New Research: Payment Reductions Better Prevent Default than Principal Reduction

New Research: Payment Reductions Better Prevent Default than Principal Reduction

In the immediate aftermath of the financial crisis, the Obama Administration implemented the now-defunct Home Affordable Modification Program (HAMP), first created as a part of the Economic Stabilization Act of 2008, designed to prevent default for underwater homeowners.

HAMP modified payments for homeowners to make them more affordable, with some recipients receiving an average principal reduction of $67,000 on their mortgages. By reducing mortgage payments and the total amount of money owed, underwater borrowers would have more money to dedicate to consumption, making HAMP a form of economic stimulus.

A new paper from Peter Ganong and Pascal Noel finds, however, that the reductions in principal under HAMP were ineffective at boosting consumption and reducing defaults, and that the program crowded out private-sector alternatives to help struggling homeowners.

We use variation in mortgage modifications to disentangle the impact of reducing long-term obligations with no change in short-term payments (“wealth”), and reducing short-term payments with approximately no change in long-term obligations (“liquidity”). Using regression discontinuity and difference-in-differences research designs with administrative data measuring default and consumption, we find that principal reductions that increase housing wealth without affecting liquidity have no effect, while maturity extensions that increase only liquidity have large effects. Our results suggest that liquidity drives borrower default and consumption decisions, and that distressed debt restructurings can be redesigned with substantial gains to borrowers, lenders, and taxpayers.

Why didn’t principal reduction work as well as HAMP’s supporters hoped? The authors find that inability to make mortgage payments was more a question of homeowners lacking the money to make their payments (a liquidity problem), and reducing the total amount of money owed didn’t change this.

More interesting is how HAMP’s inefficient payment modification component crowded out a more effective private-sector alternative. Qualification for HAMP payment modifications prevented recipients from receiving private-sector loan modifications to reduce payments. Despite the belief that HAMP would be more effective at helping distressed homeowners, “borrowers [who participated in HAMP and spent less than 42% of income on mortgage payments before modification] received payment reductions smaller than the 30 percent payment reductions offered in private modifications. For these borrowers, an alternative private bilateral modification program…would have resulted in more generous immediate payment reduction and…lower default rates without requiring any government subsidy.”

The authors estimate total cost of this inefficiency in HAMP’s design to be about $108 billion, and that a program designed to maximize payment reductions without changing principal would have led to 240,000 fewer defaults. In fact, the estimated cost of the program was $556,000 per avoided foreclosure, above the social cost of foreclosure.

I didn't find this helpful.This was helpful. Please let us know if you found this article helpful.
By |2018-09-11T06:20:29-07:00September 10th, 2018|Blog, Financial Regulation|