With HAMP and other government housing recovery programs cycling through their first year, some hard numbers are emerging to gauge program effectiveness. We watch the market changes every week here and it’s elucidating to watch local trends respond to the incentive systems put in motion. An intriguing result is how academic and housing market policy research undertaken in recent years has been largely ignored when developing and implementing these programs. Much of this research originates from the Federal Reserve, HUD, and leading research universities.
As Peter Goodman writes in his New York Times article last week – “U.S. Loan Effort Is Seen as Adding to Housing Woes” – a look at these programs indicate adverse results. Here are a few key points that Goodman makes, with reference to the published research that may reveal vital solutions to the current housing market challenges. (Please note: This isn’t intended to be a political statement of any kind. We’re Data Geeks here at Altos Research. When data and empirics are ignored, we get a little hot under the collar…)
Principal Forgiveness & Permanent Relief
From Goodman’s article:
“Since President Obama announced the program in February, it has lowered mortgage payments on a trial basis for hundreds of thousands of people but has largely failed to provide permanent relief. . . From its inception, the Obama plan has drawn criticism for failing to compel banks to write down the size of outstanding mortgage balances, which would restore equity for underwater borrowers, giving them greater incentive to make payments. A vast majority of modifications merely decrease monthly payments by lowering the interest rate… The biggest source of concern remains the growing numbers of underwater borrowers — now about one-third of all American homeowners with mortgages… The Obama administration clearly grasped the threat as it created its program, yet opted not to focus on writing down loan balances.”
The research shows that simply modifying mortgage payments is ineffectual when compared to principal reduction loan modifications. Paul Willen’s presentation to the Kennedy School of Government in February 2008 offered that negative equity was the main problem in foreclosure situations, not interest rates. Willen later co-authored a Public Policy Discussion Paper in 2009 with Christopher Foote and Kristopher Gerardi at the FRB Boston – “Negative Equity and Foreclosure: Theory and Evidence” that provided further empirical evidence.
In their August 2009 Working Paper – “Tailoring Loan Modifications: When is Principal Reduction Desirable?” – Robert Quercia and Lei Ding at the University of North Carolina at Chapel Hill conclude:
We find that modifications that rely on rate reduction exclusively are not effective for all borrowers in all markets. In contrast, modifications that increase the level of home equity have more consistent impacts. More narrowly, we find that loan modifications with a principal reduction have the lowest redefault risks and can create even better cash flow for investors in many cases, especially in the states with more subprime lending, steepest price declines, and highest foreclosure rates. Probably, this is because such modifications do not only address short term affordability concerns but also longer term equity considerations.
Quercia and Ding’s conclusions are published in Cityscape, an online research journal published by the US Housing and Urban Development (truth is stranger than fiction) – “Loan Modifications and Redefault Risk: An Examination of Short-Term Impacts” –
[T]he findings show an even lower level of redefault when payment reduction is accompanied by principal reduction. Among the different types of modifications, the principal forgiveness modification has the lowest redefault rate, most likely because it addresses both the short-term issue of mortgage payment affordability and the longer term problem of negative equity. The results indicate that households with negative home equity are more likely to redefault over time, even when a modification has initially lowered the mortgage payment.
In this published work, Quercia and Ding also conclude that “[i]f the costs related to the loan modifications outweigh the benefits from the reduced foreclosures, foreclosure may be the better option for the lender.” Which leads us to…
Mortgage Servicers, Loan Mods & Underwater Borrowers
Several statements from Goodman’s article:
“Under the current program, the government provides cash incentives to mortgage companies that lower monthly payments for borrowers facing hardships… As of mid-December, some 759,000 homeowners had received loan modifications on a trial basis typically lasting three to five months. But only about 31,000 had received permanent modifications — a step that requires borrowers to make timely trial payments and submit paperwork verifying their financial situation… In late November, with scant public disclosure, the Treasury Department started the Foreclosure Alternatives Program, through which it will encourage arrangements that result in distressed borrowers surrendering their homes. The program will pay incentives to mortgage companies that allow homeowners to sell properties for less than they owe on their mortgages [short sales]. The government will also pay incentives to mortgage companies that allow delinquent borrowers to hand over their deeds in lieu of foreclosing.”
