Eliminating the Moral Hazard in Real Estate
Landmark Healthcare Bill Advances in Senate
Housing Recovery…or Not?
The Amazon Tax
Short-Sale Plan May Help Distressed Homeowners
Historic New Rules Approved to Govern America’s Financial System
State Moves to Repeal Anticompetitive Real Estate Law

This just in from the Paybacks are Hell Department.

The concept of “moral hazard” has been much discussed recently as it relates to the real estate sector. A moral hazard results when someone is able to profit from an action while they are at the same time economically insulated from the risk of that action. If there’s no risk associated with an otherwise profitable endeavor, the only remaining barrier could be ethical concerns about possible injury to others. The moral hazard is that the party who stands to benefit may have no ethics. The subprime mortgage crisis and the recession that resulted is a perfect example.

In the subprime mortgage crisis, loans were made to home buyers who were unlikely to be able to keep up with their mortgage payments for a variety of reasons. Those home buyers may not have had sufficient income to pay a mortgage except at temporary teaser rates, or may have had marginal credit histories, or they knew they wouldn’t be required to document their income and/or assets. By abandoning sound underwriting practices, lenders could make many more mortgage loans than would otherwise have been possible.

The additional influx of buyers helped artificially drive up home prices and create profits for other segments of the real estate services sector. Some real estate agents abandoned their fiduciary duty to buyers they knew couldn’t afford those mortgages and steered them to mortgage brokers who were willing to originate risky mortgages that they both knew were doomed to failure. Both profited, and both were also insulated from risk since neither had a financial stake in the mortgages.

The moral hazard in mortgage lending led to the near collapse of the financial services sector and the entire U.S. economy. Ultimately the U.S. financial services sector had to be bailed out by taxpayers. While the profits associated with subprime mortgages remained in the private sector, the risks and costs became socialized. This risk/cost socialization is normal. Of the nearly 100 banking crises that have occurred internationally during the last twenty years, all were resolved by bailouts at taxpayer expense, according to the World Bank.

American homeowners have not been so fortunate. Some subprime borrowers were financially naïve, and were lead into mortgage products they did not comprehend by unscrupulous real estate agents and/or mortgage brokers. Other homeowners became trapped between the loss of home equity resulting from the subprime mortgage crisis and the loss of their jobs caused by the recession it spawned. Many of those homeowners have lost or will lose their homes.

At the other end of the spectrum are the majority of homeowners who still have adequate income to keep up with their mortgage payments. Most fully understand the risks and obligations of their mortgage, but many of them bought their home at the peak of the market. With home prices now off that peak by an average of 30%, one in four of all homes are worth less than their current mortgage balance (“underwater” in real estate parlance).

There is now a big economic incentive for a large number underwater homeowners to default on their mortgage, even though they have enough money to make their mortgage payments. There are growing signs that the moral hazard in the real estate/financial services sector has mutated and become contagious among many of these underwater homeowners. They simply stop making their mortgage payments, a process known as a “strategic default”.

Driving the trend is the combination of a very large equity discrepancies on many homes, and growing awareness among those homeowners that mortgage lenders either do not have a legal right to collect that shortfall or face other challenges that limit their ability to collect from defaulted borrowers.

Many of those homeowners, especially those with higher incomes and bigger homes, may owe hundreds of thousands more on their mortgage than their home is worth. At normal home appreciation rates (2-4% annually) it could take decades of mortgage payments before those homeowners regain any equity in their home. In ten states the mortgage holder’s only recourse is to take back the home. In the other forty most mortgage lenders haven’t even been able to keep up with mortgage restructuring requests from other hard-pressed homeowners who recognize their financial obligation, but can no longer afford the current payment. Lenders also face the challenge of determining whether a defaulting homeowner is not worth pursuing for the debt because they’re broke, or is making a strategic default. Now that the federal government is bailing them out for their losses, lenders have even less reason to go after strategic defaulters. Yet another incentive for strategic default is that they can usually rent an equally nice home for far less than their current mortgage payments, reducing their ongoing housing costs as well.

The argument against a strategic defaulter is that their credit becomes trashed. However their credit can be rebuilt over 5-7 years by making their other debt payments (rent, auto and other loans, credit cards, etc.) in a timely manner. Weighed against the albatross of their huge negative home equity, and the lure of substantial monthly savings on housing costs because of the cheaper rent, the math of a strategic default can be compelling.

The problem with the continued growth of strategic defaults is that the cost of this moral hazard also becomes socialized. While some might think that stiffing the mortgage lenders is a fitting dose of their own morally hazardous medicine, the losses end up borne by the rest of us. Strategic defaulters are not just assuming a place ahead of the lenders, they are also adding to the losses. A joint Northwestern University and University of Chicago study estimated that as many as 25% recent defaults may be strategic. With one in four homeowners now underwater, the economy could collapse again under the weight if the practice becomes more widespread.

