Charles Davì

The Fallacy Of Home Prices And The Reality Of Mortgage Modification

In Politicized Economy, Systemic Counterparty Confusion on March 9, 2009 at 7:07 am

Also published on the Atlantic Monthly’s Business Channel.

Why A Decline In Home Prices Should Not Cause Defaults

It seems that we have taken as an axiom the idea that if the price of a home drops below the face value of the mortgage, the borrower will default on the mortgage. That sounds like a good rule, since it’s got prices dropping and people defaulting at the same time, so there’s a certain intuitive appeal to it. But in reality, it makes no sense. Either the borrower can afford the mortgage based on her income alone or not.  However, it does make sense if you also assume that the borrower intended to access the equity in her home before the maturity of the mortgage. That is, the home owner bought the home with the intention of either i) selling the home for a profit before maturity or ii) refinancing the mortgage at a higher principle amount.

If neither of these are true, then why would a homeowner default simply because the home they lived in dropped in value? She wouldn’t. She might be irritated that she paid too much for a home. Additionally, she might experience a diminution in her perception of her own wealth, which may change her consumption habits. But the fact remains that at the time of purchase, she thought her home was worth X. And she agreed to a clearly defined schedule of monthly payments over the life of the mortgage assuming a price of X. The fact that the value of her home suddenly drops below X has no impact on her ability to pay, unless she planned to access equity in the home to satisfy her payment obligations.  Annoyed as she might be, she could continue to make her mortgage payments as promised.  Thus, those mortgages which default due to a drop in home prices are the result of a failed attempt to access equity in the home, otherwise known as failed speculation.

In short, if a home drops in value, it does not affect the cash flows of the occupants so long as no one plans to access equity in the home. And so, the ability of a household to pay a mortgage is unaffected in that situation. This is in contrast to being fired, having a primary earner die, or divorce. These events have a direct impact on the ability of a household to pay its mortgage.

I am unaware of any proposal to date which offers assistance to households in need under such circumstances.

The Dismal Science Of Mortgage Modification

Simply put, available evidence suggests that mortgage modifications do not work.

The charts above are from a study conducted by the Office Of the Comptroller of the Currency. The full text is available here. As the charts above demonstrate, within 8 months, just under 60% of modified mortgages redefault. That is, the borrowers default under the modified agreement. If we look only at Subprime mortgages, just over 65% of modified mortgages redefault within 8 months. This may come as a surprise to some. But in my mind, it reaffirms the theory that many borrowers bought homes relying on their ability to i) sell the home for a profit or ii) refinance their mortgage. That is, it reaffirms the theory that many borrowers were unable to afford the homes they bought using their income alone, and were actually speculating that the value of their home would increase.

Morally Hazardous And Theoretically Dubious

Why should mortgages be adjusted at all? Well, one obvious reason to modify is that the terms of the mortgages are somehow unfair. That’s a fine reason. But when did they become unfair? Were they unfair from the outset? That seems unlikely given that both the borrower and the lender voluntarily agree to the terms of a mortgage. Although people like to fuss about option arm mortgages and the like, the reality is, it’s not that hard for a borrower to understand that her payments will increase at some point in the future. Either she can afford the increased payments or not. This will be clear from the outset of the mortgage.

So, it doesn’t seem like there’s much of a case for unfairness at the outset of the agreement. Well then, did the mortgage become unfair? Maybe. If so, since the terms didn’t change, it must be because the home dropped in value and therefore the borrower is now paying above the market price for the home. That does sound unfortunate. But who should bear the loss? Should the bank? The tax payer? How about the borrower? Well, the borrower explicitly agreed to bear the loss when she agreed to repay a fixed amount of money. That is, the borrower promised “to pay back X plus interest within 30 years.” This is in contrast to “I promise to pay back X plus interest within 30 years, unless the price of my home drops below X, in which case we’ll work something out.” Both are fine agreements. But the former is what borrowers actually agree to.

Not enforcing voluntary agreements leads to uncertainty. Uncertainty leads to inefficiency. This is because those who have agreements outstanding or would like to enter into other agreements cannot rely on the terms of those agreements. And so the value of such agreements decreases and the whole purpose of contracting is defeated. In a less abstract sense, uncertainty creates an environment in which it is impossible to plan and conduct business. As a result, this type of regulatory behavior undermines the availability of credit.

