Three years after the US housing bubble burst, mortgage default is still a headline issue. Apart of the economic waste and personal losses, defaults and foreclosures can ruin neighbourhoods. Foreclosure often results in vandalism, disinvestment, and other negative spillover effects in the neighbourhood (Lin et al. 2009). Both the lender and borrower often lose – foreclosure is a negative-sum game. To tackle the problem, however, we have to understand the underlying individual motives.
Why do homeowners default on mortgages?
The traditional belief is that homeowners will always make a mortgage payment if they are able to. Therefore, they will only default if they have no choice. They are simply unable to make the payments because of insufficient net income.
This thinking means that most attempts to prevent default (e.g. the Home Affordable Modification Program) aim to reduce the homeowner’s expenses. However, recent evidence (Deng et al. 2000, Bajari et al. 2008, Guiso et al. 2009, Bhutta et al. 2010, and Elul et al. 2010) finds that the homeowner’s balance sheet is a significant driver of default.
Many defaults are voluntary – homeowners can in fact afford the payment but make a rational choice to default, because the value of the mortgage substantially exceeds the value of their home. Such “strategic default” is widespread and growing. Guiso et al. (2009) estimate that 30% of existing defaults are strategic. Currently, 14 million US homes suffer from negative equity, and this is projected to rise to 20 million by the end of 2010.
Addressing strategic defaults
The strategic default view implies a shift in thinking about how to prevent defaults, along two main lines. First, since default is a discretionary, rational decision made by the homeowner, an effective solution must provide incentives for the homeowner to choose not to default, rather than welfare to enable him to make payments. Second, since this decision to default is driven by negative equity rather than the loan’s affordability, the solution must target the homeowner’s balance sheet rather than income.
Principal-agent theory suggests that optimal incentive design should involve a performance measure that is easily measurable and verifiable, closely tied to the principal’s objective, and under the agent’s control. Moreover, two additional criteria are also important for the specific setting of mortgage defaults.
- First, the programme must be scalable.
A programme should be able to be rolled out to a large number of loans at little cost, avoiding the high expense of loan modifications, and without relying on mortgage servicers that are already under extreme pressure due to the crisis. In addition to being scalable across a large number of loans, a programme should also be implementable across different types of loans: securitised loans as well as whole loans, and loans on second homes, vacation homes and investor-owned homes in addition to primary residences.
- Second, the plan must be politically acceptable.
In particular, a programme that is only open to delinquent homeowners may be seen to unfairly punish those who remain current (see White 2010), and may lead to moral hazard whereby homeowners take less care to avoid delinquency in the future, or even deliberately become delinquent in order to qualify for help.
A new private programme
This is not another case of a brilliant but other-worldly solution – the idea is actually being used. It is currently being implementing via an incentive programme that aims to satisfy all of the above criteria through the operating company Loan Value Group, LLC (in which I have an ownership stake). This programme is called the Responsible Homeowner Reward and is being implemented in 45 states, plus Puerto Rico and the District of Columbia. Here’s how it works.
Responsible Homeowner Reward is a cash amount (of say, 10% of the mortgage) which is released to the homeowner only when the mortgage is repaid, and it is forfeited upon delinquency or the discovery of fraud. The value of the reward can grow over time, and each month the homeowner receives a statement showing the most recent value of their reward account.
Responsible Homeowner Reward intends to address all of the above criteria for an efficient incentive plan. It targets the homeowner’s balance sheet – the primary driver of strategic default, the prevention of which is the principal’s objective. It rewards the homeowner only if the loan is repaid. This contrasts with income-based measures (such as coupon reductions) that benefit households who still end up eventually defaulting. The programme is simple. The rules of Responsible Homeowner Reward are unambiguous, so the homeowner knows what he or she needs to do to receive the reward.
What of the alternatives?
An alternative way to repair the homeowner’s balance sheet is to reduce the loan principal (principal forgiveness). Responsible Homeowner Reward has several advantages over this alternative solution. Most importantly, it does not require modification of the existing loan – it is a separate entity altogether. This has several advantages.
