One flaw in this is a misreading of the underlying economic theory: we shouldn’t automatically assume that borrowers with negative equity will always default. What if there are two borrowers owingrn$150,000; and one prefers not to default and eventually pays off the loan.  If both loans are written down the lenderrnwill collect $190,000 ($95,000 from each borrower) but if the lender doesrnnothing it will eventually collect $50K from a foreclosure and the fullrn$150,000 from the non-defaulting homeowner. rn   </p

So, the optimal policy is to offer principal reduction to one borrowerrnand not the other. This requires the lender to perfectly identify the borrowerrnwho will pay and the borrower who won’t. “Given that there is a $55,000rnprincipal reduction at stake here, the borrower who intends to repay has arnstrong incentive to make him- or herself look like the borrower who won’t!”rn</p

The authors say this identification issue is a problem oftenrnencountered with public policy as planners need to implement the policy beforernthey know the need and that always raises the cost.  While they were initially supportive ofrnprincipal-reduction plans, they began to have doubts when they could find nornevidence that any lender was actually reducing principal. This was widelyrnblamed on legal issues related to mortgage securitization, but the incidence ofrnprincipal reduction was so low that it was clear that securitization alonerncould not be even a significant part of the problem. </p

The three economists who published this commentary say they are not ignoring research that indicates negative equity asrnthe best predictor of foreclosure; indeed they are responsible for some of it.  However what the research does not show isrnthat not all people with negative equity will lose their homes, just are morernlikely to do so.  They liken it to thernrelationship between cholesterol and heart attacks – the former dramaticallyrnincreases the incidence of the latter but the majority of people with highrncholesterol do not have heart attacks, in the short or long term. </p

The highest risk loans – those made to borrowers with problematicrncredit and little equity to begin with and located in areas with dramatic pricerndeclines, are quite rare now, most have already defaulted and beenrnforeclosed.  In addition, the principalrnreductions required to give such borrowers positive equity are so large thatrnthe $20-25 billion figure mentioned in the rumored program would prevent toornfew foreclosures to make more than a small dent in the problem.</p

Ultimately the reason principal reduction doesn’t work is whatrneconomists call asymmetric information: only the borrowers have all therninformation about whether they really can or want to repay their mortgages. Onlyrnif lenders really knew exactly who was going to default and who wasn’t, could allrnforeclosures be profitably prevented using principal reduction. </p

It also must not be ignored that borrowers often control the variablesrnthat lenders use to identify likely defaulting borrowers. For example manyrnprograms require borrowers to be delinquent to get assistance.  This seems logical – we want to help thosernwho actually need help – but it is tempting for a borrower to miss a couple ofrnpayments to qualify for a generous reduction in debt. </p

The article concludes that the argument for principal reduction dependsrnon superhuman levels of foresight among lenders as well as honest behavior byrnthe borrowers who do not need assistance. rn  The limited success of existing modificationrnprograms should make us question the validity of these assumptions. “Therernare likely good reasons for the lack of principal reduction efforts on the partrnof lenders thus far in this crisis that are related to the above discussion, sornthe claim that such efforts constitute a win-win solution should, at the veryrnleast, be met with a healthy dose of skepticism by policymakers.” </p

From MND’s point of view, this tells us a few things. The major observation we take away from this research is there must be an open line of communication between borrowers and loan servicers/lenders. Second, it implies the road ahead for housing will be long and rocky. It’s going to take focused attention from specialized loss mitigation counselors to determine the fate of each delinquent loan and underwater mortgage. That will take much time and energy. </p

Special Servicers More Motivated to Mitigate Housing Losses

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