The seductive but flawed logic of principal reduction
Federal Reserve Banks of Boston and Atlanta
March 9, 2011
(Senior economist, Boston Fed)
(Research economist, Federal Reserve Bank of Atlanta)
(Research economist, Boston Fed)
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
March 9, 2011