Home Foreclosures: Will Voluntary Mortgage Modifications Help Families Save Their Homes?


Chairman Conyers, Ranking Member Smith, Subcommittee ChairmanCohen, Ranking Member Franks, and distinguished members of theSubcommittee, I thank you for the invitation to appear at today'simportant hearing. I am Mark Calabria, Director of FinancialRegulation Studies at the Cato Institute, a nonprofit, non-partisanpublic policy research institute located here in Washington. BeforeI begin my testimony, I would like to make clear that my commentsare solely my own and do not represent any official policypositions of the Cato Institute. In addition, outside of myinterest as a citizen and a taxpayer, I have no direct financialinterest in the subject matter before the subcommittee today, nordo I represent any entities that do.

My testimony today will address two specific questions. Thefirst is: why have the Obama and Bush Administration efforts, alongwith those of the mortgage industry, to reduce foreclosures had solittle impact on the overall foreclosure numbers?

The second question is: given what we know about why previousefforts have had such little impact, what are our policyoptions?

In answering both these questions, I rely on an extensive bodyof academic literature, the vast majority of which has beensubjected to peer review, which has examined the determinates ofmortgage delinquency and default. Foremost among this literature isa series of recent papers written by economists at the FederalReserve Banks of Boston and Atlanta, in particular the work of PaulWillen, Christopher Foote and Kristopher Gerardi. My testimony owesa considerable intellectual debt to this research.

Why haven't previous efforts stemmed the foreclosuretide?

The short answer to why previous federal efforts to stem thecurrent tide of foreclosures have largely failed is that suchefforts have grossly misdiagnosed the causes of mortgage defaults.An implicit assumption behind former Treasury Secretary Paulson'sHOPE NOW, FDIC Chair Sheila Bair's IndyMac model, and the ObamaAdministration's current foreclosure efforts is that the currentwave of foreclosures is almost exclusively the result of predatorylending practices and "exploding" adjustable rate mortgages, wherelarge payment shocks upon the rate re-set cause mortgage payment tobecome "unaffordable."

The simple truth is that the vast majority of mortgage defaultsare being driven by the same factors that have always drivenmortgage defaults: generally a negative equity position on the partof the homeowner coupled with a life event that results in asubstantial shock to their income, most often a job loss orreduction in earnings. Until both of these components,negative equity and a negative income shock are addressed,foreclosures will remain at highly elevated levels.

Given that I am challenging the dominant narrative of themortgage crisis, it is reasonable to ask for more than mereassertions. First, if payment shock alone were the dominate driverof defaults then we would observe most defaults occurring aroundthe time of re-set, specifically just after the re-set. Yet this isnot what has been observed. Analysis by several researchers hasfound that on loans with re-set features that have defaulted, thevast majority of defaults occurred long before the re-set. Ofcourse some will argue that this is due to such loans being"unaffordable" from the time of origination. Yet according tostatistical analysis done at the Boston Federal Reserve, theborrower's initial debt-to-income (DTI) had almost no predictivepower in terms of forecasting subsequent default.

Additionally if payment shock was the driver of default, thefixed rate mortgages without any payment shocks would displaydefault patterns significantly below that of adjustable ratemortgages. When one controls for owner equity and credit score, thedifferences in performance between these different mortgageproducts largely disappears. To further illustrate this point,consider that those mortgages generally considered among the"safest" - mortgages insured by the Federal Housing Administration(FHA), which are almost exclusively fixed rate with no-prepaymentpenalties and substantial borrower protections, perform, on anapples to apples basis, as badly as the subprime market in terms ofdelinquencies.

The important shared characteristic of FHA and most of thesubprime market is the widespread presence of zero or very littleequity in the mortgage at origination. The characteristics of zeroor negative equity also explain the poor performance of mostsubprime adjustable rate mortgages. Many of these loans also hadlittle or no equity upon origination, providing the borrower withlittle equity cushion when prices fell. Recognizing the criticalrole of negative equity of course raises the difficult question asto what exactly it is that homeowners are losing in the event of aforeclosure.

"Unnecessary" foreclosures

Central to the arguments calling for greater governmentinvention in the mortgage market is that many, if not most, of theforeclosures being witnessed are "unnecessary" or avoidable.Generally it is argued that investors and loan servicers do notface the same incentives and that in many cases in would be betterfor the investor if the loan were modified, rather than taken toforeclosure, but still the servicer takes the loan toforeclosure.

The principal flaw in this argument is it ignores the costs tothe lender of modifying loans that would have continued payingotherwise. Ex Ante, a lender has no way of separating the trulytroubled borrowers, who would default, from those that would takeadvantage of the system, if they knew they could get a modificationjust by calling. As long as potentially defaulting borrowers remaina low percentage of all borrowers, as they are today, it is in thebest interest of the investor to reject many modifications thatmight make sense ex post. In addition, lenders may institutevarious mechanisms to help distinguish troubled borrowers fromthose looking to game the system.

