Progress of the Making Home Affordable Program: What Are the Outcomes for Homeowners and What Are the Obstacles to Success?


Subcommittee Chair Waters, Ranking Member Capito, anddistinguished members of the Subcommittee, I thank you for theinvitation to appear at today’s important hearing. I am MarkCalabria, Director of Financial Regulation Studies at the CatoInstitute, a nonprofit, non‐​partisan public policy researchinstitute located here in Washington. Before I begin my testimony,I would like to make clear that my comments are solely my own anddo not represent any official policy positions of the CatoInstitute. In addition, outside of my interest as a citizen and ataxpayer, I have no direct financial interest in the subject matterbefore the subcommittee today, nor do I represent any entities thatdo.

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 reset, 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.

What could reduce the level offoreclosures?

The high level of foreclosures has left many policymakers andmuch of the public understandably frustrated and searching foranswers. To be effective, those answers must be grounded in solidand unbiased analysis. In order to gauge the success of any federalefforts, we must also establish a reasonable baseline. I stronglyencourage both Congress and the Administration to present detailedestimates of how many foreclosures are driven by which primarycauses and how many of those foreclosures can be reasonablyavoided.

Before discussing specific policy proposals, Congress shouldbear in mind that as approximately 50 percent of foreclosures arecurrently driven by job loss, the most significant way to reduceforeclosures is to foster an environment that is conducive toprivate sector job creation. Accordingly, the worst thing Congresscan do is to insert uncertainty into the job market, pushingemployers to the sides‐​lines.

In addition to focusing on owners currently in foreclosure,efforts can also be made to reach families before they fall behindon their obligation. For instance, approximately 4 million jobshave been lost in “mass lay‐​offs” since the beginning of thecurrent recession. Mass lay‐​offs represent a double shock tohouseholds: the loss of a job along with a shock to the localhousing market as the result of a major employer downsizing. Asdamaging as mass lay‐​offs can be, they do have one advantage — weknow about them ahead of time, as the Department of Labor (DoL)collects data on mass lay‐​offs and workers must be given notice ofsuch. Despite the strong connection between mass layoffs andforeclosures, there is almost no coordination between DoL and HUD(or the many non‐​profit organizations providing housingassistance). DoL and HUD should partner in an effort to providecurrently appropriated housing counseling funds to workers whenthey receive a notice of mass lay‐​off.

Congress can also encourage bank regulators to give lenders moreflexibility to lease out foreclosed homes to the current residents.Typically banks come under considerable pressure from theirregulators not to engage in long term property leasing ormanagement, as that activity is not considered a core function ofbanks. I believe we can avoid the larger debate of banks beingproperty managers by giving banks greater flexibility in retainingproperties with non‐​performing mortgages as rentals, preferably tocurrent residents. In addition to many owners who may wish to stayin their homes as renters, approximately 20 percent of foreclosuresoccur on renter‐​occupied investment properties. If current renterscan continue to make their rent, many banks may prefer to keepthose renters rather than proceed to a foreclosure sale.

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. All federalmodification programs should also include strong recourseprovisions. We should make every effort to turn away from becominga society where legally incurred debts are no longer obligations tobe honored but simply options to be exercised.

Lastly, Congress and the Administration should focus resourceson those households most in need, who but for anintervention, would lose their home. Programs aimed at householdswho are not facing foreclosure, but simply cannot re‐​finance due tobeing “underwater” on their mortgage should be ended. Theseprograms draw off limited lenders/​servicer resources that shouldinstead focus on at‐​need families.


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. I thankyou for your attention and welcome your 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 Housing and Community Opportunity
Committee on Financial Services
The United States House of Representatives