Wednesday, January 06, 2010

New Research on Mortgage Modifications and Principal Reduction

by Bill McBride on 1/06/2010 03:54:00 PM

I've excerpted below from a paper by New York Fed Researchers Andrew Haughwout, Ebiere Okah, and Joseph Tracy: Second Chances: Subprime Mortgage Modification and Re-Default

Although the paper uses subprime data, the general results are applicable to all mortgages. The researchers point out that principal reductions lead to much lower redefault rates (that is obvious, but still worth noting). They also note that principal reductions help mitigate the mobility problem - as I've noted before, the lack of worker mobility slows the potential growth of the economy, leads to lower home maintenance, and possibly "diminished support for local public goods"1.

But the authors don't suggest who should pay for the reductions in principal. If this was a government program, it would be very expensive and unpopular. Diana Olick wrote today at CNBC: Are Principal Writedowns the Answer to Housing Crisis?

I would honestly rather see my home's value go down than see the guy next door ... who made a poor/negligent financial decision get a mulligan at my expense.
I think that would be the overwhelming public reaction.

Some people point to Lewis Ranieri's apparent success with principal reductions, from Fortune: Lewie Ranieri wants to fix the mortgage mess
Now Ranieri is championing an inventive solution for fixing the mess he's accused of enabling in the first place. Ranieri has raised $825 million from 31 foundations and corporate and public pension funds, including the South Carolina Retirement Systems, to form the Selene Residential Mortgage Opportunity Fund.

Selene's mission is simple: to buy delinquent mortgages at a deep discount, work with homeowners to get them paying again, and resell the now stable loans for profit. To get homeowners to do their part, Ranieri is taking the radical step of substantially lowering their mortgage balances.
This only works because Ranieri bought the distressed mortgages at a deep discount, and his company has no reputation risk. Ranieri wants his borrowers to know that he will reduce their principal.

Imagine what would happen to Wells Fargo or Bank of America if their borrowers found out that the banks would substantially reduce their principal if they were 1) underwater (negative equity), and 2) stopped making their payments. The delinquency rate and losses would skyrocket!

So there is no easy solution. Government supported principal reductions will probably not happen, and private principal reductions - although happening - will not become widespread. This means more foreclosures and short sales (or as I always joke, build a time machine and stop the bubble early - that might be easier!)

And here are some excerpts from the paper:
Our analysis of those modifications in which payments were meaningfully reduced indicates that re-default rates – around 57% in the first year – are distressingly high. Yet the magnitude and form of modifications make a difference. Mortgages that receive larger payment reductions are significantly less likely to redefault, as are those that are modified in such a way as to restore the borrower’s equity position. Of course, these kinds of modifications are not mutually exclusive, since reductions in mortgage balances offer both increased equity and reduced payments.

Our findings have potentially important implications for the design of modification programs going forward. The Administration’s HAMP program is focused on increasing borrowers’ ability to make their monthly payments, as measured by the DTI. Under HAMP, reductions in payments are primarily achieved by subsidizing lenders to reduce interest rates and extend mortgage term. While such interventions can reduce re-default rates, an alternative scheme would simultaneously enhance the borrower’s ability and willingness to pay the debt, by writing down principal in order to restore the borrower’s equity position. We estimate that restoring the borrower’s incentive to pay in this way can double the reduction in re-default rates achieved by payment reductions alone.

Another distinction between modifications that reduce the monthly payment by cutting the interest rate as compared to reducing the principal is the likely impact on household mobility. Ferreira et al (2010) using over two decades of data from the American Housing Survey estimate that each $1,000 in subsidized interest to a borrower reduces the two-year mobility rate by 1.4 percentage points. Modifying the interest rate to a below market rate creates an in-place subsidy to the borrower leading to a lock-in effect. .... modification creates an annual subsidy of over $3,000. The results in Ferreira et al (2010) imply that this will lead to on average a reduction in the household two-year mobility rate of over 4.4 percentage points – more than a forty percent reduction in the overall rate. In contrast, reducing the monthly payment through reducing the principal on the mortgage does not create an in-place subsidy and would not lead to a lock-in effect.
emphasis added
1 Housing Busts and Household Mobility by Fernando Ferreira, Joseph Gyourko (both from Wharton) and Joseph Tracy (New York Fed).