Principal reduction is no lifeline

Neither number makes sense. And the basic strategy is flawed.

The CoreLogic data implies that for a principal reduction policy to be successful, $5 billion won’t work. $20 billion won’t work. $200 billion won’t work. 

That’s because underwater homeowners rarely “strategically” default – walk away leaving the keys in the kitchen. A recent Federal Reserve study of defaults in the so-called “sand states” among subprime mortgages with no down payment finds that the median borrower did not strategically default until they owed 62 percent more than their home’s value.

So, more realistically millions of borrowers with underwater mortgages may default, but millions more will continue to make payments on their mortgages. Now, it would be nice if a policy would be able to tell defaulters from non-defaulters. Then it might be possible to design a principal reduction strategy that targeted the defaulters. It would be cheaper and would be more effective.

It’s not going to happen. 

This is a classic example of the problem of asymmetric information. The borrowers know if they are likely to undertake a strategic default. Lenders do not. If lenders did, they could provide principal reduction to strategic defaulters, skip the costly foreclosure process, and come out ahead. But, that makes no sense for someone who will pay the mortgage anyway. So, lenders stick to the foreclosure process that looks inefficient after the fact.

But, even if lenders could tell the difference, there’s a good chance they would be hesitant to make modifications anyway. Recent studies indicate that homeowners are far more likely to strategically default if they know someone who has defaulted on their home. A spate of modifications could create a contagion: households that otherwise may not have defaulted on their loans will now become ‘strategic defaulters’ too.

So, if strategic defaults are not the dominant problem – only one-in-five in the Federal Reserve study were strategic – what is? Recent experience suggests that most defaults are driven by two factors: borrowers must have negative equity and experience a shock to household income, such as losing a job. If you want a broad-based anti-foreclosure policy, it should be jobs, jobs, jobs.

The bottom line is that principal reduction will fail as a foreclosure prevention policy and the government should stop trying to strong-arm servicers into a policy that is doomed to fail.

Douglas Holtz-Eakin is President of the American Action Forum