Mortgage Modifications: Homes Saved or Incomes Destroyed?

By some measures, U.S. average housing prices have fallen by a third since 2006 and some forecast them to fall further. Prices have fallen more than fifty percent in Las Vegas and Phoenix, and nearly that much in Detroit, Miami and much of California.

As a result, almost 14 million homes nationwide were “underwater” in early 2009: worth less than the mortgages for which they serve as collateral. About one third of homes with mortgages in Arizona, California, Florida, and Michigan, and more than one half of homes with mortgages in Nevada, are underwater.

At the same time, U.S. employment has plummeted, especially in states that had large housing price increases prior to 2006. Many factors – too many to be considered in a single paper – caused the 2008-9 recession, but the housing price cycle and its legacy of underwater mortgages is likely among them.

Economic analysis readily reveals some effects of underwater mortgages on foreclosures and the incentives to earn income, and the degree to which those effects are shaped by public policy.

Foreclosures as a Consequence of Negative Equity

A homeowner always has the option to stop paying his mortgage. Although state laws are somewhat different, to a good approximation the worst case scenario for a homeowner who stops paying is that he can no longer own or occupy the house, and may suffer a reduction in his credit rating that might raise his costs of future borrowing.

But if the combined value of his house and these costs were less than the present value of his promised mortgage payments, then he could do better than paying in full. That’s probably an important reason why, as of early 2009, more than five million homes were already either in foreclosure or their owners were delinquent on their mortgage payments.

When foreclosures are motivated by low home values rather than the quality of the match between a homeowner and his home, a foreclosure is inefficient because it requires the homeowner to live elsewhere. The anticipation of foreclosure of an under water home probably also creates moral hazard in maintaining the house, because the occupant prior to foreclosure has no stake in the home’s value. These are some of the reasons why public policy seeks to reduce foreclosures.

Lenders have modified the terms of some of their mortgages or otherwise modified payments associated with mortgages in order to avoid foreclosure, both in this recession and previous recessions.

However, some mortgage industry participants have complained that too few mortgage modifications occur because of the excessive transaction costs in dealing with individual homeowner situations and dealing with investors who have varied stakes in the mortgage payments.

The Public Policy Response: Making It Worse

The Bush administration advocated a mortgage modification plan authored by the FDIC, which has been tweaked and further promoted by the Obama administration’s Homeowner Affordability and Stability Plan. What are the consequences for this FDIC-HASP plan for the supply of effort and the incidence of foreclosures, and how do they compare to those of a plan that maximizes lender collections, or a plan that maximizes lender collections without means-testing?

All three plans reduce foreclosures as compared to leaving the mortgages unmodified. Although the unmodified-mortgage benchmark aids understanding of the economics of mortgage modification, we cannot assume that under water mortgages would go modified absent the FDIC-HASP plan and its means-tests.

Rather, we might expect lenders to modify mortgages in a way that enhances their collections. As compared to the collection-maximizing benchmark, the implicit marginal tax rates FDIC-HASP plan – well over 100 percent – are excessive. Moreover, FDIC-HASP needlessly distorts the supply of effort for slightly underwater borrowers, because foreclosure rates among those borrowers would be low (if not zero) under the collection-maximizing plans.

For some relatively small amounts of negative equity, FDIC-HASP may result in more foreclosures and overall deadweight costs than would a plan that maximizes collections. The collection-maximizing plan uses means tests rather than foreclosures to obtain small collections from the high income borrowers, based on the fact that (from the perspective of a lender and his borrowers) the marginal deadweight costs of mean-tests are initially zero whereas the marginal deadweight costs of foreclosures are positive.

At first glance, small amounts of negative equity would seem irrelevant today because housing prices have fallen so much. However, even in Nevada where underwater mortgages are the most prevalent, “only” half of mortgages are under water, which means that half are not underwater and presumably many are only slightly underwater.

The fact that recent declines in home values have coincided with increases in the fraction of U.S. mortgages underwater shows that many mortgages are slightly underwater. Thus, even if FDIC-HASP enhanced efficiency for deep underwater mortgages (it does not), the fact that it harms efficiency for the numerous slightly underwater mortgages means that its aggregate efficiency impact could well be negative.

The mathematical analysis shown in my research papers has been confined to mortgages, with a basic setup in which one party (a “lender”) attempts to collect from a heterogeneous group (“borrowers”), using a threat of punishment (“foreclosure”) for nonpayment. With the housing crash and recession, the unsecured amount to be collected has suddenly increased, and the punishment may have lost some of its pain.

As a result, full collections are not made, but rather forgiven for those who appear to have the least ability to pay. This basic setup probably has a lot in common with revenue collection efforts elsewhere in the economy, such as the collection of trade debts, tax debts, student loans, or tuition payments. Indeed, since I began writing on mortgage modification in the fall of 2008, the federal government began to modify student loans, with the borrowers who earn less receiving more loan forgiveness (Glater, 2009).

Thus, while millions of workers have seen massive increases in their marginal tax rates during this recession as a result of mortgage modification, additional workers and businesses may also have seen significant increases in their marginal tax rates due to these other collection efforts.

Federal mortgage modification programs create excessive marginal tax rates, but the use of means-tests in the mortgage modification process would occur even without government intervention because means-tests are in the collectors’ interests. Positive marginal tax rates are thereby created in the private sector, on top of the various income taxes and means-tested benefits perennially administered by federal, state, and local governments. A prior economics literature has already shown how tax rates are excessive when multiple collectors have access to the same tax base.

