A lot can be said for getting to the bottom of things by not propping them up. It’s looking more and more like toxic mortgages have to be dealt with before things begin to improve on the lending so that liquidity will return:

According to new research, loan modifications without write-downs will not lead to the end to the credit crisis. There has been a tremendous amount of negative press about modifications because in many cases, the payments are not much less, with the additional fees and principal moved to the end of the term.

In a fascinating research paper by economists Patrick Bajari, Sean Chu and Minjung Park called Quantifying the triggers of subprime mortgage defaults that explores what drives borrowers to default on their mortgage.

First, default amounts to the exercise of a put option that limits the downside risk when the value of a house falls below the value of the mortgage. Thus, one strand of research has focused on how net equity or home prices affect default rates. Other studies have examined the importance of financial frictions; households may be liquidity-constrained and temporarily unable to pay, especially if they have low credit quality.

The two reasons are equal in their impact on default rates. Here’s their influence on default rates:

Based on the importance of illiquidity as a driver of default, the observed deterioration in borrower pool quality is consistent with the notion that lenders loosened their underwriting standards over time, perhaps due to flaws in the securitisation process. Because lenders do not hold mortgages that they have securitised, they do not bear the consequences of risky mortgages at the point in time when they go bad, even as they continue to generate income by originating such loans. This agency problem, coupled with the general underestimation of default risks by financial markets at the height of housing boom, gave primary lenders an incentive to lower their lending standards. Thus, a key policy implication is that future waves of default can be made less likely by measures that reduce originator moral hazard.

Write downs in principal, ie mark to market, will need to enter the recovery equation soon.

Because we find empirical importance for both illiquidity and net equity as drivers of default, this suggests that effectively mitigating foreclosures would require either some combination of policies targeting each cause, or a single instrument that targets both. For example, loan modifications that merely increase payment affordability by extending loan lengths would not be very effective as a standalone measure, as they would leave borrowers’ equity positions unchanged. On the other hand, write-downs on loan principal amounts would address both causes simultaneously, with the reduction in loan size serving both to increase the borrower’s net equity as well as reduce monthly payments.


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2 Responses to “[Housing RX] It’s The Principal Of It”

  1. Prof. Samuel D. Bornstein says:

    The 2 Ton Elephant in the Room

    There is much wisdom in the cliche.”You only see what you know”. Everyone is ignoring the “2 Ton Elephant in the Room”. Many agree that the contributing factor to most of our problems is the consumer’s lack of financial understanding. He is like a “Boat without a Paddle” when it comes to managing money and making money choices. It can be argued that this was the primary cause of the Subprime Mortgage Crisis which precipitated the Credit Crunch and our current economic woes.

    We have tried foreclosure moratoriums, loan modifications, bailouts, in the belief that these initiatives will save the Borrowers. The fact is that these measures have failed and are not working! These measures are only postponing the inevitable defaults. The evidence is that Re-default is occurring anyway at a rate of 60% within 6-8 months.

    Let’s finally address the real issue which requires developing a program of “Immediate and Specific Financial Guidance” to help the Borrower understand how to manage his financial affairs. This can and must be done, or we can expect to repeat these errors again and again. We need a more Financially Literate public in order to survive in this complex economic environment. It should be clear by now, that we are all in the same boat together. Our economy seems to be impacted by our individual financial decisions.

    bornsteinsong@aol.com

  2. Edd Gillespie says:

    I guess nobody likes ignorant borrowers, but who was it that lent the financially illiterate the money in the first place? Some equally financially illiterate banker or somebody who saw a chance to make a fast buck off dummies on both ends?
    Come on professor, underwriting designed to exploit the financially illiterate by bankers who lie to each other and the investors is the big elephant. By comparison yours is a peanut. In other words your cart is definitely in front of your horse. These financial guys had invented so many unregulated hot air derivatives that all it took was a hand full of sub prime dead beats to bring down the global economy? If it hadn’t happened due to sub-prime default on exotic loans it would have been when Ben Stein sneezed. It was going to happen. When a house of cards collapses its not really the fault of the guy who adds the last card.