- First, it is substantially cheaper and faster, and does not require the involvement of existing servicers. In addition, a modification requires homeowners to disclose new information and sign affidavits verifying it, which often deters homeowners from accepting the modification. Responsible Homeowner Reward involves no new legal contract, no re-underwriting process, and it is much easier for the homeowner to understand and accept.
- Second, Responsible Homeowner Reward can easily be applied to both whole loans and securitised loans. In contrast, there are significant legal hurdles to modifying securitised loans given the existence of multiple parties; indeed, Piskorski, Seru and Vig (2010) find that securitisation is a significant impediment to loan renegotiation.
- Third, a principal reduction triggers a full and immediate accounting charge to the lender.
- Fourth, a principal reduction is irreversible and cannot be subsequently “clawed back” for those who redefault or had committed fraud (e.g. when applying for the principal reduction).
Moreover, the behavioural effects of Responsible Homeowner Reward are likely to be significantly more powerful, for a number of reasons.
- First, the reward is salient: the homeowner is reminded each month of the reward when he receives the monthly statement, while a principal reduction is a one-time event which may be subsequently forgotten.
- Second, due to narrow framing, a $200,000 loan and a $20,000 reward is different from a $180,000 loan. In particular, the $20,000 reward is not “netted” against the loan but viewed as a separate, performance-contingent incentive. Thus, the amount of the Responsible Homeowner Reward may be compared not to the value of the loan, but the homeowner’s income. While a $20,000 Responsible Homeowner Reward is only 10% of the total mortgage, it is likely to be large relative to income and thus have a strong incentive effect, similar to a $20,000 bonus at work. Prospect theory implies that giving the homeowner a $20,000 reward has a stronger effect than reducing his mortgage from $200,000 to $180,000, because a creation of a gain is more powerful than the reduction of a large loss. The endowment effect suggests that individuals are particularly motivated by the danger of losing an asset that they already have. Hossain and List (2009) find that giving an employee a conditional bonus, which is forfeited if productivity falls below a threshold, has a significantly stronger effect on productivity than promising a bonus if productivity rises above a threshold. Here, a homeowner endowed with a Responsible Homeowner Reward is likely to attach a particularly high value to it and ensure that he does not subsequently lose it by defaulting.
Note that RH Reward bears some similarities to the idea of compensating CEOs with “inside debt”, which has garnered recent attention (Edmans 2010). In our setting, the homeowner is the equity owner equivalent to the CEO, the lender is the debtholder, and strategic default is a negative-NPV action (due its deadweight costs) that transfers wealth from debtholders to equityholders. The Responsible Homeowner Reward is a debt-like security that only pays off if the lender is repaid in full and forfeited upon default. Thus, it aligns the homeowner with the lender and deters him from taking actions to harm the lender, such as strategic default.
We are currently implementing $86 million of Responsible Homeowner Rewards through the operating company Loan Value Group, LLC. The reward providers are private-sector owners of mortgage risk. The reward does not require government intervention or taxpayer money: by saving the deadweight costs of strategic default, it aims to create total surplus which can be shared by both the homeowner and lender, and thus both parties adopt it willingly. We hope to report on the results of the programme in future.
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Bebchuk, Lucian and Holger Spamann (2010), “Regulating Bankers’ Pay”, Georgetown Law Journal, 98: 247-287.
Bhutta, Neil, Jane Dokko, and Hui Shan (2009), “How Low Will You Go? The Depth of Negative Equity and Mortgage Default Decisions”, Working Paper, Federal Reserve Board of Governors.
Deng, Yongheng, John M. Quigley, and Robert Van Order (2000), “Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options”, Econometrica 68:275-307.
Edmans, Alex (2010), “New thinking on executive compensation: Pay CEOs with debt”, VoxEU.org, 13 July.
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Guiso, Luigi, Paola Sapienza and Luigi Zingales (2009), “Moral and Social Constraints to Strategic Default on Mortgages”, Working Paper, European University Institute.
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