It is also claimed that the process of securization has driven awedge between the interests of investors and servicers, with theimplication that servicers would be happy to modify, and investorswould prefer modifications, but that the pooling and servicingagreements preclude modifications or that servicers fear being suedby investors. The first fact that should question this assumptionis the finding by Boston Fed researchers that there is littledifference in modification rates between loans held in portfolioversus those held in securitized pools. There is also littleevidence that pooling and servicing agreements preclude positivevalue modifications. According to recent Credit Suisse report, lessthan 10 percent of agreements disallowed any modifications. Whilethe Congressional Oversight Panel for the TARP has been critical ofindustry efforts, even that Panel has found that among the sampleof pools it examined with a 5-percent cap on the number ofmodifications, none of the pools examined had actually reached thatcap. If few pools have reached the cap, it would seem obvious thatthe 5 percent cap is not a binding constraint on modifications. Inmany instances the pooling agreements also require the servicer toact as if the servicer held the whole loan in its portfolio,raising substantial doubts as the validity of the "tranche warfare"theory of modifications.

A careful review of the evidence provides little support for thenotion that high transaction costs or a misalignment of incentivesis driving lenders to make foreclosures that are not in theireconomic interest. Since lenders have no way to separate troubledborrowers from those gaming the system, some positive level ofnegative value foreclosures will be profit-maximizing in theaggregate.

Is cramdown the answer?

The high level of foreclosures has left many policymakers andmuch of the public understandably frustrated and searching foranswers. One "solution" that has been regularly presented is toallow bankruptcy judges to reduce the principle balance of amortgage loan to reflect the reduced value of the home, theso-called "cramdown." For a variety of reasons, I believe allowingcramdowns would have adverse market consequences while alsoproviding little real relief to borrowers.

Given the unemployment-driven nature of most foreclosures, andthe inability of unemployed individuals to put forth a repaymentplan under Chapter 13 of the bankruptcy code, it appears thatcramdowns would do nothing for those most in need, theunemployed.

As proponents of cramdowns point out, vacation and investmentproperties can currently be subjected to cramdown. This raises thequestion: why aren't the significant number of foreclosuresinvolving investment properties being resolved via bankruptcyrather than the foreclosure process? The most likely reason is thatproperty speculators realize that even a reduced mortgage value islikely to exceed the home value in the near future. With homeprices still declining, a crammed down mortgage would be underwaterin few months. The incentive facing most speculators is often tosimply walk away and let the home fall into foreclosure. This wouldnot be a significant problem if investment properties did notconstitute approximately 40 percent of current foreclosures.

At this point, it is worth reflecting on these two points:cramdowns do little or nothing to help the unemployed andspeculators can already pursue that route, but largely choose notto, as it isn't in their economic interest. With speculators makingup about 40 percent of foreclosures, and the unemployed likelymaking up to around 50 percent, it becomes apparent that at minimumcramdowns will do little to help at least 90 percent of borrowerscurrently in foreclosure.

The main function of a cramdown would be to serve as reductionin outstanding principle, thereby lowering the monthly payment.Even significant payment reductions may not offer long-termsolutions. According to the most recent OTS/OCC mortgage metricsreport, of those delinquent borrowers seeing a payment reduction of20 percent or more 37.6 percent were again delinquent twelve monthslater. Continuingly re-modifying the same loan is not a solutionfor the borrower, investor, or lender.

We often use the term "speculator" to refer to purchasers that donot intend to live in the home and often quickly "flip" the home tomake a quick profit. That definition is useful, but far too narrow.Many borrowers purchasing a home for occupancy did not do so solelyfor the consumption benefits of homeownership, but also for theinvestment returns. They were both consumers and speculators. Asthese speculators were generally not offering to share potentialgains with their lenders, it is not clear why they should beallowed to share their losses.

Of the remaining borrowers, who were neither pure speculatorsnor unemployed, many of these borrowers invested little of theirown cash in the home purchase. Once again, the empirical evidencedemonstrates that minimal or zero downpayments on the part ofborrowers are the leading mortgage characteristic in terms ofpredicting default. If borrowers, who have placed no money of theirown at risk, are allowed to reduce their losses via cramdown, whilealso reaping any future appreciation, we are only encouragingfuture speculation in our housing markets. We should not actsurprised if the next housing cycle of bubble and bust is evenworst than the most recent.

Proponents of cramdown have also misrepresented the treatment ofvacation homes and investor properties during a Chapter 13bankruptcy. While the current Bankruptcy Code does allows secureddebts other than those secured by a principal residence to becrammed down; if they are crammed down, the debtor is required topay off the entire amount of the secured claim within thethree-to-five year duration of the Chapter 13 plan. The debtor doesnot have 30 years to pay off a modified mortgage as the originalloan term may provide. The borrower in these instances is requiredto pay the entire amount of the secured mortgage by the end oftheir payment plan. This is one of the reasons many owners ofinvestment choose to walk way rather than seek bankruptcyprotection.

