Forgiveness Formulas

Copyright, The New York Times Company

In an ideal world, collecting debts would be as simple as asking debtors to pay their obligations when they are able to. But in reality most businesses have found that they need to obtain other assurances, such as collateral or the option to shut off services to a delinquent payer. Otherwise it is too easy for debtors to claim hardship and walk away without paying.

On the other hand, many families and other debtors do experience genuine hardship. In those cases it can be compassionate and even efficient to at least partly forgive the debts of people who have fallen on hard times. Many economists see loan defaults as (sometimes) an efficiency-enhancing form of risk-sharing.

Even the most hard-hearted lender may choose to partly forgive loans because too much lender effort is required to elicit full payment. Just as you cannot squeeze blood from a stone you cannot get much revenue from someone who does not have it.

One approach would be for lenders to develop and disclose a “forgiveness formula” that would clearly define “hard times” and indicate precisely what kind of forgiveness is possible. The advantage of forgiveness formulas is that distressed borrowers can be certain where they stand with the lender and can readily evaluate whether they were treated “fairly.”

Forgiveness formulas are also consistent with the idea that agreements should be clearly specified in writing, so the parties to the agreement fully understand each other and never have to argue about what the agreement really meant. Carefully specified written agreements are sometimes found in employment relationships, tenant-landlord relationships and even marriages.

This is the approach that the Federal Deposit Insurance Corporation took during the George W. Bush administration to restructure home mortgages that had fallen under water (that is, when home prices had fallen so much that selling the home would no longer provide enough proceeds to pay the mortgage in full). Borrowers were told what new mortgage terms would be affordable and under what net-present-value conditions those terms should be considered acceptable to lenders.

The clarity of forgiveness formulas is also their weakness, because they make it easier for debtors to “game the calculation” and can ultimately make loans more costly for borrowers who pay in full. The Internal Revenue Service has long been secretive about its procedures for auditing returns and restructuring delinquent tax payments, and the Treasury maintained that approach when it became involved with restructuring home mortgages (the Congressional Oversight Panel discusses this matter on Page 41 of this report).

Hospitals are also known to partly forgive medical debts incurred by the uninsured, while they make no accommodation for many others. Some states require hospitals to explain in writing how they go about discounting charges for hardship patients (as we can see in New York’s policy), but you might guess that hospitals worry that patients will game those calculations in order to pay less.

One advantage of health reforms that get more people on health insurance is that by getting people to pay for their health care before they get sick, the reforms reduce the number of cases in which clear forgiveness has to be traded off with formula gamesmanship.

Pre-order your copies of The Redistribution Recession

In the next several days I will be reviewing the page proofs of my forthcoming book The Redistribution Recession.

You can pre-order a hard cover version with color charts, including shipping, for less than $35!! That's so cheap that you'll want to order one for home and another for the office.

Amazon.com

Barnes and Noble

Redistribution, or subsidies and regulations intended to help the poor, unemployed, and financially distressed, have changed in many ways since the onset of the recent financial crisis. The unemployed, for instance, can collect benefits longer and can receive bonuses, health subsidies, and tax deductions, and millions more people have became eligible for food stamps.

Economist Casey B. Mulligan argues that while many of these changes were intended to help people endure economic events and boost the economy, they had the unintended consequence of deepening-if not causing-the recession. By dulling incentives for people to maintain their own living standards, redistribution created employment losses according to age, skill, and family composition. Mulligan explains how elevated tax rates and binding minimum-wage laws reduced labor usage, consumption, and investment, and how they increased labor productivity. He points to entire industries that slashed payrolls while experiencing little or no decline in production or revenue, documenting the disconnect between employment and production that occurred during the recession. The book provides an authoritative, comprehensive economic analysis of the marginal tax rates implicit in public and private sector subsidy programs, and uses quantitative measures of incentives to work and their changes over time since 2007 to illustrate production and employment patterns. It reveals the startling amount of work incentives eroded by the labyrinth of new and existing social safety net program rules, and, using prior results from labor economics and public finance, estimates that the labor market contracted two to three times more than it would have if redistribution policies had remained constant.