If you’re wondering why government cash incentives are necessary incentives to mortgage servicers, it’s because these incentives are required to counteract the existing revenue models of mortgage servicers. In “Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis,” Tomasz Piskorski, Amit Seruand and Vikrant Vig describe the relationship of the servicer, borrower, and investor (which acts as the lender in cases of securitization):
In the case of a securitized loan, the servicer is an agent of the investors, and its rights, duties and compensation are set out in a “Pooling and Servicing Agreement” (PSA). Typically, servicers are compensated by fees which are annually on the order of 20-40 basis points of the outstanding loan balance. Moreover, they are reimbursed for costs incurred during the foreclosure process but typically are not reimbursed for costs incurred during renegotiation of loans – benefiting only through the extension of servicing fees. In general, these renegotiation costs may be quite substantial and can easily cost as much as $1,000 per loan. Thus, to break even on a $100,000 mortgage loan can take anywhere between 3-5 years absent any re-default or prepayment. In other words, servicers may incur up-front costs in exchange for uncertain fees when they renegotiate a loan. Foreclosure, by contrast, allows servicers an immediate, low-cost exit.
Piskorski, Seruand and Vig also find:
…that seriously delinquent loans are foreclosed at a higher rate if they are securitized as compared to loans that are held directly by the lenders… As banks are likely to fully internalize the costs and benefits of the decision to foreclose a delinquent loan, it is natural to interpret our results as suggesting that securitization has imposed renegotiation frictions that have resulted in higher foreclosure rate than would be desired by investors.
With the influx of securitized mortgages during the housing boom cycle, the government loan modification incentives are necessary for investors (owners of the mortgages) to recover costs associated with these “renegotiation frictions.”
In “Renegotiating Home Mortgages: Evidence from the Subprime Crisis,” Manuel Adelino (MIT and FRB Boston), Kristopher Gerardi (FRB Atlanta), and the aforementioned Paul Willen (FRB Boston and NBER) show “that loans held by securitization trusts are more likely to redefault conditional on receiving a modification, which reconciles our findings with the fact that delinquent loans held by securitization trusts have a higher probability of foreclosure.”
But if securitization is sub-optimal, why is the FDIC is considering mortgage securitization for mortgage asset dispersement of failed banks? Because they can take write-downs that the private sector is unable to do, a constraint introduced to the private sector by…
“Mr. Katari [Kevin Katari, managing member of Watershed Asset Management] contends that banks have been using temporary loan modifications under the Obama plan as justification to avoid an honest accounting of the mortgage losses still on their books. Only after banks are forced to acknowledge losses and the real estate market absorbs a now pent-up surge of foreclosed properties will housing prices drop to levels at which enough Americans can afford to buy, he argues.”
Check out the liquidity in the whole loan asset market. It’s mostly bone-dry because mortgage holders (investors and lenders) under shareholder pressure must avoid taking write-downs and balance sheet losses on these assets upon sale.
There are viable solutions to loan holders however, such as the Adjustable Balance Mortage (ABM) option proposed by Brent Ambrose at Penn State University and Richard Buttimer at the University of North Carolina at Charlotte, which introduces “explicit risk-sharing between the borrower and lender with respect to house prices” as opposed to the current mortgage structures where the lender bears the most of the contract risk:
At origination, the ABM is like a fixed-rate mortgage in that it has a fixed contract rate, maturity term, and is fully amortizing. At fixed, pre-set intervals, the lender and the borrower determine the value of the house. If the house value is lower than the then originally scheduled balance for that date, the loan balance is set equal to the house value, and the monthly payment is re-calculated based on this new value. If the house retains its initial value or increases in value, then the loan balance and payments remain unchanged just as in a standard fixed rate mortgage.
In their paper, Ambrose and Buttimer cite “Three Initiatives Enhancing the Mortgage Market and Promoting Financial Stability” by Diana Hancock and Wayne Passmore, advocates of the “Buy Your Own Mortgage Option.” Regarding mark-to-market rules and residential mortgage securitization –
However, despite the decline in the market value of these securities (and by implication the mortgages that backed them) when held as assets by financial institutions, homeowners who hold these mortgages as liabilities still carry their mortgage at par value. Ironically, in some cases, if the homeowner was able to recontract his or her mortgage at its market value or something close to it, the homeowner’s liabilities would decline and the homeowner’s odds of default would fall.
It seems logical from an empirical standpoint to push a few of these proposals in action on a limited basis. The FHA now making a majority of home loans, the US Treasury and Federal Reserve are purchasing the mortgage-backed securities, and the GSEs are servicing a vast number of mortgages. The government is in the self-placed position to experiment with some of these proposed policies such as principal reduction, ABM, and “Buy-your-own-mortgage” (political calculus notwithstanding of course).