Abstract:
This paper investigates whether homeowners respond strategically to news of mortgage modification programs. The authors exploit plausibly exogenous variation in modification policy induced by U.S. state government lawsuits against Countrywide Financial Corporation, which agreed to offer modifications to seriously delinquent borrowers with subprime mortgages throughout the country. Using a difference-in-difference framework, the authors find that Countrywide's relative delinquency rate increased thirteen percent per month immediately after the program's announcement. The borrowers whose estimated default rates increased the most in response to the program were those who appear to have been the least likely to default otherwise, including those with substantial liquidity available through credit cards and relatively low combined loan-to-value ratios. These results suggest that strategic behavior should be an important consideration in designing mortgage modification programs.
Commentary:
A more realistic analysis of the risks of "strategic default" and "moral hazard" than seen in other papers, particularly as the authors start with (some of) the bad act of Countrywide that lead to its 2008 multi-state settlement.
The paper also recognizes that "bounded rationality or moral considerations may decrease a borrower's ability or willingness to behave strategically", i.e. homeowners usually are decent, honest, hard-working people that want to pay their mortgage, and also that delinquency on a mortgage does present a homeowner with substantial financial costs in "of accessing liquidity through credit cards, auto loans, and any new mortgages or refinancing."
The authors present an alternative to allowing mortgage modifications for only homeowners in default, as that would allow homeowners to manufacture eligibility through "strategic default", as requiring "is to offer these benefits only to homeowners who undergo a rigorous audit that verifies that they are likely to default, or have defaulted, as a result of meaningful adverse conditions." The difficulty the authors find with this approach is that it would be costly and time-consuming. Somewhat myopically, the authors fail to recognize that this process is routinely conducted efficiently and inexpensively by bankruptcy courts. While legislative attempts to allow judicial mortgage modification have been unsuccessful, other administrative or regulatory option are feasible, including mandatory mortgage modification mediation in bankruptcy or by having the Federal Housing Finance Agency, which "owns" both Fannie Mae and Freddie Mac, mandating acceptance of Principal Pay down Plans in Chapter 13.
For more see on these alternatives:
Wisconsin Bankruptcy Mortgage Modification Mediation.PDF and Detailed Explanation of Principal Paydown Plan.PDF
For a full copy of the paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1836451
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