In The Redistribution Recession, Casey B. Mulligan offers hard evidence to contradict the notion that work incentives suddenly stop mattering during a recession or when interest rates approach zero, and offers groundbreaking interpretations and precise explanations of the interplay between unemployment and financial markets.

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I understand that physical copies are scheduled to ship from the press' warehouse on October 4 ... a week or two after that, the book should be available for immediate purchase.

The Largest Marginal Tax Rate Ever?

Copyright, The New York Times Company In 2012, the Treasury Department began a new phase of its Home Affordable Modification Program, or HAMP. In doing so, it may have the distinction of putting into place the largest marginal income tax rate ever in a non-Communist country.

For home mortgage borrowers who appear to be headed for foreclosure, mortgage programs typically recommend a revised mortgage payment amount that is lower than the payment specified in the original mortgage contract. The new payment is set in proportion to the borrower’s income at the time of the modification.

The more the borrower is earning at the time of the modification, the more she will be required to pay her lender over several years. Typically, each additional $100 a borrower is earning (on an annual basis) at the time of the modification adds $31 to the annual amount of the mortgage payment recommended by the Treasury’s mortgage modification guidelines. (This modification is not revisited over time; the income is examined one time and payments set.)

The HAMP program, and its predecessor at the Federal Deposit Insurance Corporation, usually modified the mortgage payments by adjusting the loan interest rate over the subsequent five to seven years.

Thus, assuming a five-year modification time frame, each $100 earned at the time of the modification would add $155 to the borrower’s total mortgage payments, or about $130 in present value.

It is done this way with the intention of creating a monthly payment that is “affordable” (defined as 31 percent of income). But there’s a flip side to the argument: the disadvantage of higher earnings in calculating the resulting payment. To an economist looking at it that way, it’s the equivalent of a 130 percent marginal tax rate: a $130 payment differential solely as a consequence of earning an extra $100.

This year the Treasury decided to encourage changes in this procedure. In particular, it will now subsidize lenders for modifying mortgage principal balances rather than interest payments. Because the principal balance determines payments for the life of the loan, in effect Treasury is asking lenders to modify payments for the life of the loan and not just five to seven years.

Take a 30-year mortgage originated in 2006: it has 24 years left. Under the new rules, an extra $100 earned by the borrower at the time of modification costs her $31 a year for 24 years, which amounts to a total of about $390 in present value. That’s a 390 percent marginal tax rate that applies to borrowers who are having, or expect to have, their mortgage modified.

Economists agree that marginal income tax rates of 100 percent or more are destructive to the labor market and strongly encourage corruption. The best we can hope for is that people subject to such confiscatory marginal tax rates are and remain oblivious of the incentives that Treasury is presenting them.

Marginal tax rates in excess of 100 percent are also present in antipoverty programs, especially in what is known as the Medicaid notch, where an additional $1 of income can mean the complete loss of coverage. In a sense, the Medicaid notch is a marginal tax rate in the thousands of percent, because beneficiaries lose benefits valued in thousands of dollars as a consequence of earning an additional $1.

But while a few thousands of dollars are at stake with one family’s Medicaid coverage, tens of thousands, sometimes hundreds of thousands, are at stake in each mortgage modification transaction.

For this reason, I think Treasury officials have earned the award for largest marginal income tax rate ever. Let’s hope they are not in training to yet again break their record.

Bankers, Too, Cast a Safety Net

Copyright, The New York Times Company

The combination of housing market events and the profit motive of mortgage lenders turned trillions of dollars of household debt into a huge safety net.

Household debt had been increasing during the 1980s and 1990s, but the rate of increase was extraordinary in the years leading up to the recession. By 2007, household sector debt had reached 114 percent of the nation’s personal income – more than $14 trillion. The change was almost entirely due to accumulation of home mortgage debt.

