Arnold Kling  

The Worst Solution to the Financial Crisis

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Unbent and Unbowed... Impossible Mission Commission...

Daniel Indiviglio reports on a chart from the Wall Street Journal that shows more than one quarter of mortgage loan modifications are redefaulting. He comments,


Re-default is a huge problem, because it means those homes should have just undergone foreclosure instead of modifying their underlying mortgages. After all, if those borrowers default again, the modification merely delayed the inevitable. This might indicate that the modification efforts are more focused on getting all troubled homeowners to modify, without really determining who can successfully manage those modification terms.

I've said from the very beginning that most cost-effective thing government can do is pay for moving vans to get these people out of the homes they should never have bought in the first place. The advocates of loan mods tend to be folks like Martin Feldstein, who have never held a job in mortgage servicing. The reality is that the borrowers often redefault, and the administrative costs of modifying a loan can be even higher than those of going through foreclosure.

All sorts of people tout loan mods as a win-win. The truth is that more often than not they are a lose-lose.


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COMMENTS (8 to date)
Milton Recht writes:

I agree mortgage modifications are ineffective, but there is always a base rate of foreclosures, even in better economic times.

It is unfair to say about these people, "out of the homes they should never have bought in the first place."

Unplanned adverse events do happen after a home purchase, such as illness, death of wage earner, divorce, job loss, etc. These income-lowering events often happen. In fact, medical expenses, divorces and job losses are major contributors to personal bankruptcies and have been for many years. Why shouldn't they also be major factors in home defaults?

While there are lots of anecdotes about subprime and no-doc lending, second home investment properties, etc., I have not seen any research on defaults producing a number showing the relative numbers of income qualified one-home owners who had unexpected income losses and those who were overextended at time of the purchase and mortgage loan.

I suspect even some of the two-home owners were those who purchased a second home to move and then got caught in the housing slow down and could not revert to single home ownership.

While I understand the human nature of wanting to believe that there are people and processes to blame for the current housing crisis, none of the easy theories (securitization, fraud, bad incentives, no skin in the game, capital arbitrage, credit rating agencies, etc.) really make any sense when thought about critically. They just are not capable of explaining the duration, the lending volume, the international aspects, the risk that investment bank restricted shares owners took to their wealth, and the lack of investment asset diversification in the financial industry, etc. They are weak attempts to explain the high supply of mortgage lending, but do nothing to explain the high demand for these loans. They are weak because in other times lenders raise their rates and cut off lending when it gets too heated. Likewise, in other times most borrowers do not continue to chase easy money for home purchases when they feel it can cause them financial harm and lenders find they cannot make mortgage loans in those periods.

A bubble mania does not adequately capture what happened because of the excessive degree of risk that both homeowners and financial institution took. When other bubbles occur, while there are many players who are caught up in the mania, a much smaller percentage actually is substantially at risk for most of their wealth. It was much more widespread this time. Too many players, both as homeowners and as lenders and investors, gambled too much of their wealth this time.

It will take a few years to sort out all the causes of this crisis, but it is certainly much more complicated than the common wisdom.

Jesse Blocher writes:

What do you think of Baker-Samwick (Owners stay on as renters, which as you've pointed out, they really were to begin with anyway).
Felix Salmon has been pushing this a lot.

Arnold Kling writes:

Jesse,
I think that the new owners of the houses should be able to do what they want with those houses. If they want to rent them out to the people who bought them and defaulted on their loans, fine. If not, fine. The defaulters are likely to become renters, but they can rent somewhere else. Keeping them in the same house saves moving costs, but it is administratively messy to enforce. I'd rather taxpayers eat the moving costs than pay the costs of keeping people in those houses.

Joe writes:

But, if close to 75% of the modificatiosn allow families to stay in their homes, and prevent the massive disruption to the family and the bank/mtg holder, that seems like a pretty good success rate.

If 75% of my propects came through, I would never have to make another sales call again...

Tom writes:

Arnold,

I do sympathize with your argument, but a 75% success rate is not too bad.

I don't believe modifications are nearly as costly as you think. As an anecdote, my original mortgage had a 7.8% rate. I shopped around as rates were going at 5.8%. My mortgage company found out by the inquiries to my credit report and sent me a letter to modify my loan to 6%. Had to sign an include one page document and all was done.

I'm not suggesting that these would be so simple, but surely would not cost the tens of thousands a foreclosure would cost. Add on top of that the price depression of dumping that many properties onto the market so quickly, the 25 percent re-default cost has got to be much cheaper.

Dan Weber writes:

Tom, it sounds like you're talking about a refinance. A modification generally means forgiving of principal.

If the bank could figure out which customers would default without a modification but will not with one, they would be great.

Colin K writes:

"But, if close to 75% of the modificatiosn allow families to stay in their homes, and prevent the massive disruption to the family and the bank/mtg holder, that seems like a pretty good success rate."

You can't predict the final score based on who's ahead at the end of the second inning.

The article talks about the modifications beginning in earnest six months ago (February) and it takes two months to become delinquent. So we're talking a whopping four months before a large percentage of people fell behind again. That seems pretty damning to me.

My question is, other than paperwork, what is the cost to the homeowner of a modification? Because if you're going to end up in foreclosure anyway, you might take the modification to get a couple more months even if you doubt you'll be able to do any better.

Walt French writes:

Let's be clear: what we sensibly THINK OF as a modification, and what ACTUALLY IS in many cases a mod, can be completely different.

Many mods are merely a sanctioned acknowledgement that payments were missed, but the lender will forbear their right to declare a default. The "modified" agreement has the identical terms going forward, with NO changed payment schedule, etc. Why? The bank gains the option that the borrower MIGHT recover and keep paying, and pays only today's low, low interest rates on whatever they'll recover from a foreclosure sale.

OF COURSE such "modified" loans re-default with high frequency. They do not address the cause of the fault, nor offer a meaningful way that the borrower can work his way out of a temporary glitch.

And so making Intellectual Pronouncements based on such flimsy evidence, or trying to gauge the economy from the statistics is a waste of everybody's time. Many bloggers aren't embarrassed by this sort of thing, and commenters like myself less so, but we should admit the emptiness of the exercise.

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