But even if we do not accept that voluntary agreements should be enforced for reasons of efficiency, mortgages represent some of the most clear and unambiguous promises to repay an obligation imaginable. The fact that a borrower was betting that home prices would rise should not excuse them from their obligations. There are some situations where human decency and compassion could justify a readjustment of terms and socializing the resultant losses. For example, the death of a primary earner or an act of war or terrorism. But making a bad guess about future home prices is not an act that warrants anyone’s sympathy, let alone the socialization of the losses that follow.

The Elephant In The Room

This notion that Subprime borrowers were victimized as a result of some fraudulent wizardry perpetuated by Wall Street is utter nonsense. Whether securitized assets performed as promised to investors is Wall Street’s problem. Whether people pay their mortgages falls squarely on the shoulder of the borrower. Despite this, we are spending billions of public dollars, at a time when money is scarce and desperately needed, on a program that i) is demonstrably ineffective at achieving its stated goals (helping homeowners avoid foreclosure) and ii) rewards poor decision making and imprudent borrowing. Given the gravity of the moment, a greater failure is difficult to imagine. But then again, we live in uncertain times, so my imagination might prove inadequate.

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  1. Some of what you say is true, but don’t put so much weight on the OCC study’s redefault rates. Other research (e.g., White, 2008) suggests that many modifications don’t even reduce the payment burden. Research by Credit Suisse shows that the redefault rates on meaningful modifications are much lower than those reported in the OCC study. The IMF paper that I co-wrote with Vladimir Klyuev (http://www.imf.org/external/pubs/ft/spn/2009/spn0902.pdf) suggests that, despite any moral issues, principal writedowns can be better for everyone. As for moral issues, all lenders, as well as many borrowers, went into this with their eyes open…

    • John,

      First, thank you for your thoughtful comment. You are correct that principle write downs will be much more effective than adjustments to the interest rate/maturity. However, your comment implicitly adopts my theory that many mortgages are in default because they are underwater (home value < mortgage principle), which suggests that the borrower intends to access equity in the home.

      In any case, I should have made my point more narrow, and you are right to note that principle writedowns are their own animal and deserve separate treatment. However, as I understand it, the current administration’s plan does not call for principle writedowns.

  2. Not only does the current administration not call for principal writedowns, but they almost go out of their way to discourage them.

    I’m not sure I’d go all the way to saying that many delinquencies are caused by negative equity, but negative equity is certainly a disincentive to stay current for many distrseed borrowers.

  3. BTW, I should say that I really like your blog. Your posts on the nuts and bolts of derivatives are excellent!

  4. I think there is a point here that affects — although certainly doesn’t refute! — your argument.

    A number of the subprime mortgages were written as balloon, or adjustable rate. Thus they have relatively short terms and require refinancing. A mortgage that is severely underwater can be nearly impossible to refinance successfully, at least without a massive cash infusion. Thus someone whose current payment is perfectly doable may either be faced with the inability to get a mortgage under current conditions at all, or may only be able to get a very disadvantageous mortgage that is beyond their means.

    Some kind of principal write down in that context, allowing the mortgage to be refinanced at workable terms while splitting the loss in value among the owner and lien-holder, seems like an appropriate method to handle that, and is probably financially a better deal for the lien-holder than foreclosure.

  5. It is not quite accurate to say “A Decline In Home Prices Should Not Cause Defaults.” An example — say I live in inland California and bought a home at 200% its current value between 2005-2007, with a typical null downpayment, on a $400k property now worth $200k. I would be paying around $3k monthly — roughly half for my overpayment. There is plenty to rent for less than half that, in better places with better schools, and credit is only really affected for 7-10 years. Many states are non-recourse — your only penalty for backing out is losing the property and taking a credit hit, no matter your assets or income. That is a lot smaller a cost than spending decades trying to make the bank whole on its loan, and also why “has no impact on her ability to pay” is irrelevant. As this penny drops, many people are coming to the same conclusion.

  6. First and most obvious: while the value of the house does not affect the affordability of mortgage payments, assuming no intent to extract further equity from the home, the value of the house very much *does* affect the likelihood of default if some other event — job loss, illness, divorce, etc — does affect the affordability of mortgage payments. Why? Because if there is significant equity in the home, a mortgage holder is very unlikely to go into default, as he or she can simply sell the house in order to pay off the loan. If on the other hand, the equity is negative, selling the house won’t result in enough money to pay off the loan, and default is much more likely. This effect is so significant that I would expect that typically, for ordinary mortgages in an environment of rising prices, the default rate should be close to zero, as it would be foolish for a homeowner with equity to allow foreclosure. So the notion that home prices are a (contributing) cause of defaults is not a fallacy at all, even for prime borrowers in recourse jurisdictions.

