There are currently well over ten million underwater homeowners whose mortgage obligations exceed the current value of their houses, with an aggregate negative equity position of at least $800 billion and possibly over $1 trillion. The overwhelming majority of these persons continue to make their mortgage payments even though for many their interests would be better served by defaulting. This is therefore an unstable situation that could suddenly erupt with a rapid cascade of millions of strategic defaults, potentially triggering severe macroeconomic dislocations. It is urgent that this situation be defused through the modification of the mortgages of a large number of these homeowners so as to sharply reduce or eliminate their negative equity positions. The key question is how best to overcome the obstacles that are impeding such principal-reducing loan modifications from taking place.
These impediments are numerous and complex, and include various cognitive impairments and emotional factors that make it difficult for underwater homeowners to rationally determine where their best interests lie and to demand such modifications, numerous reasons why loan servicers are reluctant to grant such modifications, and reasons why the federal government has been unable to effectively address this problem. I here set forth recommendations as to how these impediments can be best overcome. My proposals center on the implementation of a public education program designed to assist underwater homeowners in assessing where their interests lie, and then to encourage them to demand loan modifications, upon pain of default, when this proves to be their best course of action. I also recommend the adoption of federal legislation that would shelter loan servicers from litigation by mortgage investors if those servicers engage in loan modifications in good faith attempts to maximize investor returns, and greater federal enforcement efforts to assure that loan servicers are placing their investors’ interests foremost. In addition, I recommend the adoption of federal legislation that would shelter defaulting homeowners from liability for deficiency judgments, and from tax liability, and that would prevent loan servicers from reporting mortgage foreclosures to credit rating agencies.
I then contrast my approach with a recent proposal made by Professors Eric Posner and Luigi Zingales that would amend Chapter 13 of the Bankruptcy Code so as to allow underwater homeowners to obtain loan modifications that would substantially reduce or eliminate their negative equity position, in exchange for granting their lenders a 50% interest in any subsequent appreciation of the property. While this proposal would be a substantial improvement over the current status quo, it would not be nearly as effective in bringing about the needed loan modifications as would my recommendations. The Posner and Zingales proposal is hamstrung by its premise that it would be immoral for underwater homeowners to threaten to strategically default in order to obtain substantial modifications of their loans, and that it would therefore be bad public policy to encourage such behavior. I have no such qualms, and I regard assisting underwater homeowners to recognize where their true interests lie, and encouraging them to strategically default when this is in their interest, as the sine qua non to bring about the principal-reducing loan modifications that are needed.
Gregory Scott Crespi, The Trillion Dollar Problem of Underwater Homeowners: Avoiding a New Surge of Foreclosures by Encouraging Principal-Reducing Loan Modifications, 51 Santa Clara L. Rev. 153 (2011)