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What Should Be Done To Help Underwater Borrowers?

Dennis Norman
Dennis Norman

Last week I did a post about the Obama Administrations’ Home Affordable Modification Program (HAMP) and showed how it really has not been effective in helping keep families in their homes and avoid foreclosure as was the intention by the administration. When my kids tell me they don’t like the way I want them to do something I usually challenge them with “if you don’t like my way, tell me a better way to do it“. So with this in mind I went looking for an answer to this question.

In my search I ran accross a report title “Strategic Mortgage Default and the Role for Incentive-Based Solutions” (yeah, I know…sounds dull…probably won’t ever be made into a movie) that was produced by the Loan Value Group. This report addresses many issues including:
  1. Why Do Homeowners Default on Mortgages?
  2. Issues With Current Solutions to Mortgage Default
  3. An Alternative Approach to Mortgage Default

I focused primarly on number two as it addressed the problem I was looking for the answer to. Their (Loan Value Group) analysis of the situation was consistent with my post last week in that they determined that government programs to provide solutions to borrowers defaulting on mortgages “have so far proven to be ineffiective for two main reasons…first, certain solutions are founded on the idea that default occurs becasuse households have no choice due to insufficient income, and thus fail to address deafult that is a rational choice that depends on the homeowner’s balance sheet. Second, certain solutions face substantial practical hurdles to implementation.”

Translation:

  1. Some borrowers choose to default as they are underwater and tired of throwing good money after bad, not because they cannot make the payments.
  2. Government programs have too much red tape.

The report goes on to assess the effectiveness (or lack thereof) of various government programs that were supposed to be the answer. Here are the results:

  • Tax Credits. These improve the homeowner’s income, but are ineffective for balance sheet driven strategic default. First, the effect of tax credits is very small compared to the amount of negative equity, and so does little to repair the homeowner’s balance sheet. Second, the homeowner can use the tax credits to rent a new property, allowing him to default on his existing mortgage. In addition, if they fail to prevent default, they are simply a cost to the government. Finally, while the most recent plan to provide tax credits is relatively new, there is increasing evidence that fraud is being used to secure those credits.
  • HOPE for Homeowners Act of 2008. This involved the FHA insuring lenders that refinancetroubled loans into fixed-rate mortgages. As of February 2009, only 451 applications had been received and 25 loans finalized, compared to the expected participation of 400,000. The low participation has been mainly attributed to two issues of loan modifications discussed in the prior subsection: the fees associated with a modification, and the need for the lender to reduce loan principal to 90% of a property’s current value.
  • Home Affordable Modification Program (HAMP). This is similar to a payment reduction: the servicer modifies the loan to reduce monthly payments to 31% of a homeowner’s pre-tax income. As of August 2009, only 9% of delinquent borrowers (235,000 loans) were in trial modifications, compared to the goal of having 500,000 participants by November 2009.

This low take-up has been attributed to a number of causes. From the borrower’s side, the confusion and disclosure requirements described above have been an impediment; the New York Times (“Winning Lower Payments Takes Patience, and Luck”, 11/29/09) discusses “the confusing and frustrating ways of the Obama administration program aimed at keeping millions of troubled American borrowers in their homes.” One large institution tasked with using a third party to modify loans through HAMP has found that in Q2 2009, nearly 42% of loan modifications that would have resulted a monthly payment reduction were never completed by the borrower.

So what is the answer?

Almost 11 million homeowners underwater on their mortgage (they owe more than their homes are worth) and this is leading to the “strategic mortgage defaults” that are addressed in this report. In order to curtail these defaults there must be new thought given to how to prevent them. Since these underwater homeowners will be choosing to default there must be incentives for the homeowner to choose not to dafault and instead enable the borrower to make payments. In addition, since this decision is driven by negative equity rather than the inability to make payments, there must be something done to address the principal balance.

While reducing the principal balance of an underwater borrower’s loan (principal forgiveness) seems to be the answer to the problem the report does point out problems associated with principal forgiveness including:

  • It triggers a full and immediate accounting write-down to the value of the loan.
  • It is irreversible and cannot be subsequently “clawed back” for those who redefault or had committed fraud (e.g. when applying for the principal reduction).
  • The lower balance reduces the interest received by the lender. Thus, if the homeowner still ends up defaulting, the lender has been made worse off by the loan modification.
  • It creates a “moral hazard” problem: the homeowner may attempt to make further risky housing investments in the future, believing that he will receive principal forgiveness if he falls into negative equity
  • The impact on homeowner behavior may be limited for two reasons.
    • Even a large dollar reduction in absolute terms is small relative to the size of an existing mortgage. If the homeowner “frames” the reduction together with the mortgage (i.e. compares its magnitude to the size of the mortgage rather than evaluating it in isolation), he may feel that his overall position has changed little – for example, a $10,000 reduction on a $200,000 mortgage is only a 5% decrease.
    • The loan modification is “non-salient”: it is a one-time event which may be subsequently forgotten, and thus have little ongoing incentive effect.

The above practical and conceptual issues with a principal reduction are serious in reality. As a result, banks have been very reluctant to write off mortgage principal: only 10% of loan modifications involve principal forgiveness. Considering all types of loan modification, 58% of the modifications made in Q1 2008 ended up redefaulting.

So while we have identified the problem, negative equity, and even the solution, principal forgiveness, you can see from this report by Loan Value Group there are many hurdles along the way. What will happen first? Will the government figure out a way to address this issue without so much red tape that the program is actually successful? Or, will the real estate market come back to the point that underwater borrowers see light at the end of the tunnel? I hate to be pessimistic, and I am not pessimistic by nature, however I don’t have confidence in either of these things happening any time soon which is very unfortunate for all the homeowners that have found themselves underwater.

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