    Second, as a previous commenter notes, a non-recourse mortgage *effectively* gives the homeowner a put option on the house — he may deliver the house in satisfaction of the mortgage, perhaps at some cost to his credit rating. This effective put option affects his incentives to default and exercise the option when the value of the home is less than the balance of the mortgage.

    Third, there is a strong argument *for lenders* in favor of some modifications: that the lenders may recover more money than if the loan went into default and they had to sell the property in foreclosure. Not all modifications will meet this standard, but many will. We don’t need to talk about fairness or unfairness at all — only about the best interests of all the parties involved, who include not just the lenders and the homeowners, but the society at large which is adversely affected by a high foreclosure rate.

    Finally, as a minor point: I believe that the administration’s plan to help homeowners does indeed include an element intended to reduce the ratio of mortgage payments to monthly income if that ratio is too large to be affordable — which may have come about due to job loss, divorce, illness, etc…

  7. I think this sentence is telling and is very true: “Thus, those mortgages which default due to a drop in home prices are the result of a failed attempt to access equity in the home, otherwise known as failed speculation.” The problem with mortgages in the bubble states and with subprime / alt-a type mortgages in general is that these folks who took out mortgages were merely speculating on price moves. When servicers have sent information to “homeowners” they have received very few responses and the hope now program has helped only a handful of people. I would imagine that the reason for this is that the “homeowners” want a few months of free rent during the foreclosure process before they are kicked out.

    I think that the real plan to prevent these homes from clogging the housing market as inventory is that the banks should be able to take ownership of the house from those who are underwater and lease the property back to the owner. The homes would be held at the current principal value of the loan (you don’t have to mark physical assets to market), and the rent would be determined based on income. The speculators who defaulted would have a ten year option to buy at the principal amount of the mortgage at the time of default. This would ensure that those people who are defaulting solely for employment, health, or family reasons would be weeded out from those who are defaulting because they were speculating on house prices. You could call it the Rent the American Dream Program. An added benefit of this is that house prices are not pressured further by hasty sellers (like banks) and Bank income is improved because they are able to get cash flow from their assets over time instead of a paltry lump sum.

  8. A mortgage is nothing other than a secured loan. If the market value of the collateral securing the loan drops below the principal outstanding on the loan it is rational for the borrower to default on the loan, as they get out at zero (modulo impaired credit). In actual practice, the rational threshold for default takes into account the cost of this impaired credit, and the price differential between mortgage finance and other costs on a property you own and rent on a property you do not.

    If the lender only has recourse to the property (this is the case in the US, not in the UK for example) then they are short a put on the house price struck at the loan amount. Lenders should add the cost of this option they are short into the cost of the loan when they originate it, but do not. Traditional underwriting practice (relatively low loan-to-value ratios) provides them with some buffer as the borrower takes all of the loss between the appraisal value and the loan amount, but large LTVs, HELOCs etc mean the lender eats more loss.

    Either way there’s no point in originators crying now.

  9. I think this sentence is telling and is very true: “Thus, those mortgages which default due to a drop in home prices are the result of a failed attempt to access equity in the home, otherwise known as failed speculation.” The problem with mortgages in the bubble states and with subprime / alt-a type mortgages in general is that these folks who took out mortgages were merely speculating on price moves. When servicers have sent information to “homeowners” they have received very few responses and the hope now program has helped only a handful of people. I would imagine that the reason for this is that the “homeowners” want a few months of free rent during the foreclosure process before they are kicked out.

    I think that the real plan to prevent these homes from clogging the housing market as inventory is that the banks should be able to take ownership of the house from those who are underwater and lease the property back to the owner. The homes would be held at the current principal value of the loan (you don’t have to mark physical assets to market), and the rent would be determined based on income. The speculators who defaulted would have a ten year option to buy at the principal amount of the mortgage at the time of default. This would ensure that those people who are defaulting solely for employment, health, or family reasons would be weeded out from those who are defaulting because they were speculating on house prices. You could call it the Rent the American Dream Program. An added benefit of this is that house prices are not pressured further by hasty sellers (like banks) and Bank income is improved because they are able to get cash flow from their assets over time instead of a paltry lump sum.
    Sorry, forgot to add great post! Can’t wait to see your next post!

