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Government policy continues to rigidly classify mortgages by their “affordability,” and pays too little attention to strategic defaults. Policy mistakes like these serve to prolong the foreclosure crisis.
The home foreclosure process begins when a homeowner stops making his mortgage payments, so the major policy question is how to get homeowners to pay.
One school of thought is that mortgage payments are too high to be “affordable,” and if the government could arrange for payments that were a more reasonable fraction of the borrower’s income, homeowners would make their payments and keep their homes. As I explained last week, this idea is the cornerstone of federal mortgage modification programs, under both the Bush and the Obama administrations.
The other school of thought is that “affordability” cannot be so rigidly defined, and that the vast majority of homeowners — even many of the unemployed — would make their mortgage payments if they had enough incentives to do so. In this view, most foreclosures are cases of “strategic default”: homeowners who determined that it is worth a move, and a reduced credit rating, to erase their negative home equity and relieve the stress associated with sizable housing payments.
One of the criticisms in last week’s report by the Troubled Asset Relief Program’s inspector general is that federal mortgage modification programs do not reduce the principal balance of underwater mortgages, and thereby fail to address strategic defaults.
The report also pointed out that a large number of homeowners who had their mortgage payments reduced to levels that the government deemed “affordable” still defaulted. This is further evidence that the government policy will not significantly impact the foreclosure crisis by focusing on “affordability,” yet affordability is the centerpiece of the Obama administration’s new set of policy initiatives to keep unemployed workers in their homes.
As shown by a 1999 study by Martha Olney, a professor at the University of California, Berkeley, the Great Depression of the 1930s offers vivid evidence that borrowers default for strategic reasons, and make full payments even on loans that appear “unaffordable” when given the incentive to do so. (Thanks to Song Han at the Federal Reserve Board for pointing me to this study).
During the 1920s boom that preceded the Great Depression, consumer indebtedness grew twice as much as household incomes, which themselves grew significantly. From 1929 to 1933, employment and household income fell many times more than they have fallen in the current recession: If there ever was a time when households could not afford to pay their debts, the Great Depression was such a time.
Indeed, real estate mortgage defaults were common in the Great Depression, and both affordability and strategic default might be cited as reasons. But Professor Olney showed that the incentives for strategic default varied across loan types during the Great Depression, and that default on consumer installment loans made little sense from a strategic point of view.
In the 1920s, it was common for families to purchase automobiles, refrigerators, stoves, and other consumer durables with “installment debt”: that is, they made a down payment of about one-third, took the item home immediately, and promised to make regular payments until the item was fully paid. If the borrower failed to make his payments — even the last one — the item he purchased could be repossessed and he would receive no refund of his prior payments.
In other words, absent the destruction of the item purchased, it was impossible to be “underwater” on the typical installment debt contract of those days, and thus there was no incentive to strategically default.
Professor Olney found that defaults on such contracts were rare in the early 1930s: “Despite the layoffs, the wage cuts, and the unprecedented prevalence of installment credit use, families with installment debt were avoiding default” (pp. 321-2).
Later in the Great Depression, the rules for repossessing consumer durables changed, and consumers had to be given a refund of part of the payments they made prior to default. The incentive to repay installment debt fell, and Professor Olney found delinquencies and defaults on installment debt to rise.
Many people who lost their jobs in the 1930s still made their debt payments, as long as they had an incentive to do so. Today homeowners with negative equity have little financial incentive to make their payments. By focusing so much on “affordability,” the Obama adminstration’s latest policies do little to prevent strategic default, and should not be expected to alleviate the foreclosure crisis.
Government policy continues to rigidly classify mortgages by their “affordability,” and pays too little attention to strategic defaults. Policy mistakes like these serve to prolong the foreclosure crisis.
The home foreclosure process begins when a homeowner stops making his mortgage payments, so the major policy question is how to get homeowners to pay.
One school of thought is that mortgage payments are too high to be “affordable,” and if the government could arrange for payments that were a more reasonable fraction of the borrower’s income, homeowners would make their payments and keep their homes. As I explained last week, this idea is the cornerstone of federal mortgage modification programs, under both the Bush and the Obama administrations.
The other school of thought is that “affordability” cannot be so rigidly defined, and that the vast majority of homeowners — even many of the unemployed — would make their mortgage payments if they had enough incentives to do so. In this view, most foreclosures are cases of “strategic default”: homeowners who determined that it is worth a move, and a reduced credit rating, to erase their negative home equity and relieve the stress associated with sizable housing payments.
One of the criticisms in last week’s report by the Troubled Asset Relief Program’s inspector general is that federal mortgage modification programs do not reduce the principal balance of underwater mortgages, and thereby fail to address strategic defaults.
The report also pointed out that a large number of homeowners who had their mortgage payments reduced to levels that the government deemed “affordable” still defaulted. This is further evidence that the government policy will not significantly impact the foreclosure crisis by focusing on “affordability,” yet affordability is the centerpiece of the Obama administration’s new set of policy initiatives to keep unemployed workers in their homes.
As shown by a 1999 study by Martha Olney, a professor at the University of California, Berkeley, the Great Depression of the 1930s offers vivid evidence that borrowers default for strategic reasons, and make full payments even on loans that appear “unaffordable” when given the incentive to do so. (Thanks to Song Han at the Federal Reserve Board for pointing me to this study).
During the 1920s boom that preceded the Great Depression, consumer indebtedness grew twice as much as household incomes, which themselves grew significantly. From 1929 to 1933, employment and household income fell many times more than they have fallen in the current recession: If there ever was a time when households could not afford to pay their debts, the Great Depression was such a time.
Indeed, real estate mortgage defaults were common in the Great Depression, and both affordability and strategic default might be cited as reasons. But Professor Olney showed that the incentives for strategic default varied across loan types during the Great Depression, and that default on consumer installment loans made little sense from a strategic point of view.
In the 1920s, it was common for families to purchase automobiles, refrigerators, stoves, and other consumer durables with “installment debt”: that is, they made a down payment of about one-third, took the item home immediately, and promised to make regular payments until the item was fully paid. If the borrower failed to make his payments — even the last one — the item he purchased could be repossessed and he would receive no refund of his prior payments.
In other words, absent the destruction of the item purchased, it was impossible to be “underwater” on the typical installment debt contract of those days, and thus there was no incentive to strategically default.
Professor Olney found that defaults on such contracts were rare in the early 1930s: “Despite the layoffs, the wage cuts, and the unprecedented prevalence of installment credit use, families with installment debt were avoiding default” (pp. 321-2).
Later in the Great Depression, the rules for repossessing consumer durables changed, and consumers had to be given a refund of part of the payments they made prior to default. The incentive to repay installment debt fell, and Professor Olney found delinquencies and defaults on installment debt to rise.
Many people who lost their jobs in the 1930s still made their debt payments, as long as they had an incentive to do so. Today homeowners with negative equity have little financial incentive to make their payments. By focusing so much on “affordability,” the Obama adminstration’s latest policies do little to prevent strategic default, and should not be expected to alleviate the foreclosure crisis.
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