The Fallacy Of Home Prices And The Reality Of Mortgage Modification

Why A Decline In Home Prices Should Not Cause Defaults

It seems that we have taken as an axiom the idea that if the price of a home drops below the face value of the mortgage, the borrower will default on the mortgage. That sounds like a good rule, since it’s got prices dropping and people defaulting at the same time, so there’s a certain intuitive appeal to it. But in reality, it makes no sense. Either the borrower can afford the mortgage based on her income alone or not.  However, it does make sense if you also assume that the borrower intended to access the equity in her home before the maturity of the mortgage. That is, the home owner bought the home with the intention of either i) selling the home for a profit before maturity or ii) refinancing the mortgage at a higher principle amount.

If neither of these are true, then why would a homeowner default simply because the home they lived in dropped in value? She wouldn’t. She might be irritated that she paid too much for a home. Additionally, she might experience a diminution in her perception of her own wealth, which may change her consumption habits. But the fact remains that at the time of purchase, she thought her home was worth X. And she agreed to a clearly defined schedule of monthly payments over the life of the mortgage assuming a price of X. The fact that the value of her home suddenly drops below X has no impact on her ability to pay, unless she planned to access equity in the home to satisfy her payment obligations.  Annoyed as she might be, she could continue to make her mortgage payments as promised.  Thus, those mortgages which default due to a drop in home prices are the result of a failed attempt to access equity in the home, otherwise known as failed speculation.

In short, if a home drops in value, it does not affect the cash flows of the occupants so long as no one plans to access equity in the home. And so, the ability of a household to pay a mortgage is unaffected in that situation. This is in contrast to being fired, having a primary earner die, or divorce. These events have a direct impact on the ability of a household to pay its mortgage.

I am unaware of any proposal to date which offers assistance to households in need under such circumstances.

The Dismal Science Of Mortgage Modification

Simply put, available evidence suggests that mortgage modifications do not work.

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The charts above are from a study conducted by the Office Of the Comptroller of the Currency. The full text is available here. As the charts above demonstrate, within 8 months, just under 60% of modified mortgages redefault. That is, the borrowers default under the modified agreement. If we look only at Subprime mortgages, just over 65% of modified mortgages redefault within 8 months. This may come as a surprise to some. But in my mind, it reaffirms the theory that many borrowers bought homes relying on their ability to i) sell the home for a profit or ii) refinance their mortgage. That is, it reaffirms the theory that many borrowers were unable to afford the homes they bought using their income alone, and were actually speculating that the value of their home would increase.

Morally Hazardous And Theoretically Dubious

Why should mortgages be adjusted at all? Well, one obvious reason to modify is that the terms of the mortgages are somehow unfair. That’s a fine reason. But when did they become unfair? Were they unfair from the outset? That seems unlikely given that both the borrower and the lender voluntarily agree to the terms of a mortgage. Although people like to fuss about option arm mortgages and the like, the reality is, it’s not that hard for a borrower to understand that her payments will increase at some point in the future. Either she can afford the increased payments or not. This will be clear from the outset of the mortgage.

So, it doesn’t seem like there’s much of a case for unfairness at the outset of the agreement. Well then, did the mortgage become unfair? Maybe. If so, since the terms didn’t change, it must be because the home dropped in value and therefore the borrower is now paying above the market price for the home. That does sound unfortunate. But who should bear the loss? Should the bank? The tax payer? How about the borrower? Well, the borrower explicitly agreed to bear the loss when she agreed to repay a fixed amount of money. That is, the borrower promised “to pay back X plus interest within 30 years.” This is in contrast to “I promise to pay back X plus interest within 30 years, unless the price of my home drops below X, in which case we’ll work something out.” Both are fine agreements. But the former is what borrowers actually agree to.

Not enforcing voluntary agreements leads to uncertainty. Uncertainty leads to inefficiency. This is because those who have agreements outstanding or would like to enter into other agreements cannot rely on the terms of those agreements. And so the value of such agreements decreases and the whole purpose of contracting is defeated. In a less abstract sense, uncertainty creates an environment in which it is impossible to plan and conduct business. As a result, this type of regulatory behavior undermines the availability of credit.

But even if we do not accept that voluntary agreements should be enforced for reasons of efficiency, mortgages represent some of the most clear and unambiguous promises to repay an obligation imaginable. The fact that a borrower was betting that home prices would rise should not excuse them from their obligations. There are some situations where human decency and compassion could justify a readjustment of terms and socializing the resultant losses. For example, the death of a primary earner or an act of war or terrorism. But making a bad guess about future home prices is not an act that warrants anyone’s sympathy, let alone the socialization of the losses that follow.

