Real Estate Research
Real Estate Research provides analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog include the Atlanta Fed's Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.
March 05, 2014
Government Involvement in Residential Mortgage Markets
With the federal funds rate effectively at the zero lower bound, the Federal Reserve has used unconventional forms of monetary policy. Specifically, the central bank has issued forward guidance about the policy path and purchased large amounts of U.S. Treasury bonds and agency mortgage-backed securities (MBS) in an effort to lower long-term interest rates. In the case of agency MBS purchases, a goal was to stimulate the housing market by lowering mortgage rates. Two papers presented at the recent Atlanta Fed/University of North Carolina—Charlotte conference, "Government Involvement in Residential Mortgage Markets," examine the extent to which the Federal Reserve has been successful.
Unanticipated announcements of new large-scale asset purchase programs (LSAPs), or changes in these programs, should have an immediate impact on interest rates under the assumption that the total stock of purchases is what matters. On the other hand, the flow of purchases may independently influence markets through portfolio rebalancing—that is, investors reacting to the removal of duration and convexity from the market—and liquidity effects—that is, ease of reselling assets in the future. Diana Hancock and Wayne Passmore conduct an empirical analysis of the differing effects of the LSAPs in their paper, "How the Federal Reserve's Large-Scale Asset Purchases Influence MBS Yields and Mortgage Rates." Using weekly data from July 2000 to June 2013, the authors estimate a model of MBS yields that controls for market expectations about future interest rates and find that the Federal Reserve's market share of MBSs and Treasuries are negatively related to MBS yields. Under their model, the Fed's holdings of MBSs has lowered MBS yields by 54 basis points and the Treasury holdings have pushed down the MBS yields another 70 basis points. This finding is consistent with portfolio rebalancing and liquidity effects being important determinants of MBS yields.
The finding is important because it suggests that agency MBS yields and mortgage rates will rise when the Federal Reserve reduces its MBS purchases—even if the Fed successfully signals that it intends to keep rates low for an extended time. On the margin, this could serve to dampen housing market activity, including refinancing. Since the beginning of the third phase of quantitative easing (QE3), the Fed's MBS market share has grown from around 17 percent to nearly 24 percent. Given the estimate that each percentage point increase in market share pushes MBS yields down by 2.3 basis points, reducing the Fed’s MBS market share back to a pre-QE3 level would push MBS yields up by around 16 basis points, which is unlikely to be economically meaningful.
While the cost of mortgage refinancing is borne by MBS investors, most of the policy attention is placed on the benefit to borrowers through an increase in their disposable income. In cases where borrowers are underwater and having difficulty making mortgage payments, refinancing can ease borrowers’ financial distress. In "The Effect of Mortgage Payment Reduction on Default: Evidence from the Home Affordable Refinance Program," Jun Zhu, Jared Janowiak, Lu Ji, Kadiri Karamon, and Douglas McManus estimate that during the 2009 to 2012 period, a 10 percent reduction in monthly mortgage payments for participants in Freddie Mac’s Home Affordable Refinance Program (HARP) resulted in a 12 percent reduction in the monthly default hazard for 30-year fixed rate conventional-conforming mortgages. This likely helped slow the flow of mortgages entering the foreclosure pipeline and gave neighborhoods time to stabilize.
Government involvement in residential mortgage markets takes many forms (see the conference website for papers that examine other forms of intervention). Taken together, the papers discussed here provide evidence that the Federal Reserve's LSAPs and Freddie Mac's HARP did put downward pressure on longer-term interest rates and facilitated refinancing activity that helped to support housing and mortgage markets. The tapering of the MBS LSAPs should not be a cause for concern. The Fed’s strong forward guidance combined with the slow, judicious pace of the taper imply that stagnation of the housing market is unlikely.
By Carl Hudson, Director, Center for Real Estate Analytics in the Atlanta Fed's research department, and
April 26, 2012
Can home loan modification through the 60/40 Plan really save the housing sector?
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In a recent article in the Federal Reserve Bank of St. Louis Review, Manuel Santos, a professor at the University of Miami, claims to offer a simple solution to "save the housing sector." Called the "60/40 Plan," his proposal is the centerpiece of a business called 60/40 The Plan Inc. Santos’s article is, in our opinion, written less like an academic article and more like promotional material.
The developer of the 60/40 Plan, Gustavo Diaz, is seeking a patent for the proposal. Unfortunately for the stressed mortgage market, his idea is simply a specific variant of a long-standing mortgage-servicing practice known as "principal forbearance." In general, principal forbearance occurs when the mortgage lender grants a temporary reduction of a borrower’s monthly mortgage payment, often reducing the payment by a significant fraction, with the stipulation that the borrower repay this benefit, with interest, at a later date.
Principal forbearance is a loss-mitigation tool that mortgage lenders and servicers have been using for decades. In fact, Fannie Mae and Freddie Mac are currently using this technique as a loss mitigation tool and alternative to principal forgiveness (which Federal Housing Finance Agency Acting Director Edward DeMarco discussed here). Private mortgage lenders have also widely used principal forbearance, especially in the first few years of the recent foreclosure crisis.
As articulated in Diaz’s 60/40 Plan, principal forbearance simply splits a distressed borrower’s current principal balance into two parts: a 60 percent share that will fully amortize over 30 years and be subject to interest payments at market rates, and a 40 percent share that is treated as a zero-interest balloon loan due at the time of sale.
Of course, in practice, the optimal shares and other terms of a principal forbearance program should be, and often are in practice, based on a given household’s financial situation. One size does not fit all. Professor Santos advocates the 60/40 Plan in large part because it is, in the language of economists, "incentive compatible." What this means is that borrowers who need assistance with their mortgage payments will find the program helpful and borrowers who do not need assistance will not find the program very appealing and thus will have little incentive to pretend to be a borrower in need of help in order to qualify for the program.
He writes: "It is important to understand that the 60/40 Plan builds on financial postulates and incentive compatible mechanisms that can be firmly implemented. It is designed as a first-best contract between the homeowner and the lender by holding onto some basic principles of incentive theory."
We agree completely with this sentiment. In fact, one of us wrote an article almost five years ago that advocated a policy of principal forbearance over principal forgiveness for exactly these reasons. Thus, the 60/40 Plan is not a novel concept, as Professor Santos seems to believe. But even more problematic, principal forbearance, as we have come to realize over the past few years, is not a panacea for the housing market for several reasons. First, it is really only helpful and appealing to borrowers that have temporary cash-flow problems who do not wish to move. This is because under the 60/40 Plan and principal forbearance in general, a borrower remains in a position of negative equity, which makes it virtually impossible to sell, since the borrower would need to come up with the amount of negative equity in cash to repay the entire principal balance of the mortgage at closing. For example, in the numerical example that Professor Santos works through to illustrate how the 60/40 Plan would work in practice, the borrower remains in a position of negative equity for 15 years. Thus, if a cash-strapped borrower needs to move immediately, or even a few years down the road, default (or re-default) is very likely.
Second, carrying 40 percent of the mortgage at a zero (or below market) interest rate imposes significant costs on the lender or investor. (These costs are viewed as being offset by savings from avoiding foreclosure.) Nevertheless, principal forbearance is not always going to be a positive net-present-value proposition; this depends on the share being protected (40 percent is quite high), the amortization schedule (30 years is very long), the discount rate, and the re-default rate. Indeed, Professor Santos seemingly assumes no re-default despite the fact that under the plan a borrower would remain in negative equity for a very long time, as we discussed above.
