of Loan Value Group who previously led mortgage banking teams at Morgan Stanley and Credit Suisse.
The size of the reward isn’t going to make up for the borrower’s entire negative equity whole, but Mr. Pallotta says the incentive payments are designed to present enough of a “shock-and-awe number upfront” to change the borrower’s psychology. Instead of thinking about how much debt they’re getting out of by walking away, maybe some borrowers will think about the cash bonus they’ll get if they stay current and are able to recover their equity if home prices stabilize and recover.
At the same time, investors don’t have to consider writing down the principal of the loan, which can often require the investor to mark-to-market the restructured loan and recognize an immediate loss.
The program isn’t designed to help borrowers who can’t afford their mortgage, though mortgage-holders certainly could offer the program to at-risk borrowers who’ve already received a modification in their monthly payments through the government’s Home Affordable Modification Program.
To be sure, the program raises plenty of questions: will investors want to put up cash for borrowers who might pay anyway? Mr. Pallotta says the program is liable to pay for itself if it only convinces a small fraction of borrowers to avoid walking away, given the significantly higher costs of foreclosure. If strategic defaults are as serious a problem as some housing analysts and studies show, it will certainly be worth watching to see if such a program catches on with other investors.