Principal Reduction Debate: Federal Reserve

The idea that a reduction program would cure housing ills has been kicking around since the crisis began and there are now rumors that the administration and states' attorneys general may soon announce a settlement agreement that will require lenders to write down principal balances on troubled loans by as much as $25 billion. Policy wonks, the article says, will probably greet this with glee, but are they right? The authors don't think so.

The idea of principal reduction is correct at its heart: borrowers with positive equity rarely lose their homes to foreclosure. If financial difficulties occur the borrower sells the home rather than default so foreclosures are rare in normal times when home prices are rising normally. Today, however many homeowners don't have this option. Therefore it follows that getting everyone back into positive-equity territory would end the foreclosure crisis. To do this we must inflate house prices, a virtual impossibility, or reduce mortgage balances and it is estimated that underwater borrowers owe almost a trillion dollars more than their homes are worth. So who pays?

The "wonks" believe that principal reduction is a no-cost answer. They argue that foreclosure allows lenders to recover only the current value of the house, which may be far less because of a protracted delinquency period where interest is lost, foreclosure expenses, the physical deterioration of the property, holding and selling costs, etc. Reducing the principal balance to equal the house value guarantees the lender at least that amount because the borrower now has positive equity and "research shows that borrowers with positive equity don't default." For example, if the borrower owes $150,000 on a $100,000 house and the lender forecloses he might collect, after costs, $50,000. However, if the lender writes principal down to $95,000, it will collect $95,000 because the borrower now has positive equity and won't default on the mortgage.

One flaw in this is a misreading of the underlying economic theory: we shouldn't automatically assume that borrowers with negative equity will always default. What if there are two borrowers owing $150,000; and one prefers not to default and eventually pays off the loan. If both loans are written down the lender will collect $190,000 ($95,000 from each borrower) but if the lender does nothing it will eventually collect $50K from a foreclosure and the full $150,000 from the non-defaulting homeowner.

So, the optimal policy is to offer principal reduction to one borrower and not the other. This requires the lender to perfectly identify the borrower who will pay and the borrower who won't. "Given that there is a $55,000 principal reduction at stake here, the borrower who intends to repay has a strong incentive to make him or herself look like the borrower who won't!"

The authors say this identification issue is a problem often encountered with public policy as planners need to implement the policy before they know the need and that always raises the cost. While they were initially supportive of principal-reduction plans, they began to have doubts when they could find no evidence that any lender was actually reducing principal. This was widely blamed on legal issues related to mortgage securitization, but the incidence of principal reduction was so low that it was clear that securitization alone could not be even a significant part of the problem.

The three economists who published this commentary say they are not ignoring research that indicates negative equity as the best predictor of foreclosure; indeed they are responsible for some of it. However what the research does not show is that not all people with negative equity will lose their homes, just are more likely to do so. They liken it to the relationship between cholesterol and heart attacks - the former dramatically increases the incidence of the latter but the majority of people with high cholesterol do not have heart attacks, in the short or long term.

The highest risk loans - those made to borrowers with problematic credit and little equity to begin with and located in areas with dramatic price declines, are quite rare now, most have already defaulted and been foreclosed. In addition, the principal reductions required to give such borrowers positive equity are so large that the $20-25 billion figure mentioned in the rumored program would prevent too few foreclosures to make more than a small dent in the problem.

Ultimately the reason principal reduction doesn't work is what economists call asymmetric information: only the borrowers have all the information about whether they really can or want to repay their mortgages. Only if lenders really knew exactly who was going to default and who wasn't, could all foreclosures be profitably prevented using principal reduction.

It also must not be ignored that borrowers often control the variables that lenders use to identify likely defaulting borrowers. For example many programs require borrowers to be delinquent to get assistance. This seems logical - we want to help those who actually need help - but it is tempting for a borrower to miss a couple of payments to qualify for a generous reduction in debt.

The article concludes that the argument for principal reduction depends on superhuman levels of foresight among lenders as well as honest behavior by the borrowers who do not need assistance. The limited success of existing modification programs should make us question the validity of these assumptions. "There are likely good reasons for the lack of principal reduction efforts on the part of lenders thus far in this crisis that are related to the above discussion, so the claim that such efforts constitute a win-win solution should, at the very least, be met with a healthy dose of skepticism by policymakers."