Reserve economists are out to debunk the theory that reducing principal
balances on mortgage loans is a no-cost cure for the housing crisis. The three,
Kris Gerardi, Federal Reserve Bank of Atlanta, Chris Foote, and Paul Willen, Federal
Reserve Bank of Boston, recently published their paper, The Seductive but Flawed Logic of Principal Reduction, in the
Atlanta Fed banks' Real Estate Research Blog.
The idea that a reduction program would cure housing ills has been kicking around since
the crisis began and there are now rumors that the administration and states'
attorneys general may soon announce a settlement agreement that will require lenders
to write down principal balances on troubled loans by as much as $25 billion. Policy
wonks, the article says, will probably greet this with glee, but are they
right? The authors don't think so.
The idea of principal reduction is correct at its heart: borrowers with
positive equity rarely lose their homes to foreclosure. If financial difficulties occur the borrower sells
the home rather than default so foreclosures are rare in normal times when home
prices are rising normally. Today, however many homeowners don't have this
option. Therefore it follows that getting everyone back into positive-equity
territory would end the foreclosure crisis. To do this we must inflate house
prices, a virtual impossibility, or reduce mortgage balances and it is
estimated that underwater borrowers owe almost a trillion dollars more than
their homes are worth. So who pays?
The "wonks" believe that principal reduction is a no-cost answer.
They argue that foreclosure allows lenders to recover only the current value of the
house, which may be far less because of a protracted delinquency period where
interest is lost, foreclosure expenses, the physical deterioration of the
property, holding and selling costs, etc. Reducing the principal balance to equal the
house value guarantees the lender at least that amount because the borrower now
has positive equity and "research shows that borrowers with positive
equity don't default." For example, if the borrower owes $150,000 on
a $100,000 house and the lender forecloses he might collect, after costs, $50,000.
However, if the lender writes principal down to $95,000, it will collect
$95,000 because the borrower now has positive equity and won't default on the
One flaw in this is a misreading of the underlying economic theory: we shouldn't automatically assume that borrowers with negative equity will always default. What if there are two borrowers owing
$150,000; and one prefers not to default and eventually pays off the loan. If both loans are written down the lender
will collect $190,000 ($95,000 from each borrower) but if the lender does
nothing it will eventually collect $50K from a foreclosure and the full
$150,000 from the non-defaulting homeowner.
So, the optimal policy is to offer principal reduction to one borrower
and not the other. This requires the lender to perfectly identify the borrower
who will pay and the borrower who won't. "Given that there is a $55,000
principal reduction at stake here, the borrower who intends to repay has a
strong incentive to make him- or herself look like the borrower who won't!"
The authors say this identification issue is a problem often
encountered with public policy as planners need to implement the policy before
they know the need and that always raises the cost. While they were initially supportive of
principal-reduction plans, they began to have doubts when they could find no
evidence that any lender was actually reducing principal. This was widely
blamed on legal issues related to mortgage securitization, but the incidence of
principal reduction was so low that it was clear that securitization alone
could not be even a significant part of the problem.
The three economists who published this commentary say they are not ignoring research that indicates negative equity as
the best predictor of foreclosure; indeed they are responsible for some of it. However what the research does not show is
that not all people with negative equity will lose their homes, just are more
likely to do so. They liken it to the
relationship between cholesterol and heart attacks - the former dramatically
increases the incidence of the latter but the majority of people with high
cholesterol do not have heart attacks, in the short or long term.
The highest risk loans - those made to borrowers with problematic
credit and little equity to begin with and located in areas with dramatic price
declines, are quite rare now, most have already defaulted and been
foreclosed. In addition, the principal
reductions required to give such borrowers positive equity are so large that
the $20-25 billion figure mentioned in the rumored program would prevent too
few foreclosures to make more than a small dent in the problem.
Ultimately the reason principal reduction doesn't work is what
economists call asymmetric information: only the borrowers have all the
information about whether they really can or want to repay their mortgages. Only
if lenders really knew exactly who was going to default and who wasn't, could all
foreclosures be profitably prevented using principal reduction.
It also must not be ignored that borrowers often control the variables
that lenders use to identify likely defaulting borrowers. For example many
programs require borrowers to be delinquent to get assistance. This seems logical - we want to help those
who actually need help - but it is tempting for a borrower to miss a couple of
payments to qualify for a generous reduction in debt.
The article concludes that the argument for principal reduction depends
on superhuman levels of foresight among lenders as well as honest behavior by
the borrowers who do not need assistance.
The limited success of existing modification
programs should make us question the validity of these assumptions. "There
are likely good reasons for the lack of principal reduction efforts on the part
of lenders thus far in this crisis that are related to the above discussion, so
the claim that such efforts constitute a win-win solution should, at the very
least, be met with a healthy dose of skepticism by policymakers."
From MND's point of view, this tells us a few things. The major observation we take away from this research is there must be an open line of communication between borrowers and loan servicers/lenders. Second, it implies the road ahead for housing will be long and rocky. It's going to take focused attention from specialized loss mitigation counselors to determine the fate of each delinquent loan and underwater mortgage. That will take much time and energy.
Special Servicers More Motivated to Mitigate Housing Losses