Opinion: Moral hazards and troubled borrowers

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Whenever the Times editorial board has opined in favor of helping troubled homeowners, most of the responses have been along the lines of, ‘Why should those of us who’ve been responsible bail out the ones who haven’t?’ This is the so-called moral hazard issue, and it came to mind again this week as the Los Angeles City Council and the federal government launched or expanded initiatives to aid borrowers who were struggling to pay their mortgages.

The City Council approved a plan Wednesday to offer payment-free loans of up to $75,000 to homeowners in foreclosure. The effort will be tested first in Pacoima, with $1 million available -- enough to help a couple dozen borrowers. The money will go to lenders who agree to write down the loan to the current, depressed value of the home. To participate, lenders may have to write off significantly more debt than the city will pay for, but they would still come away with more than they could collect by repossessing and selling the home.

Because the impact of foreclosures are felt most strongly by the surrounding community, it makes sense on some level for Los Angeles to try to attack the problem instead of waiting for the feds to fix their version of the loan-writedown program. But it’s an expensive undertaking, and the city isn’t exactly swimming in cash. The borrowers wouldn’t have to make payments on the city’s loans until they sold their homes. The hope is that property values would bounce back, enabling the city to be repaid with interest. But the risk is that the borrower sells or defaults before that, wiping out the city’s investment. The only party sure to benefit from the transaction would be the lender, whose losses would be reduced, if not eliminated, by the money the city contributes. You could argue that there’s no moral hazard in helping borrowers who are struggling because of unanticipated personal crises or unscrupulous lenders, but it’s hard to find a similar way around the moral hazard problem posed by rescuing lenders. The only rationale there is that it’s a necessary evil -- the stakes for communities and the economy in general are great enough for us to look the other way.

Meanwhile, the Treasury Department announced a few new wrinkles Thursday in its main program to help troubled borrowers. These were aimed mainly at those who couldn’t be saved from foreclosure -- in other words, the ones who piled up so much debt, they can’t afford their mortgage even if it were written down to the property’s current value. The program provides financial incentives for lenders to repossess properties without foreclosing on the borrower’s loan, either by allowing ‘short sales’ or simply taking back the deeds. The main motive seems to be sparing those borrowers from having their credit scores ruined by a foreclosure. Hmmmm. No moral hazard problem there, no sirree.

I know, I know -- driving down the borrowers’ credit ratings would only exacerbate their debt problems. And it’s certainly true that many borrowers’ troubles don’t stem from fiscal recklessness or ignorance. They may have lost their jobs or endured a financially crippling illness. But those who took on gargantuan debt on a wing and a prayer, or who kept accumulating debt by living well beyond their means, should see their credit dry up. It’s part of the dynamic equilibrium that the system provides, albeit not in a precise, Swiss watch sort of way. That’s why I cringe at the thought of subsidizing this group of borrowers and their lenders, who really should bear the full cost of the decisions they made.