Normally, home mortgages are fully secured by a residential property, and when a homeowner fails to make the scheduled payments on time, the lender can seize the property and sell it to recover its principal, interest and fees. When the lender has this valuable foreclosure option, borrowers overwhelming either make their home mortgage payments on time or sell their property in an orderly fashion to obtain the money to repay the mortgage lender, even in cases when the homeowner is unemployed.

When residential property values plummeted in 2008 and 2009, a number of residential properties were suddenly “under water” — worth less than the mortgages they secured. In those cases, the lender’s foreclosure option was no longer valuable – selling the property would be likely to yield too little money to cover principal, let alone interest and fees.

Lenders needed a way to estimate which borrowers would still pay in full and a way for other borrowers to work out a mortgage modification that would give them an incentive to pay at least a bit more than their homes were worth.

Naturally, a borrower’s income is a factor considered – borrowers with high income can be expected to repay more than borrowers with low income. Thus, a partial solution to the lenders’ collection problem is to insist that high-income borrowers pay more of the mortgage amount due and allow at least some low-income borrowers to pay less.

From this perspective, the lenders’ desire to maximize debt collections (after the collapse of residential real estate values) causes them to create a kind of safety net program that gives low-income people more help with their housing expenses (much the way the federal food stamp program gives low-income people more help with their food expenses) in the form of modified mortgage payments.

To quantify the size of the loan modification safety net and its changes over time, I estimate the amounts that “home retention actions” (as the federal government calls these mortgage modifications that allows people to stay in their homes) actually changed mortgage payments from the original mortgage contract, which specified only payment in full or foreclosure.

To estimate those amounts for 2008-10, I first measured the number of residential properties in each quarter receiving loan modifications, lender permission for short sale or lender permission for deed-in-lieu of foreclosure.

Next, I multiplied the number of transactions by a $20,319 average value of each loan modification (a typical modification reduced monthly payments by $400 for a minimum of 60 months; at an annual discount rate of 7 percent, that’s a present value of $20,319). I do not have data on the number of home retention actions for the years 2006 and 2007, but I assume the dollar value of discharges those years were, as a proportion to discharges in 2008, the same as total mortgage loan discharges by commercial banks.

Because the home retention actions are necessary primarily when homes are worth less than the mortgages they secure, the amount discharged by home retention actions is much less in 2006 and 2007 when residential property values were still high. During 2010, mortgage lenders discharged more than $70 billion of mortgage debt through home retention actions. Seventy billion dollars for one year is small in comparison to the total amount that homeowners were under water but is more than the spending by the entire food stamp program for that year.

The last row of the table displays discharges on other consumer loans, such as credit card debt. Those discharges are smoother over time because they are not directly tied to the housing cycle but still totaled more than $70 billion in 2010. The combination of discharges of other consumer loans and discharges of home mortgages by home retention actions was almost $150 billion in 2010, which exceeds the peak spending for entire unemployment insurance system.

Bankers deserve a lot of blame for getting us into this mess, have dipped far too deeply into the United States Treasury to help themselves, and have been far too slow to modify mortgages. For these reasons, it’s remarkable that their own selfish pursuits have forced them to create a safety net of sorts that rivals the amounts spent by public sector safety net programs.

More Evidence of Hamp Failures

CNBC reports:

"Homeowners applying to the foreclosure-relief program say the program is a bureaucratic mess, with banks losing documents and failing to return phone calls. Banks blame homeowners for failing to submit needed paperwork."

This result is no surprise.

Marginal Tax Rates in the Private Sector

I have written about the erosion of incentives to earn income, especially during this recession, by a variety of public and private sector programs (foremost among the private sector programs are debt collection programs that forgive debts for people with low incomes, but enforce them for those with high incomes). Here's another example that involves fewer dollars, but illustrates the point:

http://www.google.com/hostednews/ap/article/ALeqM5hTp5DVv4Qisj9CFdbTFX-j1rBE6Q?docId=4d140ccf08a0495f9f55429d89b5afe6

Why HAMP Failed

Copyright, The New York Times Company

The Obama administration’s Home Affordable Modification Program for reducing mortgages of homeowners who owe more than their houses are worth has fallen far short of its objectives. Officials seem surprised by that outcome and blame the result on administrative problems. But, all along, the program’s bad economics doomed it to failure.

