Mortgage Modification Program Encourages Default

One often hears frustrated citizens asking why the bank won't write down the principal on underwater mortgages, when after all it's better for the bank to get something than to foreclose.

This is why:

Christopher J. Mayer, Edward Morrison, Tomasz Pikorski, and Arpit Gupta of Columbia University (variously Business School and Law School) find that a mortgage modification program that Countrywide Financial agreed to implement as part of a settlement with U.S. state attorneys general caused more people to become delinquent. Give people an incentive not to pay their mortgage and some of them will decide--not to pay their mortgage.

A lot of advocates have tried to frame principal mods as a "win- that makes the bank and the borrower better off.  But of course, if you modify principal for some borrowers, other borrowers will default in the hopes of getting the same deal.  If the rate is high, the savings on mortgage modifications need to be pretty spectacular to make the math work.  And the rate was pretty high--13-20% higher, which is impressive considering that the program wasn't too well publicized, and most people probably don't pay too much attention to the name of their mortgage servicer.  Plus as far as I can tell, these modifications didn't even involve principal reductions, just interest rate fixes; principal reductions should make delinquency and modification even more attractive.

Now, maybe you think we should do mortgage modifications anyway; there are arguments for it. But it's not going to be win-win.