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Mayer et al on Perverse Incentives from Mortgage Modification

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Incentives Matter

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.

In a difference-in-difference framework, we estimate the percentage increase in defaults among Countrywide borrowers during the months immediately following the Settlement announcement relative to the percentage increase during the same period among comparable borrowers who were unaffected by the Settlement because their loans were not serviced by Countrywide (the "Control Group"). In regressions controlling for many borrower attributes, including current credit scores and indebtedness, we find a thirteen percent increase in the overall probability that Countrywide 2/28 ARMs loans roll straight from current to sixty days delinquent during the three months immediately after the Settlement announcement (relative to a control group of loans with non-Countrywide servicers). The effect of the Settlement rises to over twenty percent when we subset on borrowers with (i) greater access to liquidity through credit cards and (ii) lower current combined loan-to-value (CLTV) ratios. These borrowers were arguably less likely to default in the near term because they had significant untapped liquidity through their credit cards or some positive equity in their homes.

We also find no effect of the Settlement on default rates among subprime Countrywide borrowers with respect to debts (credit cards, second mortgages) that were not targeted by the Settlement. In fact, Countrywide borrowers exhibit a very large increase in the likelihood of being delinquent on their first mortgage while remaining current on other debts relative to the control group.

The full study is at Christopher J. Mayer, Edward Morrison, Tomasz Piskorski, and Arpit Gupta, "Mortgage Modification and Strategic Behavior: Evidence from a Legal Settlement with Countrywide," NBER Working Paper No. 17065, May 2011.

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COMMENTS (2 to date)
Josh writes:

The current system of incentivizing borrowers to go delinquent in their mortgages in order to get relief on their existing mortgage is contradictory to the values we should be upholding and seems perverse to reward individuals for falling behind in their mortgage. Now I’m probably speaking more towards those that are looking at the decision from an investment perspective rather than an individual experiencing a forced financial hardship situation. I have had several clients that are faced with the dilemma involving this issue. Should they honor the contract they originally signed to continue paying on the mortgage on a property that is so deep under water that they likely won’t see any equity in their property for ten years or should they look at it from a purely investment standpoint and discontinue throwing good money after bad by going into default on the mortgage through nonpayment. In order to receive any consideration for a mortgage modification from the loan servicer, in most instances, the borrower must be delinquent on his mortgage for a period of 60 days. The loan servicers, based on my understanding, are not permitted to provide any remedy to the mortgage unless the borrower is in default under FHA rules. Why should they if the borrower is current in making his or her payments? It is a difficult predicament, and I can see both sides of this argument.
As one who favors less government, my preference would be to see business and contractual obligations run their course as they always have under our legal commerce system. Those who default on their mortgages lose the property to foreclosure and the property gets relisted for another buyer. This would consequently create deeper losses in the real estate market but it would cleanse the market of all of the artificial manipulation created by government policies and intervention. We would be on the road to reaching market equilibrium where supply meets demand and the real estate market could begin a course of natural growth. Government intervention in our lending programs has created an artifice that is acting as a price floor. The quantity of houses supplied far exceeds the quantity demanded and this is preventing prices from lowering to meet the equilibrium point where supply and demand harmonize and market conditions have the potential to grow in a healthy government. The feds involvement in foreclosure prevention is hampering the capitulation that needs to occur in the real estate market. Ultimately prices need to settle and from my viewpoint we’re merely delaying the inevitable.

Eric Falkenstein writes:

Interestingly, our Fed chief has been absolutely, 100% certain that initiatives to increase home ownership by targeted historically disadvantaged communities had nothing to do with the crisis. If our biggest, and frankly, smartest, regulator can maintain this kind of cognitive dissonance, why should we expect any fixes to help?

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