Another example today of moral hazard as the FDIC announces plans to test principal reductions.
A principal reduction is when the bank allows a foreclosed homeowner to have their total home loan value reduced, also known as a “cram-down” or “principal forgiveness.”
For example, your neighbor buys a house for $750,000 but they could only afford a house half that price. They are now in foreclosure. With a cram-down, the government will authorize the home loan to be reduced from $750,000 to say, $375,000.
In today’s article, the FDIC wants to offer cram-downs for people who are actually making their mortgage payments but are underwater (owe more on the house than it’s worth). This is an effort to encourage people to continue to pay rather than performing a strategy that is growing in popularity known as strategic default (when a homeowner decides he is so much underwater that he will never recoup his money and just walks away from the house and lets it default).
The $375,000 that he doesn’t have to pay will be paid by you and me as taxpayer bailout money to the bank that suffers this loss or the FDIC that covers the loss.
So let me be clear. The government is subsidizing homeowners in foreclosure through bank bailouts and mortgage modifications as well as subsidizing homeowners not in foreclosure through cram-down incentives.
What is the government doing for the rest of us who either rent and will not pay the price for these overpriced homes or live in homes that we can afford?
For us, comes the bill.
The good news is only 1% of current outstanding mortgages would be eligible for this, so if they focus on just underwater homeowners (11 million) then for every 1 million of them, 10,000 of your neighbors get to keep their overpriced homes thanks to your generosity.
And by generosity I mean the one where the government will send you to jail if you don’t pay your taxes so they can give your money to your neighbor.
The bad news is, if this gets popular and the government expands this program we can immediately expect to be on the hook for millions more of our neighbors homes.