The Elephant In The Room

This notion that Subprime borrowers were victimized as a result of some fraudulent wizardry perpetuated by Wall Street is utter nonsense. Whether securitized assets performed as promised to investors is Wall Street’s problem. Whether people pay their mortgages falls squarely on the shoulder of the borrower. Despite this, we are spending billions of public dollars, at a time when money is scarce and desperately needed, on a program that i) is demonstrably ineffective at achieving its stated goals (helping homeowners avoid foreclosure) and ii) rewards poor decision making and imprudent borrowing. Given the gravity of the moment, a greater failure is difficult to imagine. But then again, we live in uncertain times, so my imagination might prove inadequate.


Originally published at Derivative Dribble and reproduced here with the author’s permission.

13 Responses to "The Fallacy Of Home Prices And The Reality Of Mortgage Modification"

  1. Anonymous   March 9, 2009 at 6:14 pm

    I’m sure you’re talking somebody’s book or some no longer relevant ideological bent. But it aint mine, Babe. No, no, no, it aint mine, Babe.

  2. Guest   March 9, 2009 at 7:51 pm

    No direct reason why the owner should default, but maybe plenty of indirect reasons – such as an increased likelihood of the owner becoming unemployed as a result of other people losing their houses and the local economy taking a nosedive, and the company who employs the person in your example heading out of town or closing its doors entirely. So I agree with your point but wonder how relevant it really is in the current situation.

  3. Guest   March 9, 2009 at 9:26 pm

    very good article ..but too complex for the dumb washington politicians

  4. Mike   March 9, 2009 at 9:58 pm

    what’s missing is the average terms of the loan pre- and post-modification. If the modifications are trifling, then a redefault is likely, whereas if – say – you modified the loans such that the income required to service the debt met classic debt-service vs income ratio tests, you might have a better chance. My reading into modifications indicates that the former has been happening, yet the mortgage relief plan from Washington appears to try the latterWould it not be reasonable to think that if the previous modifications still didn’t meet classic ratios but the future ones will, that this story and the previous data would then be moot?

  5. Guest   March 10, 2009 at 10:18 am

    I read your piece Mr Davi.I would suggest you go back on your medication.I respectfully disagree with your entire philosophy.It is utter nonsense.

  6. Guest   March 10, 2009 at 11:51 am

    as someone who bought at the top of the market, and has watched the value of my home do nothing but decline, I have to say that I agree with this article whole-heartedly. A home is not an asset – it is a place to live. For too long, people bought homes for the express purpose of cashing out when the market rose. Fine, no problem – nobody complained during the good years. But now that the market is in decline, every Joe in the neighborhood whines and complains because he/she is upside down in his/her mortgage. It’s ridiculous.Make your payment. Live in your home. Be a responsible human being.

  7. 2cents   March 10, 2009 at 12:45 pm

    @ Davi,This is one of the most ridiculous pieces I’ve ever read!You seem to think that via theory and conjecture that you know what home borrowers are thinking. You can theorize all you want, but if you just ask borrowers who default (kind of a statistically important and germane group) why they defaulted, you’ll get the complete opposite picture of what you think.You might want to check out a seminal paper put out by the Boston FED that is contrary to your line of thought.

  8. Bry   March 10, 2009 at 1:53 pm

    This was honestly the most senseless, ridiculous article i have ever wasted my time reading. I wont even bother to elaborate, as this rubbish doesn’t even warrant the time necessary to write counterpoint. Good GOD, PLEAsE check back into the real world, where there are real problems that must be solved.

  9. Guest   March 10, 2009 at 11:34 pm

    Maybe that’s why they’re focusing on restructuring (longer terms, lower initial rates) rather than a write-down of principle. It makes the loans more affordable in the sense of lowering monthly payments, without the moral hazard issue.

  10. Derivative Dribble   March 11, 2009 at 8:23 am

    Guest on 2009-03-10 23:34:39,Principle write downs would probably work a lot better, since it cures the negative equity problem.

  11. Derivative Dribble   March 11, 2009 at 8:24 am

    @ ALL,Please comment on the original post on my blog. I cannot manage two discussion boards.

  12. Anonymous   March 11, 2009 at 3:00 pm

    I completely agree with this article. Key point being:”The fact that a borrower was betting that home prices would rise should not excuse them from their obligations.”

  13. Guest   March 15, 2009 at 12:35 am

    It is estimated that it could benefit 8 to 9 million homeowners from the new modification procedures. So how do you qualify for the Mortgage Modification? Check the website http://mortgagemodificationprogram.blogspot.comto see if you qualify. I was in trouble I am glad I did check it before I talk to my mortgage company and it worked – John Mayer, California