Third, most distressed mortgages are not held by depository institutions as whole loans. Fannie Mae and Freddie Mac have been able to selectively employ principal forbearance because they make investors whole in terms of the original promised principal and interest payments. This is not true for private-label securitizations, and there have been ongoing disagreements between investors and servicers as to optimal loss-mitigation strategies. (And there is no reason to think this proposal would not be similarly controversial.) The 60/40 Plan also seemingly ignores the significant complications posed by existing second liens and mortgage insurance policies.
Finally, Professor Santos claims that the 40 percent zero-coupon balloon shares—typically nonrecourse loans to severely distressed homeowners—will have a deep secondary market to pull liquidity back into the housing market. This seems far-fetched given that these assets have little or no yield and will have high default rates with no recourse. However, reading further, it appears that the proposal assumes a Federal Deposit Insurance Corporation (FDIC) insurance wrap for these assets to facilitate their sale. The cost of this insurance would likely be expensive and require a controversial new program, with premiums expected to cover losses or a congressional appropriation. However, it also ignores the fact that FDIC-insured depository institutions only hold about 25 percent of all mortgages.
Principal forbearance can be a useful loss-mitigation tool, although its value depends on economic circumstances. The 60/40 Plan that Professor Santos advocates is an example of principal forbearance and not a novel concept. Moreover, the 60/40 Plan does not consider a number of important institutional factors that have hampered loss-mitigation activities since the onset of the mortgage foreclosure crisis. Simply put, the 60/40 Plan will not save the housing market.
By Scott Frame, financial economist and senior policy adviser, and
Kris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta
March 09, 2011
The seductive but flawed logic of principal reduction
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The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die. If news stories are true, the administration, in conjunction with the state attorneys general, will soon announce that lenders have agreed to write down borrower principal balances by a grand total of $20–$25 billion as part of a deal to address serious procedural problems in foreclosure filings. Policy wonks and housing experts will greet this announcement with glee, saying that policymakers have ignored principal reduction for too long but have seen the light and are finally going to cure the epidemic of foreclosures that has gripped the country since 2007. Are the wonks right? In short: we think not.
Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders, not borrowers. It is the quintessential win-win or even win-win-win solution. The logic of principal reduction is that in a foreclosure, a lender recovers at most the value of the house in question and typically far less. This is because of the protracted foreclosure process during which the house deteriorates and the lender collects no interest but has to pay lawyers and other staff to navigate 50 different byzantine state bureaucracies to get a clean title to the house, which it then has to sell in an extremely weak market. In contrast, reducing the principal balance to equal the value of the house guarantees the lender at least the value of the house because the borrower now has positive equity and research shows that borrowers with positive equity don’t default. To put numbers on this story, suppose the borrower owes $150,000 on a $100,000 house. If the lender forecloses, let's assume it collects, after paying the lawyers and the damage on the house, etc., $50,000. However, if it writes principal down to $95,000, it will collect $95,000 because the borrower now has positive equity and won't default on the mortgage. Lenders could reduce principal and increase profits!
The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages. To understand why this assumption is crucial to the argument, suppose there are two borrowers who owe $150,000 but one prefers not to default (perhaps because she has a particularly strong preference for her current home, or because she does not want to destroy her
credit, or because she thinks there's a chance that house prices will recover) and eventually repays the whole amount while the other defaults. If the lender writes down both loans, it will collect $190,000 ($95,000 from each borrower). If the lender does nothing, it will eventually foreclose on one and collect $50,000, but it will recover the full $150,000 from the other borrower, thus collecting $200,000 overall. Hence, in this simple example, the lender will obtain more money by choosing to forgo principal reduction.
The obvious response is that the optimal policy should be to offer principal reduction to one borrower and not the other. However, this logic presumes that the lender can 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!
This is an oft-encountered problem in the arena of public policy. Planners often have a preventative remedy that they have to implement before they know who will actually need the assistance. This inability to identify the individuals in need always raises the cost of the remedy, sometimes dramatically so. A nice illustration of this problem can be seen in the National Highway Traffic Safety Administration's (NHTSA) proposed regulation to require all cars to have backup cameras to prevent drivers from running over people when they drive in reverse. Hi-tech electronics mean that such cameras cost comparatively little: $159 to $203 for cars without a pre-existing navigation screen, and $53 to $88 for cars with a screen, according to the NHTSA. $200 seems like an awfully small price to pay to prevent gruesome accidents that are often fatal and typically involve small children and senior citizens. But the NHTSA says that the cameras are actually extremely expensive, and arguably prohibitively so. What gives? How can $200 be considered a lot of money in this context? The problem is that backup fatalities are extremely rare, something on the order of 300 per year, so the vast majority of backup cameras never prevent a fatality. To assess the true cost, one has to take into account the fact that for every one camera that prevents a fatality, hundreds of thousands will not. Done right, the NHTSA estimates the cost of the cameras between $11.3 and $72.2 million per life saved.
The idea of principal reduction starts with a correct premise: borrowers with positive equity—that is, houses worth more than the unpaid principal balance on their mortgages—rarely ever lose their homes to foreclosure. In the event of an unexpected problem (like an unemployment spell) that makes the mortgage unaffordable, borrowers with positive equity can profitably sell their house rather than default. The reason that foreclosures are rare in normal times is that house prices usually increase over time (inflation alone keeps them growing even if they are flat in real terms) so almost everyone has positive equity. What happened in 2006 is that house prices collapsed and millions of homeowners found themselves with negative equity. Many who got sick or lost their jobs were thus unable to sell profitably.
With this idea in mind, it then follows that if we could somehow get everyone back into positive-equity territory, then we could end the foreclosure crisis. To do that, we either need to inflate house prices, which is difficult to do and probably a bad idea anyway, or reduce the principal mortgage balances for negative-equity borrowers. So we have a cure for the foreclosure crisis: if we can get lenders to write down principal to give all Americans positive equity in their homes, the housing crisis would be over. Of course, the question becomes, who will pay? Estimates suggest that borrowers with negative equity owe almost a trillion dollars more than their homes are worth, and a trillion dollars, even now, is real money. The principal reduction idea might stop here—an effective but unaffordable plan—but people then realized that counting all the balance reduction as a cost was wrong. Furthermore, in fact, not only was the cost far less than a trillion dollars, but, as we noted above, many principal reduction proponents argue that it might not cost anything at all.
The logic that principal reduction can prevent foreclosures at no cost is compelling and seductive, and proposals to encourage principal reduction were common early in the foreclosure crisis. In a March 2008 speech, one of our bosses, Eric Rosengren, noted that "shared appreciation" arrangements had been offered as a way to reduce foreclosures; these arrangements had the lender reduce principal in return for a portion of future price gains realized on the house. In July 2008, Congress passed the Housing and Economic Recovery Act of 2008, which created Hope for Homeowners, a program that offered government support for new loans to borrowers if the lender was willing to write down principal.
While we were initially supportive of principal-reduction plans, we began to have doubts over the course of 2008. Our reasons were twofold. First, we could find no evidence that any lender was actually reducing principal. Commentators blamed the lack of reductions on legal issues related to mortgage securitization, but we became skeptical of this argument, because the incidence of principal reduction was so low that it was clear that securitization alone could not be the only problem or even a major one, (Subsequent research has shown this to be largely right: the effect of securitization on renegotiation was between nil and small in this crisis, and lenders did not reduce principal much even during the Depression, when securitization did not exist.) And the second issue, of course, was our realization of the logical flaw described above.
