Brookings scholar: Principal reductions the wrong approach

Victor Joecks

Conservatives and libertarians have long understood that a government-mandated principal reduction for underwater homeowners is the wrong approach to solving the nation’s and Nevada’s housing problems.

Now, even the liberal Brookings Institution has agreed. In Sunday’s Las Vegas Review-Journal, Ted Gayer, a senior fellow at the Brookings Institution, and Phillip Swagel, a professor at the University of Maryland School of Public Policy, wrote that principal reductions would do more harm than good for the housing market.

Targeting principal reduction to the 20 percent of underwater borrowers with delinquent Fannie and Freddie loans (approximately 600,000 in total) does have the potential to prevent some foreclosures, but at far too much a price. It is extremely difficult to target federal help to a select group of borrowers without providing an incentive for other borrowers to stop paying their mortgages. Indeed, research by Christopher Mayer, Edward Morrison, Tomasz Piskorski and Arpit Gupta of Columbia University found a statistically significant increase in such strategic increase in strategic behavior in response to principal reduction announcements. …

As the housing adjustment continues, we should avoid taking actions that accomplish little while providing incentives for borrowers to renege on obligations. Such efforts will only prolong the problem. (Added a link the study)

In economics, they call this a moral hazard – government incentivizing bad behavior.

There’s also another reason to oppose government-mandated write-downs – it’s morally wrong.

It is unjust for the government, which exists in part to protect property rights, to take away property from someone (the banks and their stockholders) and give it to someone else (underwater homeowners) by rewriting a contract. Property rights aren’t optional or applicable only when the economy’s doing well. Imagine the outrage if a bank tried to increase someone’s mortgage, because the value of his house increased. A contract is a contract is a contract. Government’s role in that contract should be to enforce it, not rewrite it because of political pressure

Protecting and enforcing property rights is an essential role and duty of government. If we lose that, we’ve lost something much more valuable than any number of houses.