Wednesday, December 31, 2008

Want to Cut Your Debt? Work Less

Mortgage modification programs create terrible work incentives and are ubiquitous these days, and this is one reason why this recession is so different from previous ones.

In most cases, a homebuyer takes out a mortgage that covers only part of the value of the house he’s buying. In other words, the house a person buys is worth more than the mortgage he owes on it. This means that in the event of borrower delinquency, the lender can, in most cases, obtain his full principal by foreclosing on the house and selling it to a new purchaser.

However, housing prices have fallen dramatically since 2006. By 2008, about 12 million mortgages were “under water” – meaning that market value of the house had fallen below the amount owed on the mortgage. Because of the low resale values, foreclosing on any of those homes will not yield lenders their entire principal; lenders in those cases must rely on the good behavior of the borrowers.

Officials at the Federal Reserve, the United States Treasury, the F.D.I.C., Fannie Mae (most recently, its “Early Workout” program) and Freddie Mac have encouraged lenders in such cases to “modify” mortgages – that is, to accept a stream of payments from the borrowers that is different from the amounts promised when the mortgages were initially signed. In particular, these “modification programs” encourage lenders to reduce mortgage payments so that each borrower’s housing payments (including principal, interest, taxes and insurance) are 38 percent of the borrower’s gross income. The payments are to be reduced for the next five years, or when the mortgage is paid off (whichever comes first).

Of course, a borrower cannot be harmed by the opportunity to have his mortgage payment reduced. But what is economically noteworthy is that 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 have her housing payments reduced to $38,000 per year, whereas a borrower whose annual income is $50,000 can have his payments reduced to $19,000 per year.

One implication of the mortgage modification rules is that a family that earns $50,000 less in the year prior to their modification stands to save $19,000 per year for the following five years – or a total of $95,000 on its housing payments! Those are 95,000 reasons to hesitate when looking for a new job, when wrapping up a maternity or paternity leave, or when confronting other job transition situations.

I do not expect every adult among those in the 12 million underwater households to be without a job because of the modification rules. Although modification professionals have specialized in educating homeowners about their modification options, many homeowners probably do not fully understand the mortgage consequences of their earning decisions. Nobody knows the exact numbers, but, even if 90 percent of homeowners were oblivious or uninterested in their modification options, that would leave over a million households that were aware. One million plus workers would make a large dent in the employment statistics.

My previous post reminded readers that productivity has been rising and employment falling in this recession. If approximately one million workers realized that earning income in 2008 was not in their financial interest – and acted on this realization – their actions would have the effect of significantly reducing aggregate employment and hours. As businesses operated with less labor, labor productivity would rise. Maybe the housing crash and mortgage modification that followed have something to do the recession of 2008.


Unknown said...

This is purely based on the assumption that the ONLY benefit gained from work is money. Ask many people, and work brings far more utility than money...

Pride, Accomplishment, Community, and personal enrichment are sorely missing from your model...

Another rotten remark is the suggestion that 1 million of the newly unemployed are homeowners...if we assume the distribution of home ownership of the newly unemployed and employed is the same....less than 1/2 would own a home....

Forget the fact that if I take home 50K instead of 100K, I lose out on at least 5k of 401k moneys (assuming a 10% deposit rate, which d=becomes even less attractive if I recognize that I am giving up not just today's 5K, but the compound interest on that 5k for n years until need the money).

The best strategy is to buy a house now, for less, while your current house underwater, and the give the old house to the bank...they should have known better than to appraise the value of the house so high...they are the lending experts....and they control if I get the $$$ or not....

Tino said...

A quick look at the American Housing Survey 2007:

3.7% mortgage below home value (3.9% have mortgage and home equity loan below home value. Ignore home equity loan, since people who take those are more likely to actively adjust their home equity rather than fall below through price movements).

Median household income for those with mortgage under home value is 63000 compared 70.000 for all those with reported mortgages (and 44000 for the entire sample, including non-home owners). Mean income is the same at 91.000 and 90.000.

There is a strong association between mortgage size and probability of mortgage being under home value, the mean mortgage size is 167.000, while the mean mortgage size for those under is 330.000. People with negative home equity are median 25% below their mortgage (mean 93000).

A regression with demographics controls AND the value of mortgage has that given mortgage size the dummy for negative home equity is associated with 37% lower income.
Not including mortgage size, and instead using the share of negative equity of total mortgage, each 1% in negative equity as share of mortgage is associated with 0.33% lower income.

Using the value, each dollar of negative equity is associated with 0.2 dollars lower income.

The coefficient for of the negative home equity dummy is smaller in other years, -15% 2005 and -11% 2001. If I take the regressions seriously it may mean that banks are negotiating more during the downturn, or just that the bubble popped in higher income areas in 2007.

In 2001 the 2.5% of people with negative home equity were more clearly lower income than 2007, with both lower median and mean income.

Unfortunately the geographic data in AMS is bad, otherwise maybe changes in home prices could be used as an instrument for negative home equity and labor supply.

Casey B. Mulligan said...

Tino -- Can you email me? I would like to know more about your AMS regressions!