To Buy, or Not to Buy? Moral hazard, or prudent risk management?

Janie and Bob, a fictional California family, own a home. Well, they own 2/3rds of a home, and a bank owns the other third. They have a 15-year mortgage, and they've made home improvements using a combination of cash and a HELOC. Janie and Bob paid off the HELOC. They have a good bit of equity. They have virtually no tax break, because their mortgage is very low and they can't deduct state taxes under the Alternative Minimum Tax.

They want another house - a little larger, but, most importantly, closer to school and work. They can afford a larger payment, but they're not willing to pay a great deal more - their current house is affordable and puts a roof over their heads. Anything more is nice-to-have, but not a true necessity.

If Janie and Bob sold their house and bought another, they could "liberate" equity from the current house, making the minimum down payment on a larger house. If the new house drops in value, they could ask the bank to renegotiate the mortgage balance to the lower value. The bank might not do it, but I used to think they would never, ever do a thing like that, and now banks are renegotiating mortgages in all sorts of "creative" ways. With the cash from their current house, and California's non-recourse mortgage loans, buying a new house would protect Janie and Bob's equity by cashing it out, while shifting the risk of further price declines to the bank. Heck, they could buy a house in another state for cash, and walk away from the new house if they wanted.

This is the "moral hazard" of low-down, non-recourse, renegotiable mortgages. It's like buying an option on a house for 3% down - Janie and Bob get all the upside profit, the bank gets all the downside risk and the only thing Janie and Bob stand to lose is their downpayment and their credit rating. With $100k in the bank from selling the old house, a bad credit rating wouldn't hurt that much.

Even contemplating such a move feels wrong, but then I think. People like Janie and Bob - who save, invest, watch their expenses, drive sensible cars instead of fun cars, and basically try to be financially responsible - pay the taxes to cover the costs of bailing out homeowners who weren't as responsible and thoughtful? Shouldn't Janie and Bob ensure their own family has at least as much protection and benefits as the people their taxes support? Shouldn't responsible citizens receive equal or greater protection under the law?

The homeowner with little or nothing down receives the benefits of homeownership in return for their interest payments, but the also receive a sort of pricing insurance. If the home devalues, the homeowner with no skin in the game doesn't have to keep making high payments, they don't have to pay off the loan deficiency to sell, they don't have to stay tied to a house that no longer works for them, waiting for the loan to stop being "underwater". Janie and Bob pay market rate on interest, but they don't get that free price-level insurance because they have too much equity invested. They are self-insuring the part that's paid off.

Should Janie and Bob buy a house, knowing they might default, but knowing they'll have a lot more cash as a result? Or should Janie and Bob stay in a house they don't love, in a location they don't love, because honoring a contract is the right thing to do? Forget for a moment the debate about whether the government should intervene in the housing market - accept the fact that government is intervening - what should a responsible family do? Suck up the higher taxes that will result, or grab their own brass ring while the grabbing's good?

Would it change your opinion if Janie and Bob were going to use the cash from the old house to finance their retirement? What if they used it to send their kids to school? What if they used it to pay for live-saving medical care for a child? What if they used it to buy a Hummer and go on that honeymoon they always dreamed of? What if they used it to pay the new mortgage for several years? Does it matter? Are they dumb for leaving their equity at risk, or immoral for shifting the risk to a lender?