  10. >why would a homeowner default simply because the home they lived in dropped in value?

    Homeowners with negative equity are de facto renters. Housing payments significantly higher than rents would make it a smart choice to go into default and switch from overpaying for a de facto rental to actually renting, with upsides such as flexibility to move etc.

    To precisely analyze it you’d look at cashflow for defaulting vs the casflow for staying current on the mortgage. As long as the mortgage is underwater the homeowner isn’t building any equity, so they’d be better off if they come out ahead with the default and re-enter at a later point.

    >Well, the borrower explicitly agreed to bear the loss when she agreed to repay a fixed amount of money.

    Not in certain situations they didn’t. What the borrower agreed to is to make the agreed payments or go through legally defined default proceedings. In non-recourse situations, the lender is limited to foreclosure alone to collect on a default. So the borrower agreed to bear the loss or lose the home, their choice.

    Both the borrower and the lender entered into the mortgage aware of the default procedures. The lender got paid a premium for the risk of going through that default procedure. To then turn around and try to shame borrowers from shielding lenders from the risks the lenders got paid for is disingenuous at best.

  11. @ All,

    Perhaps my phrasing wasn’t clear, but the point is that depreciation does not affect the ability to pay. This is an obvious point. But unfortunately our elected officials do not seem understand this.

    The second point is that statistical evidence suggests that mortgage modifications do not work, as a general rule. This is likely due to the fact that they don’t cure the negative equity problem. That is, the mortgage mods proposed to date do not write down principle.

  12. pantheistic multiple-ego solipsist,

    “Both the borrower and the lender entered into the mortgage aware of the default procedures. The lender got paid a premium for the risk of going through that default procedure. To then turn around and try to shame borrowers from shielding lenders from the risks the lenders got paid for is disingenuous at best.”

    I never said that it’s shameful to enter into default procedures/foreclosure. In fact, in a non-recourse state, it could be the rational thing to do. My point is that negative equity does not warrant A rewriting of the mortgage.

    I think I’ve addressed your other comments in my comment above.

  13. erdosfan: “The second point is that statistical evidence suggests that mortgage modifications do not work, as a general rule. This is likely due to the fact that they don’t cure the negative equity problem. That is, the mortgage mods proposed to date do not write down principle.”

    This is such an important point. Unfortunately servicer data is not detailed enough to verify this, although what little evidence we do have supports the idea that redefault rates are lower for principal writedowns. Ocwen and Litton seem to think so and are putting their money where their mouths are.

  14. Dear Mr. Davy,

    By random chance, I had the opportunity to read your CDS paper today. It was so absurdly ignorant that I had to do more research on you.

    I then ran across your blogs and your articles, which confirmed my suspicions, and motivated me to send you this message.

    First a bit about my background. I am a mathematician with years of experience in finance.

    Now for the message. With all due respect, you are one of the most insufferable people I have ever encountered. Your writing is a mix of obfuscation, half-truths (so blatant that I wonder if they are intentional)and ignorance. You are like a fool who writes a long and jargon and formula filled proof explaining why the moon is a flat plate in the sky. You are also a terrible writer, which is surprising for someone who went to law school.

    The only justice in all of this is that your work is attached to your name, humiliating you in front of anyone with knowledge and insight of the field.

    For your own sake, and for the sake of the readers whose time you waste, or whose potential for knowledge you thwart, please consider whether the world needs to hear your opinions.

    And please note that I didn’t read your post on why people have no reason to cancel underwater mortgages, but it’s clearly as absurdly ignorant a proposition as your other work.

    • Dear A,

      As a former mathematics enthusiast myself, I find your credentials surprising. Most mathematicians are familiar with Aristotle’s rules of argumentation, since they are intellectually adjacent to his mathematically critical rules of logic. Yet rather than discuss any specific flaws in my reasoning, you choose to attack my character, and perhaps most bizarre, my writing abilities.

      As a mathematician, I’m sure you realize that you have not put forth any statements that can be derived logically from a set of true assumptions. In short, you must realize, that you have said nothing at all.

  15. NB for A,

    My name, which is clearly stated atop my blog and all over the internet which you claim that you searched, is “Davi,” not “Davy.”

    Such imprecision is unbecoming of a mathematician.

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