Housing industry analysts estimate that more than 10.8 million homeowners have negative equity, and thus face imminent mortgage default. The government’s effort to provide these homeowners a viable short sale alternative with incentives through the new Home Affordable Foreclosure Alternatives Program (HAFA) deserves kudos for effort. Short sales reduce long-term vacancies, leverage existing market mechanisms, and keep neighborhoods intact.

Unfortunately, HAFA lacks the necessary incentives to get people moving.

Property values won’t rise significantly anytime soon. To date, loan modifications have been viewed as the primary solution to the foreclosure crisis. We now know, however, that borrowers with substantial negative equity are unlikely to retain their homes under any circumstances. Given the right options, it’s a safe bet they would readily opt for an alternative to foreclosure if the outcomes and consequences were truly better.

In this regard, HAFA falls short. If we want the program to succeed and short sales to become an effective option, HAFA must offer competitive incentives and lighter penalties. This starts with getting inside the minds of homeowners who have already done the math and concluded that the metrics associated with foreclosure work in their favor over the short term.

Who can blame them? The short sales relocation benefit doesn’t stack up to the “cash for keys” incentive and the savings afforded from living months in default and rent (mortgage) free. What else do these distressed homeowners have to lose? The industry hasn’t differentiated the credit impact and penalties between a short sale and foreclosure. Homeowners have no real motivation to be proactive.

With a few minor tweaks, however, HAFA could avoid this stalemate and truly incite action. Here are some changes that would help:

• Lower the penalty period for homeowners, so they can return to the market sooner. Fannie and Freddie underwriting guidelines prohibit anyone with a bankruptcy or foreclosure from being eligible to receive a new mortgage for a period of four years. Reducing this “lock-out” period from four years to two years for people who pursue a short sale, gives distressed homeowners a tangible incentive to choose short sale over foreclosure.
• Revamp incentives for short sales and foreclosures. HAFA currently provides $1500 for relocation expenses, whereas most lenders are paying foreclosed borrowers in excess of $3000 for “cash for keys”. At minimum relocation benefits for short sellers need to equal or beat “cash for keys” payouts.
• Differentiate the credit consequences between short sales and foreclosures. The industry must create some uniformity around how short sales are reported to the credit bureaus. We must enable people to recover faster so that they have the option to reenter the market sooner while home values are still affordable.

Negative equity mortgages are predicted to be the single largest driver of future defaults. HAFA and the streamlined short sale alternative it offers homeowners have the potential, with a few key changes, to avert further losses and stabilize communities.

Without question, any solutions that help us avoid more shuttered neighborhoods and move millions of disenfranchised homeowners to stable ground is a step in the right direction that will benefit us all.