Thus, it is ironic that the federal government has raised the implicit marginal tax rates associated with mortgage modification, when it would enhance efficiency and its own tax collections by unconditionally repudiating some of the private debts, or at least pushing private collectors to rely less on means-tests than would be in the collectors’ interest.

Prohibiting means-tested mortgage modification is not the same as prohibiting modification: it’s just that mortgages would have to modified without means tests. In other words, those borrowers with significantly negative equity would be forgiven regardless of whether they were able to pay.

In theory, lenders could find it optimal (given that they were not permitted to means test) to write down underwater mortgages so much that foreclosure rates would ultimately be quite low. Of course, a large and across-the-board mortgage write-down would dramatically reduce lender collections, but the objectives of efficiency and lender collections are quite different.

The bottom line: the federal government is spending your tax dollars to further damage the housing and labor markets.

Comments

[jkatzman]

It's really hard to condense all the research behind something like this into an article. Making it comprehensible to people without a PhD in this area just adds to the difficulty.

In my case, it failed. Reading this, I had way too many "missed connections," where x is said to lead to y, without explanation of the connection, or sometimes even of x and y (example: when you started talking about mortgage collection as marginal tax rates, you lost me completely because I associate the latter term with something else).

The end result is that I have a clear starting situation and a concluding sentence at the end, but they don't fit together for me, and so most of the learning and work behind the article was lost in transmission. Perhaps they will fit much much better to others who are already starting with an advanced economics background in this area.

2009 Aug 06 12:56 PM

[User 467580]

This was a painful article to read. I was not able to delineate the 3 plans nor draw any meaningful comparisons between them. Was their an assumption of previous knowledge regarding the various foreclosure prevention plans? I have too many missed connections as well. For example,

"But if the combined value of his house and these costs were less than the present value of his promised mortgage payments, then he could do better than paying in full."

Do better than paying in full? That doesn't even make sense. This is a terrible way of saying that "when borrowers are so upside down that the future payments outweigh the benefits of keeping the home, some borrowers are better off walking away."

Where did this come from?

"Thus, while millions of workers have seen massive increases in their marginal tax rates during this recession as a result of mortgage modification, additional workers and businesses may also have seen significant increases in their marginal tax rates due to these other collection efforts."

Missed connection: How have mortgage modifications increased marginal tax rates? What's a "marginal" tax rate?

I'm going to try to forget I read this article.

2009 Aug 06 01:50 PM

[cadoggy]

Agreed. My eyes glazed over more than once.

2009 Aug 06 01:51 PM

[Mad Hedge Fund Trader]

The whole program is just a band aid for a heart attack. Deutsche Bank has put out a report on residential real estate that will raise the hair on the back of your kneck if you still own your own home. Prices have not hit bottom and have another 14% to fall by 2011, putting in a 42% fall from top to bottom. By then, almost half of all mortgage holders in the US will be underwater. The top underwater cities in the US is not good news for the Land of Fruits and Nuts, where lending was the most aggressive and imaginative:

Merced, CA 85%
El Centro, CA 85%
Modesto, CA 84%
Las Vegas, CA 81%
Stockton, CA 81%

The murder weapons in these nearly home equity free cities break out as the following:

Option ARMS 89%
Subprime 69%
Alt-A 66%
Jumbo 46%
Conforming 41%

These forecasts tell us that a second stimulus package is a sure thing, that unemployment will soar over 10%, and that a “W” shaped recession is a lock. Gee, do you thing the stock market might go down on this?

2009 Aug 06 04:31 PM

[Troyhector]

Foreclosures have been a major issue of the economic recession that has hit all countries across the world. The Bush administration overlooked the foreclosure issues of the average homeowners which the Obama administration is struggling to tackle with various initiatives.

The loan modification efforts to prevent the increase of foreclosure rates have not got a huge welcome. The reason is because the lender needs to revise the ‘borrowing terms’ of the troubled borrower who is struggling to repay the loan on time. It also involves reducing the interest rate which is generally not received well by the lender who would lose some margin in the sale. In addition, the revised plan involves cutting the principal amount by reconsidering the financial state of the borrower and hence, it tackles the benefit of the borrower than guarding the interest of the lender. Hence the lenders and their representatives or not willing to either reduce the principal amount as well as the interest received from the borrowers as the amount they pay to the bank also reduces over time making it further difficult for them to tackle the vicious circle.

Read More: www.housingnewslive.com

2009 Aug 07 01:31 PM

[Dave136]

"In theory, lenders could find it optimal (given that they were not permitted to means test) to write down underwater mortgages so much that foreclosure rates would ultimately be quite low."

"In theory.." is the word! In REALITY they don't. Look at BofA and Wells Fargo as prime examples...4% and 6% respectively of their modification "requests" have been granted. This may improve some over the next year, but not to the point of making a dent in people losing their homes!

In reality, lenders have NO INCENTIVE to modify loans. They have NO CONSEQEUENCES hanging over them (unlike the homeowner who bought their home in good faith with the BAD mportgage product these lenders provided!) and , in fact, have been "immunized" from any consequences by a huge TARP bailout, that only served to LESSEN their incentive.

Bottomline, lenders do want these bad loans off their books...only they want them off without carrying the original borrowers...i.e., let's foreclose, bite the "small" (relatively) bullet, and keep our asses covered while we ride this wave out.

And the government has only helped them accomplish this, to the detriment of the now FORMER homeowner. And the downward cycle continues to drain the value of any existing homeowners still "hanging on"...thus more foreclosures are fed into the fire of property values destroyed.

2009 Aug 08 06:24 PM