For these reasons we must eliminate moral hazard in the financial services and real estate sectors. Ultimately the problems resulted from the decisions of individuals, whether they are individual homeowners, real estate agents, mortgage brokers, or the CEO’s/senior management policymakers of some of the nation’s largest financial services firms who made the actual decision to abandon sound underwriting practices. Their bonuses may have been enlarged by those decisions, but their stockholders equity was reduced, and taxpayers paid the price.

Pending Congressional reforms of the financial services sector will help reduce the moral hazard, but an even better, and more market-based approach would be to make it professionally and/or financially hazardous in the future for individuals to succumb to moral hazards. Future taxpayer bailouts of financial services companies should be tied to agreements with the boards of companies receiving bailouts to replace, in an orderly fashion, the CEO’s and other senior executives who made the morally hazardous policy decisions. There’s no need to reach further down into a company’s middle management to punish others who could not have contributed to the problems absent enabling company policies. Qualified replacements should not be hard to find, because relatively few financial services firms were involved (though unfortunately, many of the large ones), and even within those firms there remain many capable executives had nothing to do with the policies that caused the problem.

Many state and local governments have faced severe budget challenges as a result of the current recession. Not only are income tax revenues down because of growing unemployment, but real estate property tax revenues have also been severely hurt by dropping home values. As a result most states have already made substantial cuts to their budgets, and some face further cuts in critical areas like emergency services, education, and other programs that are widely supported by their constituents.

Many state governors and legislators are therefore looking around for potential new sources of tax revenue. There aren’t a lot of volunteers. Many consumers and businesses are already hard pressed due to the weak economy, and most new taxes are unpopular even in a healthy economy. Still, consumers find some types of taxes less onerous than others.

An AARP survey asked Iowa residents which tax increases they would choose if they were assigned the responsibility of raising revenues as a way to help balance the state’s budget. The survey revealed that at least six in ten respondents support:

The Center on Budget and Policy Priorities argues that one of those options, a temporary income tax surcharge, is one of the least painful budget balancing alternatives available. It will likely have less negative impact on economic growth than cuts in state programs, and less negative impact than a tax increase on low and middle-income taxpayers.  In a recent paper, Nobel prize-winning MIT economist Joseph Stiglitz and Brookings Institution economist Peter Orszag concluded that tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run. Reductions in government spending on goods and services, or reductions in transfer payments to lower-income families, are likely to be more damaging to the economy in the short run than tax increases focused on higher-income families.  This is because most of this money gets spent on payrolls directly or indirectly. By contrast, when taxes are increased on wealthier taxpayers, some of the additional tax payments will probably be made from savings rather than from funds that would otherwise be spent.

Some of the other alternatives are extremely unpopular with voters. An example is sales taxes on Internet purchases. In a 2008 issue of Parade Magazine, readers were asked: “Should Internet Sales Be Taxed?” Of the 3,125 survey responses, 85% opposed taxing Internet sales. For that reason it is curious that some state legislators are seeking to expand the collection of sales taxes on consumers’ Internet purchases.

New York State legislators recently passed a law requiring Amazon and other Internet retailers to collect sales taxes from New York consumers who buy through Amazon affiliates on the retailers' Web sites. The law follows similar recent laws in North Carolina and Rhode Island. Amazon has challenged the New York law, and the case is now in the New York state courts. State government organizations have also supported a federal “Streamlined Sales Tax Project” that would greatly expand Internet sales tax collections.

It is odd that state legislators would seek to make their constituents pay more taxes on their Internet purchases when they are so unpopular and there are many other more palatable alternatives to closing state budget deficits. In addition, there are many policy arguments against the collection of sales taxes on Internet purchases. A click of the mouse uses a lot less gas and produces a lot less pollution than a trip to the mall, and the mail carrier and FedEx/UPS trucks delivering the goods will be coming down their street anyway. Internet commerce also reduces the pressure on the transportation infrastructure, saving money for state and local governments.

There are social benefits to Internet commerce as well. Americans work more hours than any other society. Online shopping saves a lot of time, a precious commodity for all of us in our society where long working hours leaves too little time for personal relationships and other interests. Because of the substantial economic and environmental benefits from Internet commerce, it would be good policy to exempt it from all state and local sales taxes on goods and services. Many state and local governments currently provide exemptions from sales taxes for a variety of economic activities (sales tax holidays on back to school expenses is but one example), and a permanent Internet sales tax holiday is an equally good idea.

The Obama Administration deserves the thanks of American homeowners for its latest effort to help distressed homeowners and stabilize home values. Announced on December 1, the plan seeks to streamline the short sale process. In a short sale a first mortgage lender agrees to let an underwater home seller who cannot afford to make mortgage payments sell their home for less than the mortgage balance, and accept the proceeds as full payment.

