(Thanks to Frank Pallotta of LVG for sharing this.) download paper here
Current Loan Modification Programs Will Not Solve Strategic Default Crisis,
According to New White Paper Released by Loan Value Group
Rumson, NJ, December 7, 2009 – With an estimated 29% of all U.S. mortgages, or 15 million homes, currently in a position of negative equity, the issue of strategic mortgage default is fast becoming one of the biggest problems faced by mortgage security investors, loan owners and servicers as well as the current administration. According to a new white paper released today by Loan Value Group LLC, however, existing solutions for the mortgage industry’s strategic default crisis can’t solve the problem because they are too cumbersome, a burden on the servicers, and ignore the consumer’s behavioral response to the problem of negative equity.
The white paper, authored by Alex Edmans, Assistant Professor of Finance at The Wharton School of the University of Pennsylvania, addresses the behavioral aspects of strategic default in terms of an approach that provides incentives for borrowers to remain current on their mortgages without the need to reduce principal through a loan modification.
Professor Edmans, who is an academic advisor to LVG as well as a behavioral economist and noted expert in incentive structures, said, “The government and loan owners are currently pursuing a number of existing solutions to default. However, they have so far proven to be ineffective for two main reasons. First, certain solutions are founded on the idea that default occurs because households have no choice due to insufficient income, and thus fail to address default that is a rational choice that depends on the homeowner’s balance sheet. Second, certain solutions face substantial practical hurdles to implementation.”
In the white paper, Professor Edmans notes that existing loan modification programs – whether initiated by the government or by the lender – are inherently ineffective:
• First, they entail a significant amount of costs, including legal and documentation fees
for the new legal contract, a re‐underwriting process, and closing costs. In addition,
they require the use of existing mortgage servicing resources, which are currently under
extreme pressure due to the crisis. This pressure is likely to increase as the crisis
intensifies.
• Second, each of the two types of modifications involves their own issues. Payment
reductions/holidays or loan restructurings to increase affordability (e.g. HAMP) do not
address the issue that, even if a homeowner is able to pay, he may choose not to do so
and walk away. Principal forgiveness triggers a full and immediate write‐down to the
value of the loan, which deters lenders from offering them. As such, the uptake of both
types of modification has been limited.
• The lack of effective, systemic results to date by lenders and servicers argues for a new
approach that aligns the interest of the borrower with the mortgage owner. First, since
default is a discretionary, rational choice made by the homeowner, an effective solution
must provide incentives for the homeowner to choose not to default, rather than
welfare to enable them to make payments. Second, since this decision to default is
driven by negative equity rather than the loan’s affordability, the solution must target
the homeowner’s balance sheet rather than income.
“If an incentive‐based solution is not adopted rapidly, strategic default will likely accelerate as house prices continue to decline,” said Professor Edmans. “In contrast, adoption of a successful incentive‐based solution to strategic default will yield substantial benefits to numerous constituencies. Most obviously, it will now be rational for the homeowner to remain in their property, preserving their credit rating and avoiding the dislocation costs caused by having to relocate after foreclosure. Mortgage lenders, investors and insurers will avoid the delinquency, foreclosure and liquidation costs associated with a default, and mortgage servicers will benefit from lower servicing costs due to reduced delinquency rates.”
At the same time, he added, the potential benefits of an incentive‐based program “extend far beyond the specific borrower and lender involved in the mortgage. The local community avoids the social costs of foreclosure, such as the homeowner’s failure to maintain property,
vandalism of property, or mass emigration from certain communities. In addition, given
contagion effects in strategic default, deterring one homeowner from defaulting may help
deter others. Finally, local governments and taxpayers benefit from property tax revenues as borrowers remain in their home, supporting social services and related jobs.”
Copies of the white paper are available at LVG Academic Papers.
About Loan Value Group LLC
Loan Value Group LLC based in Rumson, NJ, works with mortgage owners and servicers to
positively influence consumer behavior to help reduce the risk of strategic default by rewarding the responsible homeowner. Their solutions align the interests of all stakeholders, including homeowners, risk‐owners, servicers and the government through incentive‐based programs and turn‐key solutions that stabilize and preserve neighborhoods while lowering foreclosures.
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