Negative equity and foreclosure
But aren't we being pessimistic here? Aren’t we ignoring research that shows that negative equity is the best predictor of foreclosure? No, we aren't. On the contrary, we have authored some of that research and have long argued for the central importance of negative equity in forecasting foreclosures. But what research shows is not that all or most people with negative equity will lose their homes but rather that while people with negative equity are much more likely to lose their homes, most eventually pay off their mortgages. The relationship of negative equity to foreclosure is akin to that of cholesterol and heart attacks: high cholesterol dramatically increases the odds of a heart attack, but the vast majority of people with high cholesterol do not have heart attacks any time in the near or even not-so-near future.
To be sure, there are some mortgages out there with very high foreclosure likelihood: loans made to borrowers with problematic credit and no equity to begin with, located in places where prices have fallen 60 percent or more. However, such loans are quite rare now—most of those defaulted soon after prices started to fall in 2007—and make up a small fraction of the pool of troubled loans currently at risk. To add to the problem, the principal reductions required to give such borrowers positive equity are so large that the $20–25 billion figure discussed for the new program would prevent at most tens of thousands of foreclosures and make only a small dent in the national problem.
Millions of borrowers with negative equity will default, but there are many millions more who will continue to make payments on their mortgages, behavior that is not, contrary to popular belief, a violation of economic theory. Economic theory only says that borrowers with positive equity won’t default (read it carefully). It is logically false to infer from this prediction that all borrowers with negative equity will default. "A implies B" does not mean that "not A" implies "not B," as any high school math student can explain. And in fact, standard models show that the optimal default threshold occurs at a price level below and often significantly below the unpaid principal balance on the mortgage.
The problem of asymmetric information
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, information that lenders don’t have access to. If lenders weren't faced with this asymmetric information problem—if they really knew exactly who was going to default and who wasn't—all foreclosures could be profitably prevented using principal reduction. In that sense, foreclosure is always inefficient—with perfect information, we could make everyone better off. But that sort of inefficiency is exactly what theory predicts with asymmetric information.
And, in all this discussion, we have ignored the fact that borrowers can often control the variables that lenders use to try to narrow down the pool of borrowers that will likely default. For example, most of the current mortgage modification programs (like the Home Affordable Modification Program, or HAMP) require borrowers to have missed a certain number of mortgage payments (usually two) in order to qualify. This is a reasonable requirement since we would like to focus assistance on troubled borrowers need help. But it is quite easy to purposefully miss a couple of mortgage payments, and it might be a very desirable thing to do if it means qualifying for a generous concession from the lender such as a reduction in the principal balance of the mortgage.
Economists are usually ridiculed for spinning theories based on unrealistic assumptions about the world, but in this case, it is the economists (us) who are trying to be realistic. The argument for principal reduction depends on superhuman levels of foresight among lenders as well as honest behavior by the borrowers who are not in need of assistance. Thus far, the minimal success of broad-based modification programs like HAMP should make us think twice about 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.
Senior economist and policy adviser at the Boston Fed
Research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta
Research economist and policy adviser at the Boston Fed
December 21, 2010
Revisiting real estate revisionism: Concessionary mortgage modifications during the Depression
During the current foreclosure crisis, lenders have seemed far more willing to foreclose on delinquent borrowers rather than offer them loan modifications. Some commentators have argued that this was not always the case. They claim that loan modifications are infrequent today because so many loans have been securitized, and thus are not owned by any one person or firm. They also say that the modern securitization process reduces loan modifications because securitization separates the entity that makes the modification decision—that is, the mortgage servicer—from the entities that gain the most if a foreclosure is avoided—that is, the mortgage investors. As we pointed out in our last post, Yale economist John Geanakoplos and Boston University law professor Susan Koniak argued in a March 2008 New York Times op-ed that the uncomplicated relationship between banks and borrowers in the good old days allowed the banks to work out modifications when their borrowers ran into trouble.
The Congressional Oversight Panel, created by Congress in October 2008 to "review the current state of financial markets and the regulatory system," expressed a similar belief in a March 2009 report on the state of the U.S. housing market:
For decades, lenders in this circumstance [that is, with troubled borrowers] could negotiate with can-pay borrowers to maximize the value of the loan for the lender (100 percent of the market value) and for the homeowner (a sustainable mortgage that lets the family stay in the home). Because the lender held the mortgage and bore all the loss if the family couldn't pay, it had every incentive to work something out if a repayment was possible.
Even in the good old days, lenders reluctant to restructure
Such claims, however, have usually been made with little or no reference to supporting research. Fortunately, a recent paper by Andra Ghent of Baruch College exploits a new data set to shed considerable light on this topic. Her findings argue against the idea that lender reluctance to modify is a recent phenomenon.
Ghent uses a data set from the National Bureau of Economic Research (NBER) that covers mortgages from 1920 to 1939, a period that encompasses the massive housing turmoil of the Great Depression. The data set consists of "mortgage experience cards," which the NBER collected in the 1940s from mortgage lenders in the New York metropolitan area. On the cards are the answers to short questionnaires about the characteristics of individual mortgage loans (see page 5 of Ghent's paper for an example). The cards also contain explicit information about any loan modifications, including the date of the modification and whether it was principal reduction, interest-rate reduction, change to the amortization schedule, or something else. The cards include loans from three types of mortgage lenders: life insurance companies, savings and loans, and commercial banks.1
Ghent finds few modifications in these cards, and these few were not particularly generous. Using a fairly conservative definition of what constitutes a concessionary modification, Ghent finds that approximately 5 percent of loans originated between 1920 and 1939 were modified, while 14 percent were terminated by foreclosure or a deed-in-lieu of foreclosure (the latter occurs when the owner surrenders the house to the lender without going through the foreclosure process). Of the loans that received a concessionary modification, about 40 percent received an interest rate reduction, which Ghent defines as an interest rate cut of at least 25 basis points (relative to origination) resulting in a new rate that is at least two standard deviations below the average interest rate on newly originated loans. The average rate reduction was only 78 basis points below the prevailing interest rate of new originations, suggesting that interest rate cuts were not particularly generous.
Another 40 percent of the modified loans received reductions in their amortization schedules, which would have likely decreased the required mortgage payments. However, Ghent points out that most of these extended amortizations occurred before 1930. In the period 1930–32, when house prices fell and unemployment rose the most, this type of modification was rare.
Principal balance reductions—and increases
Ghent also finds that less than 2 percent of all loans received principal balance increases. She argues that such increases may correspond to instances of forbearance. Forbearance occurs when a lender reduces the required mortgage payment for a short period. At the end of the period, the lender adds the arrears back to the loan balance. We have a minor quibble on this point: today, forbearance is not considered a permanent concessionary modification when the lender does not have to write down any debt.
What about principal reductions? Perhaps the most surprising finding is that the data set shows no instances of principal reduction in the New York City metropolitan area and only a handful of instances in a broader sample that includes the entire states of Connecticut, New Jersey, and New York over a similar period. To us, this low number of principal reductions is compelling evidence that even Depression-era lenders were averse to renegotiating with troubled borrowers, just as lenders are today.