Home buyers take usually out mortgages that cover only part of the value of the houses they are buying. In other words, the house is worth more than the mortgage owed. This means that in the event a borrower defaults, the lender can, in most cases, be repaid in full by foreclosing on the house and selling it to someone else.

However, housing prices have fallen dramatically since 2006. By 2009, about one in four home mortgages was “under water” — the market value of the house had fallen below the amount owed on the mortgage, or, put differently, the home equity was negative.

Under President George W. Bush, the Federal Deposit Insurance Corporation, the Federal National Mortgage Association (known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (known as Freddie Mac) all announced debt forgiveness or “loan modification” formulas. The Treasury Department under President Obama continued this policy with the Home Affordable Modification Program, part of its Home Affordable initiative, which replaced the Fannie and Freddie programs. The modification program alone was aimed at three million to four million mortgages.

These modification programs encourage lenders to reduce mortgage payments, so that each borrower’s housing payments (including principal, interest, taxes and insurance) are no more than 31 percent of the borrower’s gross income. The payments are to be reduced for five years or to whenever the mortgage is paid off (whichever comes first).

The amount of the payment reduction depends on the borrower’s income — the less he or she earns, the more the payment is reduced. For example, a borrower whose annual family income is $100,000 can get housing payments reduced to $31,000 a year; a borrower whose annual income is $50,000 can have the payments cut to $15,500 a year.

If the mortgage modification rules were actually followed, one implication would be that a family that earns $50,000 more in the year before the modification stands to pay an additional $15,500 a year for five years on housing payments — a total of $77,500. Adding $50,000 to your income adds $77,500 to your expenses: the mortgage lender gets more than 100 percent of your extra income! Economists call this a marginal “tax rate” that exceeds 100 percent, because the person earning that income is obligated to give all of it to a third party (the lender, in this case), and then some.

Economists may argue about how high tax rates should be, but we all agree that marginal income tax rates of 100 percent (or more) are terribly destructive. And the terrible incentives in the federal mortgage modification guidelines were known even before the Obama administration put together its program.

Because of its destructive economics, the modification program was proposing changes that were only marginally beneficial to borrowers and massively costly for banks. Assuming that banks understood this, I predicted that banks would pursue their own interest by randomly and arbitrarily refusing to modify most of their mortgages according to the program formula.

A year and half into the program, this is no longer just a theoretical possibility. The Associated Press reported that many borrowers say the modification program is a bureaucratic nightmare. The A.P. report said, “They say banks often lose their documents and then claim borrowers did not send back the necessary paperwork.” Instead of modifying three million mortgages and preventing their foreclosures, less than one-half million mortgages have been modified under the program, while about three million borrowers received foreclosure notices (see the latest report by the Office of the Special Inspector General of the Troubled Asset Relief Program).

Rather than overtly contradicting the Treasury by denying eligible borrowers, banks are encouraging borrowers to deny themselves by requiring those borrowers to endure deluge of paperwork.

Both the Bush and Obama administrations have run roughshod over incentives, and the housing market and the wider economy continue to suffer because of it. We can hope that economic policy might be different after yesterday’s electoral shake-up, but more likely we’ll be drinking old wine from new bottles.

Latest Mortgage Modification Readings

http://www.sigtarp.gov/reports/congress/2010/October2010_Quarterly_Report_to_Congress.pdf
http://www.economicpopulist.org/content/tarp-bail-out-blasted
http://www.nytimes.com/2010/10/28/business/28victims.html

The Supply of Bureaucratic Nightmares

The AP reports today

"Many borrowers have complained that [Obama's mortgage modification] program is a bureaucratic nightmare. They say banks often lose their documents and then claim borrowers did not send back the necessary paperwork."

