The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die. Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders,... [more]
The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die.
Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders, not borrowers. It is the quintessential win-win or even win-win-win solution. The logic of principal reduction is that in a foreclosure, a lender recovers at most the value of the house in question and typically far less. This is because of the protracted foreclosure process during which the house deteriorates and the lender collects no interest but has to pay lawyers and other staff to navigate 50 different byzantine state bureaucracies to get a clean title to the house, which it then has to sell in an extremely weak market. In contrast, reducing the principal balance to equal the value of the house guarantees the lender at least the value of the house because the borrower now has positive equity and research shows that borrowers with positive equity don’t default.
The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages.
Negative equity and foreclosure
But aren't we being pessimistic here? Aren’t we ignoring research that shows that negative equity is the best predictor of foreclosure? No, we aren't. On the contrary, we have authored some of that research and have long argued for the central importance of negative equity in forecasting foreclosures. But what research shows is not that all or most people with negative equity will lose their homes but rather that while people with negative equity are much more likely to lose their homes, most eventually pay off their mortgages. The relationship of negative equity to foreclosure is akin to that of cholesterol and heart attacks: high cholesterol dramatically increases the odds of a heart attack, but the vast majority of people with high cholesterol do not have heart attacks any time in the near or even not-so-near future.
The problem of asymmetric information
Ultimately the reason principal reduction doesn't work is what economists call asymmetric information: only the borrowers have all the information about whether they really can or want to repay their mortgages, information that lenders don’t have access to. If lenders weren't faced with this asymmetric information problem—if they really knew exactly who was going to default and who wasn't—all foreclosures could be profitably prevented using principal reduction. In that sense, foreclosure is always inefficient—with perfect information, we could make everyone better off. But that sort of inefficiency is exactly what theory predicts with asymmetric information.
http://realestateresearch.frbatlanta.org/rer/2011/03/seductive-but-flawed-logic-of-principal-reduction.html[less]