Balloon mortgages sank some borrowers
Another interesting finding concerns the refinancing decisions of lenders. Short-term balloon mortgages were more common in the 1920s and 1930s than they are today, and various scholars have linked the high foreclosure rate of the Depression to the unwillingness of lenders to refinance these mortgages when they came due. In fact, lender reluctance to refinance maturing mortgages is often used to explain the existence of the Home Owners' Loan Corporation (HOLC), a government organization set up in the early 1930s to refinance troubled mortgages. Ghent revisits this hypothesis with her data, measuring the frequency at which short-term balloon mortgages ended in foreclosure. She finds that balloon mortgages that were about to expire did indeed experience increased rates of foreclosure (see Ghent's table 4). However, this relationship only exists during the years when HOLC was purchasing a great many loans (1933–35). In other years, balloon mortgages were no more likely to end in foreclosure than other loans.
To us, this finding suggests a "HOLC effect." While HOLC was actively buying loans, private lenders may have refused to roll them over so that the borrowers would qualify for a HOLC refinance. If they did, then the lenders would be paid close to par for the loans by the government (see our previous post about the generosity of the HOLC program). In particular, the lenders received what were effectively government bonds in return for their mortgage. While these bonds carried lower interest rates, they carried vastly less credit risk as well.
To explain her findings, Ghent points to information problems between borrowers and lenders. In particular, lenders may not have known which borrowers were likely to truly need modifications, nor did they know with certainty which borrowers were likely to re-default if a modification were offered. Note that these information problems must have been quite severe. The national unemployment rate hit 10.8 percent in November 1930 and stayed in double digits for more than a decade. In this environment, a borrower asking for a modification was quite likely to really need one. The fact that lenders made few modifications suggests some strong intrinsic hurdles to renegotiation when information between borrowers and lenders is less than perfect.
Old problems, new analysis
The crucial policy question is what the Depression-era reluctance of lenders to renegotiate teaches us about today's foreclosure crisis. Ghent surmises that the information problems are less of an issue in the current environment, but we disagree. Even with better data and screening technology, today's lenders face significant information problems when deciding on modifications. Moreover, Ghent's paper is also informative on the role of securitization in reducing modifications. Even when individual lenders owned entire loans, modifications were rare.
All told, Ghent's paper is full of solid analysis on a topical subject. And while she doesn't quite go this far, we believe that her findings not only confirm the importance of information problems, but also they may bury the notion that securitization is the primary obstacle to renegotiation in the current foreclosure crisis.
Research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta
Chris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston
1 Ghent argues that the data set probably provides a representative sample of loans held by life insurance companies and commercial banks in the 1920s and 1930s, but is less likely to be representative of loans held by savings and loans due to a survivorship bias. Unlike life insurance companies and commercial banks, savings and loans were not able to reliably report data on their inactive loans at the time of the survey.
November 15, 2010
Mortgage relief in the Great Depression
Bemoaning the unwillingness of lenders to renegotiate loans in the current mortgage crisis, critics often point to the "old days" when, they argue, foreclosures were a rarity because of a different institutional setup. John Geanakoplos and Susan Koniak took this view in an op-ed they wrote for The New York Times.
In the old days, a mortgage loan involved only two parties, a borrower and a bank. If the borrower ran into difficulty, it was in the bank's interest to ease the homeowner's burden and adjust the terms of the loan. When housing prices fell drastically, bankers renegotiated, helping to stabilize the market.
Luigi Zingales uses almost the same language to make the same argument in an article in The Economist's Voice.
In the old days, when the mortgage was granted by your local bank, there was a simple solution to this tremendous inefficiency. The bank forgave part of your mortgage….
But what evidence do we have to back up these claims? The authors do not provide any direct evidence, do not provide a source for the evidence, and are not clear about what exactly they mean by "the old days." Until recently, there was little hard evidence on the subject. However, the simple existence of foreclosure crises in the past—in New England in the 1990s, for example, and across the nation during the Depression—is, at least on the surface, evidence that large numbers of mortgages escaped the seemingly win-win solution of modification even in the past.
In the last two years, two researchers, Andra Ghent of Baruch College and Jonathan D. Rose, an economist with the Federal Reserve System's Board of Governors, have gone to the records from the Depression, in one possible definition of "the old days," to see if, indeed, lenders renegotiated on a wide scale. Looking at the Depression gives us a good opportunity to test the theory that our current set of institutions are the problem because the institutional setup was different during the Depression—and if there was ever a profitable opportunity to modify loans, it was the period from 1932 to 1939. The extent of the crisis at the time minimized the information problems that we argue prevent profitable modifications now. Even if some borrowers who received modifications then could have afforded to repay their loans or more than their modified loans, there were so many deeply delinquent borrowers that the gains on the rest should have made up for it.
Comparing the 1930s Home Owners Loan Corporation to today's programs
In this post, we focus on the paper by Rose, who explores the Home Owners Loan Corporation (HOLC), a federal program aimed at transitioning troubled borrowers into new loans. (We will focus on Ghent's paper in the next post.) Many of today's critics have held up HOLC as an example of enlightened government policy; it was the model of the Hope for Homeowners (H4H) program enacted by Congress in 2008. Rose argues in his paper that, contrary to popular belief, HOLC actually did not offer particularly good terms to borrowers and instead focused mostly on assisting banks.
The last time that national housing prices crashed as low as they have over the past three to four years was during the Depression. As with today's crash, the 1930s fall coincided with a rash of mortgage defaults and foreclosures. According to Wheelock (2008), by 1933, 13.3 of every 1,000 mortgages in the United States was in foreclosure, and by the beginning of 1934, almost half of all outstanding urban home mortgages were delinquent. To stem the rising tide of foreclosures, the Roosevelt Administration created HOLC in 1933. Over the following three years, HOLC purchased and refinanced more than 1 million delinquent home loans. Although 1 million loans may not seem like that many, keep in mind that the U.S. mortgage market was significantly smaller 80 years ago and that current government programs have permanentlymodified or refinanced far fewer than 1 million loans during this crisis.
HOLC was a voluntary program that aimed to prevent foreclosures by refinancing troubled borrowers into mortgages that were more affordable. The program accepted applications from borrowers from June 1933 to November 1934, and then again from May to June 1935. Rather than paying cash for the mortgages, HOLC exchanged its own bonds for the lender's claim on the underlying house. The tax-exempt bonds were essentially equivalent to U.S. Treasury securities and thus could be considered very low-risk assets, especially relative to mortgage debt at the time. After HOLC purchased the loan from the lender, it would issue a new 15-year, fully amortizing mortgage at an interest rate of between 4.5 and 5 percent. The HOLC loans contained no prepayment penalties and had an interest-only option for the first three years. Thus, in most cases, a HOLC refinance gave the borrower a more affordable mortgage by lowering the interest rate and stretching out payments. Like modification programs today, HOLC tried to help borrowers in financial duress, discouraging applications from borrowers who just wanted a lower interest rate or borrowers for whom a refinance from a private lender was a viable alternative.
Did HOLC inflate home appraisals to encourage lenders to modify loans?