I am not surprised because, as I wrote earlier this year, "lenders have an incentive to foreclose on borrowers deemed modification eligible by the federal programs." Rather that overtly contradicting the U.S. Treasury by denying eligible borrowers, banks are just encouraging borrowers to deny themselves.

Article on Strategic Defaults

Here's an article with vivid evidence that many mortgage defaults are not because of unemployment, unless unemployment were (miraculously) to disproportionately hit people who were able to borrow a lot just a few years ago.

Working Around Federal Mod Programs

Some information about that trend in this article.

More Substitution of Unemployment for Foreclosures

Fannie Mae will now penalize some of the borrowers who walk away from their mortgages. Penalizing delinquent borrowers can help the foreclosure crisis, but giving a free pass to those with low incomes will increase the supply of low income people.

Free Rent

http://www.nytimes.com/2010/06/01/business/01nopay.html

Mortgage Modifcation Data Update

link to Treasury report.

link to NYT summary.

Apple Does It, Fed Government Doesn't

How is it that Apple does as many transactions in a weekend that Federal Mortgage Modification Programs do in a year?

Maybe it has something to do with incentives.

Article on the Credit Score Impact of Mortgage Modification

http://money.cnn.com/2009/12/28/news/economy/loan_modifications_credit_history/index.htm

Strategic Default: Lessons from the Great Depression

Copyright, The New York Times Company

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.

The Depressing Scenario Comes True

Almost a year and a half ago, I wrote "A Depressing Scenario: Mortgage Debt Becomes Unemployment Insurance" about how unemployment could, in theory, become a ticket to free housing.

This week the Obama Administration made that scenario come true (Treasury link).

Modification Critique, Without Economics

SIGTARP is critical of the Treasury's program, but apparently does not think much about economics.

The Housing Crisis and the Resentment Zone

Copyright, The New York Times Company

Means-tested government benefits, and the “resentment zone” that goes with them, are more prevalent than ever, thanks to the housing crash. Programs like these delay the housing market’s recovery.

Home buyers take usually out mortgages that cover only part of the value of the houses they are buying. In other words, the house is worth more than the mortgage owed. This means that in the event a borrower defaults, the lender can, in most cases, be repaid in full by foreclosing on the house and selling it to someone else.

However, housing prices have fallen dramatically since 2006. By 2009, about one in four home mortgages was “underwater” — meaning that the market value of the house had fallen below the amount owed on the mortgage (a.k.a., home equity is negative). Because of the low resale values, foreclosing on any of the homes will not yield lenders their entire principal; lenders in those cases must rely on the good behavior of the borrowers.

Meanwhile, homeowners are considering whether it is worth moving, and a reduced credit rating, in order to erase their negative home equity by walking away from their home and its mortgage.

As it has with health care, student loans, nutrition and other areas, the federal government has responded to the mortgage crisis with another layer of means-tested benefits. And these may be the largest means tests yet.

The government’s idea was to “modify” underwater mortgages in order to give homeowners an additional incentive to stay in their house. But the government will not sponsor such modifications for people with negative home equity who also earn “enough” to make their mortgage payments.

The government programs aim to modify the mortgage so that the modified mortgage payments, together with taxes and insurance, are 31 percent of the borrower’s income. Those reduced payments remain in place for five years, if not longer.

Thus, a homeowner earning $60,000 per year would have his annual housing expenses reduced to $18,600 (31 percent of his income), whereas one earning $70,000 would have expenses of $21,700. In other words, the fact that one person earns an additional $10,000 for the year obligates him to $15,500 additional housing expenses (an additional $3,100 per year for five years).

For this reason, mortgage modification has dramatically larger penalties for earning than other means-tested government programs. This not only adds to an already large pool of resentment, but is also partly responsible for the slow pace of modification by mortgage lenders and servicers, and for the dearth of income tax revenues collected by state and federal treasuries.