There are often significant complications. A short sale will usually leave nothing for any other creditors whose debt is also secured by the home, such as home equity lenders. They have the ability to block the short sale, and usually no incentive not to. The first mortgage lenders understandably wish to limit their losses as much as possible, so they have to be confident that the selling price is about as much as they expect in the current market. Bureaucratic rules and inconsistent procedures are another barrier to short sales.

The new plan mandates uniform documentation, terms and deadlines for lenders and mortgage loan servicers. It also provides incentives to encourage parties to support the effort. Homeowners can receive $1,500 to assist with relocation. This can be important because many are so broke that they can’t afford moving expenses. Mortgage lenders/servicers/second tier lenders/investors get $1,000 - $3,000 from the proceeds to encourage their cooperation. Under the plan real estate agents can’t be forced by lenders to cut their commissions if necessary to make a sale viable. It is not uncommon in short sales and other cases where a small amount separates the amount a buyer can pay and the seller must have, for others involved in the transaction (real estate or mortgage brokers, etc.) to agree to a modest reduction in their fees in order to make the deal work. We believe that the government should be able to decide to spread commission/fee reductions among those parties if there is only a small gap remaining (1% of the selling price or so).

As home values still continue to plummet in many parts of the country, the new plan will hopefully help both beleaguered homeowners sell their homes, and also the rest of us who continue to watch our home equity melt before our eyes. While previous attempts have not met hopes and expectations, the Administration still deserves an enormous amount of credit for its persistence.  

The new standardized short-sale plan is a step forward, but it isn’t perfect.  The requirement that second-lien holders to drop all financial claims against short-selling borrowers beyond the $3,000 maximum they take out of the deal could limit participation by second-lien holders who are owed large sums. The $3,000 cap makes sense because many second-lien holders have no equity left in the home because the first mortgage holder gets paid first, up to the full amount of the mortgage balance, so it is more than fair settlement. However, if this cap turns out to severely reduce participation, Treasury might want to restructure it in some manner that provides a little more incentive to those second-mortgage lenders who face a particularly large loss on their lien.

On the other hand, the rule in the new standardized short-sale plan that prohibits banks from forcing real estate agents to cut their commissions from the listing agreement as part of the final deal should be eliminated. Many real estate agents and brokers voluntarily reduce commission rates in good times and bad in order to make tight deals work. Their reasons include a mix of self interest and kindness, and are made easier by the fact that U.S. real estate sales commissions are about twice as high as real estate commissions in most other developed countries.

The state of New Jersey is poised to pass legislation that would reverse a trend in state legislation in many states. Real estate broker trade associations have used their powerful grassroots lobbying organizations to pass state laws and regulations intended to keep real estate commissions as high as possible. Those 5-6% commission rates, about twice as high as those in other developed countries, have been threatened by more cost-effective Internet business models and rogue independent real estate brokers who are willing to pass savings on to consumers.

One example is real estate commission rebates. In recent years more home buyers have begun to do their own home searches on the Internet. They can narrow down the number of homes they are interested in without the need for any assistance from a real estate agent. As many as 90% of all buyers now search for homes on the Internet, according to some estimates. Recognizing that their workload has been eased, some independent real estate brokers began rebating a portion of the half of the sales commission that they typically receive, which is paid by the home seller. In some cases, these independent real estate brokers will rebate as much as 2% of the selling price to the home buyer.

Many state real estate trade associations have responded to this threat to their high commissions by passing state laws prohibiting real estate brokers from giving commission rebates to consumers. New Jersey is one of those states. Other states have also passed laws effectively outlawing discount real estate brokers who will list home sellers’ homes for a fraction of the traditional 5-6% commission.

Until the introduction of recent New Jersey legislation that would repeal the state’s current anti-rebate law, all the state laws and regulations were aimed at protecting commissions rather than consumers. The New Jersey legislation is the first that would reverse the protectionist laws and regulations that real estate brokers have worked so hard to put in place. The American Homeowners Grassroots Alliance and the U.S. Justice Department have been supporting the legislation, which has already passed the New Jersey General Assembly and is poised for a vote in the Senate in early January.

In letters to members of the Senate Commerce Committee, which passed the repeal (S-139) on Monday, December 14^th, AHGA pointed out how the legislation will help New Jersey homeowners. As mortgage lending standards have tightened, leading to higher down payment requirements, those rebates have become increasingly important in facilitating home sales. Commission rebates, which can amount to as much as 2% of a home’s selling price, may enable a home sale that would otherwise not be possible, especially for low and moderate income buyers. As a result, real estate commission rebates are becoming increasingly popular in most states.

As long as the antirebate law continues, New Jersey home buyers will be unable to benefit from the potential savings. Conversely, if the commission rebate ban is repealed, it will likely increase the pool of buyers and help to slow future declines in New Jersey home values. The U.S. Department of Justice (DOJ) has testified in the Assembly Regulated Professions Committee to the unfair and anticompetitive aspects of this restriction. Our organization fully-supports DOJ’s analysis and call for the repeal of this prohibition.