Until Rose did the research for his paper, a lack of data—other than a handful of aggregate statistics—prevented us from knowing much about HOLC activities. However, Rose was able to obtain loan-level data for a sample of HOLC loans from New York, New Jersey, and Connecticut.1 His goal was to analyze how HOLC encouraged lenders to part with their loans—after all, although HOLC bonds were much less risky than the mortgage debt that lenders held on their portfolios at the time, the bonds also carried lower interest rates. Thus, some 1930s lenders could have decided to take their chances with their old mortgages and refuse participation in the government's program. One key factor affecting the lender's decision was the amount of mortgage debt that HOLC was willing to refinance, which because of a combination of law and HOLC policy, was only 80 percent of the value of the property as estimated by a HOLC appraisal. If the amount of the new HOLC mortgage was lower than the old mortgage, then a participating lender would receive a "haircut" on the loan and the borrower would receive a principal reduction in addition to a lower interest rate and longer maturity schedule.2
Rose's main finding is that HOLC seems to have recognized that placing a low value on the house would make it more likely that the lender would have to offer a principal reduction, so that a low appraisal would reduce the chance that the lender would participate in the program. As a result, Rose argues, HOLC tended to place high values on properties in its appraisal process. This practice was good for lenders, who, in many cases, were paid in full for their mortgages. But high appraisals were bad for borrowers, because they made principal reductions less likely.3
A strength of the Rose paper is a careful explanation of how HOLC appraisals came to be relatively high. The HOLC appraisal formula consisted of three components. The first was the estimated present market value of the property, as in today's appraisals. The second was the estimated cost of purchasing the lot and constructing a similar structure. The third component was capitalizing the estimated monthly rental value of the property over the past ten years over a ten-year period assuming no discount rate. HOLC averaged these three measures to determine the final appraised value.
Because of the dramatic decline in housing values at the beginning of the Depression, the second and third measures were typically higher than the first one, the market-based measure, which resulted in appraisals being higher than market values on average. According to Rose's data, which consists of loan applications that HOLC accepted and mortgages that they refinanced, the appraisals exceeded the market-value estimates almost 74 percent of the time and equaled the market-value estimates approximately 8 percent of the time. The value that came out of this process was not necessarily the actual value the organization used, however. HOLC performed two additional reviews (at the district and then the state level) on each application to guard against any obvious errors. These two reviews were highly subjective. HOLC's policy was that these reviews could lower the final appraisal without bound but could raise the appraisal only by 10 percent. According to Rose's analysis, the final appraisal exceeded the market value estimate in 58.5 percent and equaled it in 10.6 percent of the cases, showing that the review process was proactive in adjusting the values that came out of the three-component appraisal formula. Even more compelling is the fact that almost one-third of the HOLC refinances had amounts that exceeded 80 percent of the estimated market value of the property, while HOLC regulations meant that none had amounts that exceeded 80 percent of the final appraisal.
Inflated appraisals helped keep Depression-era banks solvent, at the expense of homeowners
We view these findings as convincing evidence that HOLC was inflating appraisals in order to increase lender participation rather than directly reducing principal or trying to make lenders take write-downs. Rose takes this reasoning a step further and concludes that the inflated appraisals were motivated by the desire to keep banks and other lending institutions solvent, at the expense of mortgage borrowers. While he cannot offer a straightforward way to confirm this interpretation, Rose does offer some tantalizing contemporaneous quotations to support it. For example, he includes this quote from one of the HOLC loan examiners:
There seems to be a deliberate effort made by the Connecticut officials to make high appraisals with the purpose of holding up real estate values. We have had this suspicion confirmed in a recent interview with the State Counsel, Mr. Tierney. This gentleman, during a call in our office last month, stated that they believed it necessary, to prevent depreciation of realty value as much as possible so as to maintain the soundness of the banks and other financial institutions which had made mortgage loans during the past 5 years, to make high appraisals. His opinion was that many of these financial institutions would be today in an unsound condition if their mortgage loans were appraised on a basis of today's realty values. This statement is illuminating when appraisals by our Connecticut offices are being analyzed. (p. 19)
One potential problem with Rose's interpretation is that it assumes HOLC didn't negotiate to the fullest possible extent with lenders. That may be true, but it's also possible that lenders were unwilling to substantially write down loans, which would have forced HOLC to maximize lender participation by paying high prices.
What does the HOLC experience teach us about the current foreclosure situation?
Lenders today still seem reluctant to modify large numbers of troubled loans. In the Depression, HOLC solved the problem of lender reluctance with high appraisals and by essentially transferring a large amount of mortgage credit risk from the private sector to the public sector. By contrast, in today's Home Affordable Mortgage Modification (HAMP) program, government payments encourage a modification only when the modification is determined to be a win-win proposition for both the borrower and the lender. The small number of modifications to date may suggest that the number of win-win modifications is low. In other words, just as in the Depression, today's lenders may be willing to take their chances with existing mortgages rather than offer generous concessionary modifications to borrowers.
We find the HOLC policy of refusing to directly reduce mortgage principal to be potentially informative to the current modification debate in another way. Principal reductions appear to have been as rare in the 1930s as they are today (more on this in our post about the Ghent paper). Many have blamed securitization by private institutions for this pattern today, but if securitization were the real culprit, how do we explain a similar lack of principal reduction in a period when securitization was basically nonexistent?
3 Of course, even borrowers who did not receive principal reductions were helped because they could swap their short-term balloon mortgages with longer-term HOLC loans. A longer amortization period tends to lower monthly payments, which make homeownership more affordable. Borrowers who could not roll over balloon mortgages when they came due no doubt found HOLC mortgages particularly helpful in preventing foreclosure.
October 20, 2010
Securitized mortgage loan or not, lenders are not restructuring
In a new paper, Agarwal, Amromin, Ben-David, Chomsisengphet, and Evanoff (2010) finally put to rest the widespread belief that securitization massively exacerbated the foreclosure crisis by preventing lenders from renegotiating loans. The authors show that the data do not support the argument articulated by Paul Krugman and Robin Wells in the New York Review of Books:
In a housing market that is now depressed throughout the economy, mortgage holders and troubled borrowers would both be better off if they were able to renegotiate their loans and avoid foreclosure. But when mortgages have been sliced and diced into pools and then sold off internationally so that no investor holds more than a fraction of any one mortgage, such negotiations are impossible.
This post is the first in a three-part series in which we discuss recent studies, including that of Agarwal et al. (2010), providing evidence that the low modification rate has not resulted from an excess of securitized loans, what we call the "institutional view." These studies show, rather, that the low rate comes from lenders having imperfect information. This view—the "information view"—holds that lenders cannot determine whether a delinquent borrower will default even if the lender makes concessions.
While Agarwal et al. (2010) find that lenders fail to renegotiate 93 percent of seriously delinquent securitized mortgages, they also find that the figure drops only to 90 percent for portfolio loans without the supposed problems generated by securitization. Whether that 3-percentage-point difference really reflects securitization frictions is disputable, as we discuss below. But since most renegotiated mortgages fail anyway, it means that the elimination of securitization frictions would at most have reduced the number of foreclosures by less than 2 percent. The authors clearly show that Krugman and Wells and others who argue that securitization frictions were generating millions of unnecessary foreclosures are way, way off base. Securitization may or may not inhibit renegotiation, but most troubled borrowers cannot blame it for their situation, since their lender probably would not have helped them even if the lender owned the loan free and clear.
The trouble with imperfect information
We mention above the two schools of thought about why lenders are reluctant to renegotiate. Proponents of the institutional view argue that securitization creates perverse incentives for mortgage servicers, the agents that collect monthly mortgage payments from borrowers and who are given the responsibility for renegotiating troubled loans. In short, the institutionalists argue that servicers gain little from successful loan modifications, even though the ultimate owners of the mortgages (that is, the investors in the MBS) gain a lot. They claim that so few modifications take place because the incentives of mortgage servicers and investors were not properly aligned when the MBS was created.
The information view, on the other hand, holds that lenders face a difficult decision whenever they are confronted with a delinquent borrower, and they cannot easily predict which of three groups a delinquent borrower belongs to. One group of delinquent borrowers will "cure" on their own, becoming current on their loans without a modification. Another group will wind up defaulting even if they are given a modification. A third group will default without a modification but will remain current if their loans are modified. In other words, only modifications in the third group are profitable for lenders.
