I've written a few times that principal reductions are necessary to have any meaningful success fighting foreclosures. While this has been shown indirectly by the failing efforts of other means of modifying mortgages, it would be nice to see some historical data supporting this claim. As it turns out, University of Chicago professor Casey Mulligan identifies exactly that in a NY Times Economix post today. He uses a study on the Great Depression to show that with more skin in the game, consumers care much more about defaulting on their property and possessions.
Here's the gist of his explanation, based on a 1999 study by UC Berkley Professor Martha Olney:
In the 1920s, it was common for families to purchase automobiles, refrigerators, stoves, and other consumer durables with "installment debt": that is, they made a down payment of about one-third, took the item home immediately, and promised to make regular payments until the item was fully paid. If the borrower failed to make his payments -- even the last one -- the item he purchased could be repossessed and he would receive no refund of his prior payments.
In other words, absent the destruction of the item purchased, it was impossible to be "underwater" on the typical installment debt contract of those days, and thus there was no incentive to strategically default.
Professor Olney found that defaults on such contracts were rare in the early 1930s: "Despite the layoffs, the wage cuts, and the unprecedented prevalence of installment credit use, families with installment debt were avoiding default" (pp. 321-2).
Later in the Great Depression, the rules for repossessing consumer durables changed, and consumers had to be given a refund of part of the payments they made prior to default. The incentive to repay installment debt fell, and Professor Olney found delinquencies and defaults on installment debt to rise.
And of course, this makes perfect sense. When people have something to lose, they care more about losing it. Obviously, right? So Mulligan worries about the problem of strategic defaults -- a term commonly used these days to explain foreclosures resulting from underwater homeowners deciding it's pointless to pay a mortgage balance higher than their home's value. He then points to the failed government mortgage modification efforts and says principal reduction -- not affordability -- should be used to ensure success in foreclosure prevention:
Many people who lost their jobs in the 1930s still made their debt payments, as long as they had an incentive to do. Today homeowners with negative equity have little financial incentive to make their payments. By focusing so much on "affordability," the Obama adminstration's latest policies do little to prevent strategic default, and should not be expected to alleviate the foreclosure crisis.
If I read this last Thursday, I would have agreed wholeheartedly. But, in fact, on Friday, the administration announced broad changes to their mortgage modification program which would stress principal write-downs. So either his piece was written last week but just posted today, or he missed that news.
But, in fact, Friday's changes specifically address this concern. While affordability still matters, the administration is providing banks with a solid incentive to lean towards principal reduction, instead of just lowering interest rates or extending terms. If banks write down more mortgage principal, then that could, indeed, prevent more foreclosures. Even though many borrowers still won't have positive equity for several years, being far less underwater could convince them that the house is worth keeping.
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