Means-Tested Mortgage Modification: Homes Saved or Income Destroyed?

By some measures, U.S. average housing prices have fallen by a third since 2006 and some forecast them to fall further. Prices have fallen more than fifty percent in Las Vegas and Phoenix, and nearly that much in Detroit, Miami and much of California. As a result, almost 14 million homes nationwide were “underwater” in early 2009: worth less than the mortgages for which they serve as collateral. About one third of homes with mortgages in Arizona, California, Florida, and Michigan, and more than one half of homes with mortgages in Nevada, are underwater.

At the same time, U.S. employment has plummeted, especially in states that had large housing price increases prior to 2006. Many factors – too many to be considered in a single paper – caused the 2008-9 recession, but the housing price cycle and its legacy of underwater mortgages is likely among them. Economic analysis readily reveals some effects of underwater mortgages on foreclosures and the incentives to earn income, and the degree to which those effects are shaped by public policy.

Foreclosures as a Consequence of Negative Equity

A homeowner always has the option to stop paying his mortgage. Although state laws are somewhat different, to a good approximation the worst case scenario for a homeowner who stops paying is that he can no longer own or occupy the house, and may suffer a reduction in his credit rating that might raise his costs of future borrowing. But if the combined value of his house and these costs were less than the present value of his promised mortgage payments, then he could do better than paying in full. That’s probably an important reason why, as of early 2009, more than five million homes were already either in foreclosure or their owners were delinquent on their mortgage payments.

When foreclosures are motivated by low home values rather than the quality of the match between a homeowner and his home, a foreclosure is inefficient because it requires the homeowner to live elsewhere. The anticipation of foreclosure of an under water home probably also creates moral hazard in maintaining the house, because the occupant prior to foreclosure has no stake in the home’s value. These are some of the reasons why public policy seeks to reduce foreclosures.

Lenders have modified the terms of some of their mortgages or otherwise modified payments associated with mortgages in order to avoid foreclosure, both in this recession and previous recessions. However, some mortgage industry participants have complained that too few mortgage modifications occur because of the excessive transaction costs in dealing with individual homeowner situations and dealing with investors who have varied stakes in the mortgage payments.

The Public Policy Response: Making it Worse

The Bush administration advocated a mortgage modification plan authored by the FDIC, which has been tweaked and further promoted by the Obama administration’s Homeowner Affordability and Stability Plan. What are the consequences for this FDIC-HASP plan for the supply of effort and the incidence of foreclosures, and how do they compare to those of a plan that maximizes lender collections, or a plan that maximizes lender collections without means-testing?

All three plans reduce foreclosures as compared to leaving the mortgages unmodified. Although the unmodified-mortgage benchmark aids understanding of the economics of mortgage modification, we cannot assume that under water mortgages would go modified absent the FDIC-HASP plan and its means-tests. Rather, we might expect lenders to modify mortgages in a way that enhances their collections. As compared to the collection-maximizing benchmark, the implicit marginal tax rates FDIC-HASP plan – well over 100 percent – are excessive. Moreover, FDIC-HASP needlessly distorts the supply of effort for slightly underwater borrowers, because foreclosure rates among those borrowers would be low (if not zero) under the collection-maximizing plans.

For some relatively small amounts of negative equity, FDIC-HASP may result in more foreclosures and overall deadweight costs than would a plan that maximizes collections. The collection-maximizing plan uses means tests rather than foreclosures to obtain small collections from the high income borrowers, based on the fact that (from the perspective of a lender and his borrowers) the marginal deadweight costs of mean-tests are initially zero whereas the marginal deadweight costs of foreclosures are positive.