Unfortunately, lenders don't have the perfect information needed to place each borrower in the appropriate group. Lenders' profit-maximizing strategy may well make them stingy with modifications in general. Low modification rates mean that many borrowers in the third group will lose homes that could have been saved with a modification. But the low rates also mean that the lender does not incur losses by awarding modifications to borrowers in the first two groups.
Note that those who hold the information view argue that securitization is not an important issue because both MBS investors and owners of whole mortgages face the same information problems when deciding whether a modification is worthwhile.
Compelling evidence for the information view
Agarwal et al. (2010) do not explicitly aim to distinguish between the institutional and information views, but they do provide what we believe to be compelling evidence in favor of the information view. The researchers used a comprehensive database of troubled mortgages, known as the Mortgage Metrics database, to assess loss mitigation efforts by mortgage servicers in all of 2008 and the first five months of 2009. The Mortgage Metrics database contains detailed information on exactly how servicers handled delinquent loans for a wide range of institutions. (Other data sets force researchers to infer whether a modification was made from auxiliary information such as the interest rate or remaining maturity of the loan.) For example, the authors were able to measure how likely servicers were to offer borrowers repayment plans, in which arrears are tacked on to the remaining balance of the loan, as compared with offering concessionary modifications, such as interest-rate cuts or principal reductions. They were also able to determine whether lenders initiated and completed foreclosures or allowed borrowers such exit strategies as deeds-in-lieu-of-foreclosure, and whether lenders did nothing at all, waiting to see if troubled borrowers eventually cure on their own.
Most importantly, the database contains an extensive list of attributes of the troubled loans, which permitted the authors to look at the relationship between the likelihood of modification and such loan-level attributes as the borrower's credit history, and whether the loan was held in an MBS or in a lender's individual portfolio.
As we noted above, lenders sometimes offer delinquent borrowers repayment plans, giving them the chance to repay the loan under the original terms of the mortgage. Significantly, the repayment plan requires borrowers to pay back any arrears, usually with interest. Lenders may also offer troubled borrowers forbearance, which means the borrowers pay lower payments for some time and then make up the arrears at the end of the forbearance period. These two types of mortgage help are temporary measures aimed to help the troubled borrower through a difficult period. By contrast, loan modifications are specific, permanent changes to the terms of a mortgage after origination.
Among other things, the Agarwal et al. (2010) paper invalidates the argument that a focus on modifications is too narrow, proposed by Piskorski, Seru, and Vig (2010) and Mayer (2010: 18), and that other methods, like repayment plans and forbearance, were important forms of loan renegotiation. Table 2 in the paper shows quite definitively that loan modifications accounted for the vast majority of the resolutions of troubled loans that did not involve foreclosure proceedings during the crisis period.
"One message is quite clear: Lenders rarely renegotiate"
The paper has three additional major findings, one of them that loan modifications are indeed rare. According to Table 1.A, fewer than 10 percent of borrowers received a loan modification in the first six months after becoming 60-days delinquent (missing two mortgage payments). In other words, 90 percent of borrowers who became delinquent received no substantive assistance from the lender. This finding mirrors Adelino, Gerardi, and Willen (2010), who calculated the frequency of modification using a different data set over a slightly different time period. The Adelino, Gerardi, and Willen (2010) paper also reports a modification frequency under 10 percent, and concludes, "No matter which definition of renegotiation we use, one message is quite clear: lenders rarely renegotiate."
Another finding of the Agarwal et al. (2010) paper sheds some light on the debate between institutional and information explanations for the infrequency of modifications. Although securitization seems to have had some effect on the likelihood of modification in their data, the effects are economically small and difficult to interpret. Table 3 shows that loans securitized either by the government-sponsored enterprises (GSE), such as Fannie Mae and Freddie Mac, or by private institutions, which often handled subprime or jumbo loans, were between 3 and 6 percent less likely to receive a modification than were whole loans held in the portfolios of banks.
In some sense, this finding is evidence for the institutional school, since loans in MBSs were less likely to receive modifications. But while the 3- to 6-percentage-point difference is large relative to the overall modification rate, it is still small relative to the total number of troubled loans. Essentially, servicers do nothing to help 90 percent of delinquent private-label borrowers, compared to 87 percent of portfolio loans. Even if we assume that the entire 3-percentage-point difference between portfolio and private-label loans is a treatment effect related to problematic incentives in private securitization contracts (pooling and servicing agreements), it is still just 3 percent of delinquent mortgages. Moreover, given the extremely high redefault rates that have characterized modifications during this period, this difference translates into a reduction in foreclosure frequency of less than 2 percent. In other words, under this (extreme) assumption, if we solved all of the issues with private securitization contracts, we could prevent 2 percent of the foreclosures.
No evidence for causal link between securitization and modification
Even this measure of the effect of poor institutional incentives may be too big. There are at least two good reasons to doubt a truly causal relationship between private securitization contracts and the frequency of renegotiation. The first reason is that, as the Agarwal et al. (2010) paper finds, loans securitized by the GSEs were actually much less likely to receive a modification than even the privately securitized loans. The conventional wisdom on the link between securitization and renegotiation (see Piskorski, Seru, and Vig 2010) pointed the finger at specific details in private securitization contracts that failed to align the incentives of servicers and investors. But this story applies only to privately securitized loans, not to agency loans. None of the institutional "facts" that the Piskorski, Seru, and Vig (2010) paper proposes apply to the GSEs, since the GSEs retain all of the credit risk when they securitize a loan. When a GSE loan becomes delinquent, it effectively turns into a portfolio loan. The GSEs have full discretion to modify any loan at any time for any reason and stand to enjoy all of the benefits. Agarwal et al. (2010) point out that the "precarious financial position of the GSEs in 2008 prior to their conservatorship may have made it difficult for them to engage in modifications and the attendant loss recognition," but this argument applies to only half of the period under study. After conservatorship started in September of 2008, capital was no longer a concern for the GSEs.
The second reason to doubt a causal link between securitization and modification is that the financial crisis triggered by the failure of Lehman Brothers and the ensuing heavy intervention by the federal government make it problematic to view behavior after September 2008 as "market-based approaches to stem mounting mortgage losses" (Agarwal et al. 2010, 1) By October 2008, the Troubled Asset Relief Program (TARP) had become law, and the government effectively owned stakes in many of the major commercial and investment banks. These banks also happened to be the largest mortgage servicers. In fact, TARP explicitly linked the provision of assistance to banks on their willingness to assist borrowers. That JP Morgan announced in February 2009 a foreclosure moratorium in a letter to Congressman Barney Frank, the head of the congressional committee tasked with overhauling regulation of their industry, illustrates the political considerations in dealing with troubled mortgages. Thus, by the end of 2008, political considerations played a central role in any calculation of the relative merits of renegotiating or foreclosing on a loan. For this reason, Adelino, Gerardi, and Willen (2010) focus on the period prior to September 2008. They find that, while the overall likelihood of modification is roughly the same, the difference in modification activity attributable to private-label mortgages is much smaller: only 1 percentage point.
Finally, Agarwal et al. (2010) show that information asymmetries matter, which is the third main finding of the paper. A key impediment to renegotiation is the self-cure risk, or the possibility that a delinquent borrower will resume repayment and eventually cover the balance of the loan in full. Any concession the lender made to such a borrower would thus be wasted. The authors show evidence of precisely this mechanism at work, finding
...much lower rates of modification for troubled borrowers with higher FICO scores and lower LTV ratios, which is the group with ex ante greatest likelihood of self-curing their delinquency.