Cramdown is often presented as simply a way to put pressure onlenders to negotiate, or to "bring them to the table." It is nomore appropriate, in a free society, to use the coercive stick ofthe state to bring lenders to the table, than it would be to usethat stick to bring borrowers to the table. A government focused onthe common good, the general welfare, does not choose sides inprivate disputes.

Less tangible, but perhaps more important in the cramdown debateis the message it sends to market participants, particularlyinvestors. It has long been established in law, and in common sensefor that matter, that the body of law relevant to and existing atthe time of a contract enters into and comprises part of thatcontract. To change by legislative fiat the terms of contracts thathave already been agreed to is to change the contract itself. Ifear if the cramdown were to become law, we send a signal that anyprivate agreement is subject to being re-written depending on whichway the political winds are blowing. This is a sure recipe toreduce investment and the overall reliance of market participantson contract. In order to rebuild public trust in both our marketsand our government, I believe Congress should affirm its own trustin the voluntary decisions of private parties. To do otherwise isto weaken the very bonds that make a free and civilized societypossible.

In speaking of investors, it is also important to remember thatcramdown is not simply an issue of taking from lenders and givingto borrowers. As bad as that would be, it is made all the worse asthe ultimate investors in mortgage related assets that will sufferlosses rather than the largest banks. As the largest banks aremostly just servicers and not the ultimate investor, they will passalong any losses from cramdown to investors. As we have seen in therecent auto restructuring, often these investors are not largecorporations or wealthy individuals; they are pension fundsrepresenting the retirement savings of millions, usually retiredstate and local government employees. I have yet to hear acompelling reason why retired teachers and firefighters should beforced to bear the burden of irresponsible borrowing andlending.

Non-coercive solutions

I am concerned that inherent in the title of this afternoon'shearing is the assumption that if voluntary modifications are notworking, we must look to coercive solutions. The force of the Statemust be applied to those unwilling to see the light. Thisassumption should trouble anyone who values a free society. I urgeCongress to look for only those solutions that are voluntary.

Some voluntary alternatives to consider: encouraging bankregulators to give lenders more flexibility to lease out foreclosedhomes to the current residents. Typically banks come underconsiderable pressure from their regulators not to engage in longterm property leasing or management, as that activity is notconsidered a core function of banks. I believe we can avoid thelarger debate of banks being property managers by giving banksgreater flexibility in retaining properties with non-performingmortgages as rentals, preferably to current residents.

In order to separate out deserving borrowers, who are trying toget back on their feet, from those simply walking away from a badinvestment, Federal lending entities, such as FHA and the GSEs,should engage in aggressive recourse against delinquent borrowerswho have the ability to pay, but simply choose not too. We shouldmake every effort to turn away from becoming a society wherelegally incurred debts are no longer obligations to be honored butsimply options to be exercised.


In concluding my testimony, I again wish to strongly state: thecurrent foreclosure relief efforts have largely been unsuccessfulbecause they have misidentified the underlying causes of mortgagedefault. It is not exploding ARMs or predatory lending that drivesthe current wave of foreclosures, but negative equity driven byhouse prices declines coupled with adverse income shocks that arethe main driver of defaults on primary residences. Defaults onspeculative properties continue to represent a large share offoreclosures. Accordingly for any plan to be successful it mustaddress both negative equity and reductions in earnings. Cramdownfails on both accounts. I thank you for your attention and welcomeyour questions.

Primary References:

Foote, Gerardi, Goette and Willen (2009) "Reducing Foreclosures:No Easy Answers," National Bureau of Economic Research workingpaper 15063.

Cordell, L., K. Dynan, A. Lehnert, N. Liang, and E. Mauskopf(2008). The Incentives of Mortgage Servicers: Myths and Realities.Finance and Economics Discussion Series, Federal Reserve Board46.

Foote, C., K. Gerardi, L. Goette, and P. S. Willen (2008). Justthe facts: An initial analysis of subprime's role in the housingcrisis. Journal of Housing Economics 17 (4).

Foote, C., K. Gerardi, and P. Willen (2008). Negative equity andforeclosure: Theory and evidence. Journal of UrbanEconomics 6 (2), 234-245.

Gerardi, K., A. Shapiro, and P. Willen (2007). Subprimeoutcomes: Risky mortgages, homeownership experiences, andforeclosures. Federal Reserve Bank of Boston Working Paper07-15.

Hunt, J. (2009). What do subprime securitization contractsactually say about loan modification. Berkeley Center for Law,Business and the Economy.

Kau, J. B., D. C. Keenan, and T. Kim (1994). Defaultprobabilities for mortgages. Journal of Urban Economics 35(3), 278-296.

Sherlund, S. (2008). The past, present, and future of subprimemortgages. Finance and Economics Discussion Series 2008-63, FederalReserve Board.

Mark A. Calabria

Subcommittee on Commercial and Administrative Law
Committee on the Judiciary
The United States House of Representatives