At first glance, small amounts of negative equity would seem irrelevant today because housing prices have fallen so much. However, even in Nevada where underwater mortgages are the most prevalent, “only” half of mortgages are under water, which means that half are not underwater and presumably many are only slightly underwater. The fact that recent declines in home values have coincided with increases in the fraction of U.S. mortgages underwater shows that many mortgages are slightly underwater. Thus, even if FDIC-HASP enhanced efficiency for deep underwater mortgages (it does not), the fact that it harms efficiency for the numerous slightly underwater mortgages means that its aggregate efficiency impact could well be negative.

The mathematical analysis shown in my research papers has been confined to mortgages, with a basic setup in which one party (a “lender”) attempts to collect from a heterogeneous group (“borrowers”), using a threat of punishment (“foreclosure”) for nonpayment. With the housing crash and recession, the unsecured amount to be collected has suddenly increased, and the punishment may have lost some of its pain. As a result, full collections are not made, but rather forgiven for those who appear to have the least ability to pay. This basic setup probably has a lot in common with revenue collection efforts elsewhere in the economy, such as the collection of trade debts, tax debts, student loans, or tuition payments. Indeed, since I began writing on mortgage modification in the fall of 2008, the federal government began to modify student loans, with the borrowers who earn less receiving more loan forgiveness (Glater, 2009). Thus, while millions of workers have seen massive increases in their marginal tax rates during this recession as a result of mortgage modification, additional workers and businesses may also have seen significant increases in their marginal tax rates due to these other collection efforts.

Federal mortgage modification programs create excessive marginal tax rates, but the use of means-tests in the mortgage modification process would occur even without government intervention because means-tests are in the collectors’ interests. Positive marginal tax rates are thereby created in the private sector, on top of the various income taxes and means-tested benefits perennially administered by federal, state, and local governments. A prior economics literature has already shown how tax rates are excessive when multiple collectors have access to the same tax base. Thus, it is ironic that the federal government has raised the implicit marginal tax rates associated with mortgage modification, when it would enhance efficiency and its own tax collections by unconditionally repudiating some of the private debts, or at least pushing private collectors to rely less on means-tests than would be in the collectors’ interest.

Prohibiting means-tested mortgage modification is not the same as prohibiting modification: it’s just that mortgages would have to modified without means tests. In other words, those borrowers with significantly negative equity would be forgiven regardless of whether they were able to pay. In theory, lenders could find it optimal (given that they were not permitted to means test) to write down underwater mortgages so much that foreclosure rates would ultimately be quite low. Of course, a large and across-the-board mortgage write-down would dramatically reduce lender collections, but the objectives of efficiency and lender collections are quite different.

The bottom line: the federal government is spending your tax dollars to further damage the housing and labor markets.

[edited Aug 6, with thanks to DWAnderson]
[Added Aug 11: What do you mean "Implicit tax"?

The FDIC-HASP plan reduces a borrower's mortgage payment to 31 percent of his income, regardless of how much the borrower had originally promised to pay. The less the borrower earns at the time his mortgage is modified, the less he has to pay in mortgage payments.

The FDIC-HASP plan massively distorts the supply of income-earning efforts, because its mortgage modification is large and means-tested: its formula implies that an action taken by a borrower to increase his income would increase his housing payment obligation by 31 percent of the income increment. If the affordable payment (i.e., the payment that would comprise 31 percent of income) were re-evaluated monthly, this would amount to a 31 percent marginal tax rate in each month that a modification could occur: 31 cents out of every dollar the borrower earns is going to the bank.

A standard practice in the industry is to determine an affordable payment based on the most recent year’s income, and put that payment in place for five years (recall the Citigroup practice I blogged about last November). Thus, a marginal dollar earned in the base year raises mortgage payment obligations by 31 cents in each of the following five years. If, say, 2009 income were used to calculate an affordable payment for the years 2010-14 and the interest rate were zero, then the marginal tax rate would be 155 percent for 2009 (5 times the formula’s 0.31 limit on the payment to income ratio) and zero thereafter. Hereafter I assume an annual interest rate of 6 percent, which means that the marginal tax rate would be 131 percent for 2009 and zero thereafter.]