The growing literature disputing the institutional argument
In showing that information, not institutions, is at the heart of the renegotiation issue, the authors build on an increasingly large body of evidence, which includes the Adelino, Gerardi, and Willen (2010) paper mentioned above. They are further supported by Ghent (2010) and Rose (2010), who both debunk the myth that the absence of securitization facilitated widespread renegotiation during the Depression (more on this topic in upcoming posts). In fact, Wechsler (1984)1 shows that many of today's anti-deficiency laws, which limit the ability of lenders to pursue borrowers for the difference between the loan balance and the amount recovered in foreclosure, originated as a policy response to the particularly harsh treatment of defaulting mortgagors during the Depression. Moreover, Hunt (2010) exhaustively studied securitization contracts and found little to support for the claim that private securitization explicitly distorts the incentives of servicers of securitized loans as compared to portfolio loans, writing that:
Certain general standards are extremely common [in private securitization contracts]: Servicers typically must...act in the interests of investors, and service loans in the same manner as they service their own loans.
Finally, we note the work of Mayer, Morrison, Piskorski, and Gupta (2010), which perfectly illustrates the difficulty in identifying borrowers who are truly in financial distress and thus suitable for a loan modification. The authors find that the announcement of a generous loan modification program caused borrowers to default on their mortgages.
It is our hope that the Agarwal et al. (2010) paper will put an end to three years of misguided public policy. The appeal of renegotiations was that they appeared to allow policymakers to prevent foreclosures at little cost to investors, lenders, or taxpayers and without unfairly helping anyone. The reality is that preventing foreclosures costs money, and it's time we had a debate about how or whether we want to spend money rather than trying to convince ourselves that we can prevent millions of foreclosures by tweaking the incentives of financial intermediaries.
March 31, 2010
Anti-foreclosure policy and aggregate house price indexes
A new paper by researchers at the New York Fed and New York University argues that the Federal Housing Authority (FHA), the government's insurer of relatively high-risk loans, is seriously understating the amount of risk in its portfolio. The paper makes a number of different points, but we want to comment on one claim in particular that has policy relevance beyond the issue of FHA risk. In fact, if this claim is correct, then any policy designed to reduce foreclosures by eliminating negative home equity could face significant problems when put into effect.
Repeat sales indexes a poor predictor of individual home price
The specific issue we want to address is how well an aggregate house price index can predict the price of an individual home. A number of aggregate indexes measure average house prices for a particular area, from the national level to the ZIP-code level. Often, these indexes are based on repeat sales, meaning that they combine the price changes of individual homes over time. If a house sold for $200,000 in 1997 and $220,000 in 2001, this repeat sale provides a data point indicating that house prices rose by 10 percent from 1997 to 2001. It is true that the 2001 buyer might have gotten a great deal in that the house really should have sold for more than $220,000 at the second sale. However, the assumption is that the influence of good and bad deals washes out when data from many repeat sales are aggregated together. If they do, then researchers can infer the average, overall path of house prices.
The problem occurs, the authors of the paper say, when one uses the resulting aggregate index to predict the price of an individual home. Consider someone who purchased a home for $200,000 in 2007. Now assume that over the next two years the aggregate house price index for that particular area declined by 10 percent. The authors point out that the decline in the index does not necessarily mean that this particular homeowner would have sold the house for $180,000 in 2009. The owner may have taken extremely poor care of the house, or a beautiful park that was across the street from the house at the time of purchase may have become a strip mall. In either case, the homeowner was likely to have sold for less than $180,000. On the other hand, the homeowner may have made some improvements to the home that would have resulted in a sale of more than $180,000.
Research paper provides careful analysis of valuation errors in aggregate indexes
Potential problems with repeat-sales indexes were well known before the FHA paper was written. What the new paper contributes is a careful analysis of how large these so-called valuation errors can be and how they might relate to the probability of having negative equity. Using residential sales from Los Angeles County, the authors compare the actual sales prices of houses with predictions generated by different aggregate price indexes. The authors make two important findings.
First, the repeat-sales indexes are often biased, in the sense that the mean of the predictions does not match the mean of the recorded prices. For 2008 and 2009, repeat-sales indexes tended to overpredict house prices by 7 to 18 percent. In 2007, the indexes underpredicted house prices by about 4 percent. Second, dispersion in individual valuation errors is large—the standard deviation of valuation errors is about 20 to 25 percent, depending on the aggregate index used. Putting these two facts together gives a clear message: Using standard methods, it is difficult to predict what any individual house will sell for at any particular time.
Valuation errors undermine mortgage balance reduction policies
On a general level, this observation is not an indictment of the FHA, since a lot of other people also use aggregate indexes to infer prices of individual homes—including us. Moreover, without knowing the ins and outs of the FHA's default-prediction model, it is hard to know the quantitative importance of valuation errors in the calculation of FHA risk. But moving beyond this issue, it is not hard to see how large valuation errors could undermine the effectiveness of a policy that attempted to ease foreclosures by reducing mortgage balances for individual negative-equity homeowners. As we have blogged recently, some observers have claimed that many, if not most, foreclosures occur because owners with large amounts of negative equity simply walk away from their homes. The ostensible policy implication is to reduce these homeowners' mortgage balances to give them more of an incentive to stay.
If valuation errors are large, however, it is very difficult to know who has severe negative equity and who doesn't. This problem undermines the effectiveness of balance-reduction policies. Effective policymakers must know how to price individual homes to assess the depth of negative equity for those homes. Consider two homes that, according to an aggregate price index, have 30 percent negative equity. That amount may or may not be severe enough to get an owner thinking about walking away. If it is, then an appropriate policy might reduce both homes' mortgage balances by 20 percent, thereby reducing the negative equity to about 10 percent. (Leaving a little bit of negative equity is probably a good idea in practice because it may prevent homeowners from selling the moment that a balance reduction is made.)
Effective foreclosure prevention would consider both job loss and negative equity
If in reality one of these homes actually has 50 percent negative equity and the other has 10 percent negative equity, then the balance-reduction policy is likely to prevent no foreclosures. The owner with 50 percent negative equity remains underwater, to the tune of 30 percent, so is probably still thinking about walking away—according to the theory of default that motivated the balance-reduction policy in the first place. On the other hand, the owner with 10 percent negative equity was not going to walk, unless perhaps a job loss went along with the negative equity. But if the combination of job loss and negative equity is the real problem in the housing market rather than severe amounts of negative equity alone then we can devise much more cost-effective policies to reduce foreclosures than large-scale balance reductions.
The authors of the paper do not discuss balance reductions. However, in other papers, they argue that anti-foreclosure policy should consider balance reductions. We believe that the valuation-error results uncovered in the FHA paper indicate that balance-reduction policies face substantial hurdles in actual practice.
March 02, 2010
Should modifications 're-equify' borrowers? A look at the data
A number of recent commentators have called for a big change in government policy on mortgage modifications. Currently, the government's Home Affordable Modification Program (HAMP) pays cash incentives to servicers who reduce monthly mortgage payments to no more than 31 percent of the borrower's income. Most of the time, this reduction is accomplished by reducing the interest rate or by extending the loan term for up to 40 years. Modifications that forgive loan principal are rare.
And therein lies the problem, according to HAMP critics, who point to the strong empirical relationship between negative home equity and default. On the national level, the U.S. foreclosure rate started rising in 2006, the same time that house prices began to fall and negative equity began to emerge. Also, in loan-level data, borrowers who are "underwater" on their mortgages default far more often than owners with positive home equity. Many of HAMP's critics argue that mortgage modifications will not work unless they reduce outstanding principal balances on mortgages so that positive equity is restored. Yet a closer look at the data shows that a "re-equification" policy implemented through large-scale principal reductions may not work as advertised.
Are won't-pay borrowers really behind the high foreclosure rate?
If negative equity drives default, then why shouldn't modifications start by reducing mortgage balances? The reason is that underwater borrowers default for one of two reasons—either they can't make their payments or they won't make their payments. (You can read more about this here.) Proponents of balance reductions seem to think that foreclosures are driven mostly by won't-pay borrowers, who would rather "walk away" from their underwater homes than continue paying. But these proponents provide little hard data about how prevalent won't-pay defaults really are.
Of course, walk-away borrowers do exist and are sometimes profiled in newspaper accounts (like this one). But these accounts often involve borrowers at the extreme end of the negative-equity spectrum, where the house is worth only 50–70 percent of the mortgage balance. For owners with more moderate levels of negative equity, economic theory implies that staying current on the mortgage is usually the best policy. This theory is true even for cold-hearted homeowners who don't care about offending their lenders, damaging their credit scores, incurring any social stigma associated with default, or paying the deficiency judgments that can sometimes be levied against walk-away owners. The reason that moderately underwater homeowners should continue paying is that prices might rise and positive equity might be restored, so long as the current price is not too far below the mortgage balance. The benefit of staying in the house today is enhanced by the right to default in the future, if house prices stay low and equity remains negative.
Principal reductions may not keep can’t-pay borrowers at home
For every homeowner who defaults because they won't pay on their mortgage, there are others who default because they can't pay. Among the can't-pay group are the many borrowers who have lost their jobs. Negative equity matters for this group because it limits their options when their economic situations become dire. Before the recent fall in house prices, homeowners who lost their jobs were likely to have positive equity in their homes. This equity allowed displaced workers to sell their homes and pay off their mortgages if they needed to; cash-out refinancing may also have been an option. But underwater owners cannot sell their homes for enough to pay off their mortgages, nor can they refinance. Foreclosures are therefore likely for can't-pay borrowers with negative equity, even if they want to stay in their homes.
Unfortunately, principal reductions will probably not help can't-pay borrowers retain their homes. Consider a borrower who is 10 percent underwater and who recently lost her job. A reduction of, say, 20 percent would restore positive equity for this borrower. But it would lower her monthly payment by only about 20 percent—too little to make a difference for someone with drastically reduced income. Consequently, if this borrower gets a 20 percent principal reduction, she will probably sell her house. Anti-foreclosure policy will not keep her in her home, which was the justification for the policy in the first place.
Some might argue that a principal reduction helps can't-pay borrowers who live in a state that allows lenders to seek deficiency judgments. Because the reduction would give these borrowers positive equity, they would have no deficiency when paying off the loan. But the can't-pay borrowers probably did not have the money to pay a deficiency judgment anyway, so the reduction does not provide much of benefit. The balance reduction would help the lender, as long as the reduction is paid for by the taxpayers. If the reduction allows a sale to take place, rather than a foreclosure, it may also reduce the "deadweight" costs of foreclosure (for example, damage to the house that sometimes occurs when a house is foreclosed). For the most part, though, if can't-pay borrowers are the problem, then a policy of subsidized balance reductions would simply reshuffle losses generated by the housing bust to different parties.
Area-level data, not national data, measure can’t-pay defaults more accurately
Ideally, mortgage researchers would inform policymakers about the exact size of the can't-pay group. This is difficult to do, because borrower-level data on both unemployment and delinquency experiences do not exist. That means that we cannot measure the effect of an individual's unemployment spell on the probability of delinquency, controlling for other factors (like credit score). The best that researchers can do is match area-level unemployment rates with borrower-level mortgage data, and then see whether delinquencies rise when local unemployment goes up. According to some of our research, they do. This Congressional testimony from Laurie Goodman, a respected mortgage researcher and a proponent of balance reductions, cites some of her work that also suggests a correlation between area-level unemployment and mortgage delinquency.
While using area-level unemployment rates isn't a perfect way to measure can't-pay defaults, it is far more helpful than correlating the national unemployment rate with the national delinquency rate, which is sometimes done by proponents of balance reductions. The U.S. unemployment rate started increasing rapidly in 2008. But mortgage delinquencies had already started rising for the riskiest mortgages (like subprime) during the previous year, when house prices began their descent. Proponents of balance reductions interpret this timing pattern as evidence that unemployment is a less-important determinant of foreclosures. Policy should therefore focus on restoring equity to prevent the won't-pays from walking away.
But the fact that national delinquency rates rose before the unemployment rate did is not conclusive. Because of the large amount of job creation and destruction that always takes place, can't-pay borrowers can still exist even when the aggregate unemployment rate is low and stable. Specifically, the Business Employment Dynamics program of the Bureau of Labor Statistics indicates that gross job losses at private American firms totaled about 12.6 million positions from March 2007 to March 2008. Positions that were eliminated via involuntary layoffs were likely to have led to a lot of can't-pay foreclosures for job losers with negative equity. But this large amount of job destruction did not cause the aggregate unemployment rate to rise. Over the same period, private-sector gross job creation totaled 12.7 million jobs, so that the net number of jobs in the economy rose by about 100,000. Correlating national unemployment and delinquency rates masks the massive amount of job churning that takes place at the level of individual workers, where default decisions are made.
Foreclosure-reduction assistance is necessary but should be temporary
We have been interested in the efficacy of mortgage modifications for some time; our finding that less than 10 percent of underwater borrowers lost their homes during the early-1990s Massachusetts housing bust is often interpreted (correctly, we think) as evidence that walk-away foreclosures are not the lion's share of today's problem. Moreover, given our research findings, my co-bloggers and I support a foreclosure-reduction policy that would offer significant but temporary help to unemployed borrowers. But we also think that disinterested parties should come away from this issue with the same verdict that we do. There have been news accounts about won't-pay borrowers walking away from their homes for at least two years. Before policy encourages large-scale reductions in mortgage balances in modification programs, we believe more hard data is needed that show that won't-pay borrowers are quantitatively important.
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- Teachers Teaching Teachers: The Role of Networks in Financial Decisions
- The Pass-Through of Monetary Policy
- Keeping an Eye on the Housing Market
- Do Millennials Prefer to Live Closer to the City Center?
- The Multifamily Market: Is a Hot Market Overheating?
- Are Millennials Responsible for the Decline in First-Time Home Purchases? Part 2
- February 2017
- November 2016
- June 2016
- May 2016
- April 2016
- November 2015
- September 2015
- August 2015
- July 2015
- May 2015
- Affordable housing goals
- Credit conditions
- Expansion of mortgage credit
- Federal Housing Authority
- Financial crisis
- Foreclosure contagion
- Foreclosure laws
- Government-sponsored enterprises
- Homebuyer tax credit
- House price indexes
- Household formations
- Housing boom
- Housing crisis
- Housing demand
- Housing prices
- Income segregation
- Individual Development Account
- Loan modifications
- Monetary policy
- Mortgage crisis
- Mortgage default
- Mortgage interest tax deduction
- Mortgage supply
- Multifamily housing
- Negative equity
- Positive demand shock
- Positive externalities
- Rental homes
- Subprime MBS
- Subprime mortgages
- Supply elasticity
- Upward mobility
- Urban growth