The Congressional Oversight Panel appointed to oversee the Home Affordability
Modification Program (HAMP) has put out a very interesting 6-month report
on the effectiveness of HAMP. The report first analyzes the current market
and what has happened to date.
The report notes that the crisis has come in waves. The first was driven
by speculators abandoning homes when the prices started falling. This
drove the prices even lower and brought about the second wave with Option
ARMs and other exotic mortgages resetting, homeowners were unable to refinance
and faced the choice of whether or not to let the house go because they
could not refinance to an affordable payment.
The next wave has been a little more subtle but has continued to grow unabated
and is now the dominant factor in the residential market: negative equity.
Life changes sometimes force relocation and debtors do not have the option
of staying in a particular house. If the house has positive equity, it
is easy to sell the house. But, if the house has no equity, it must either
be foreclosed upon or sold at a short sale. Foreclosures and short sales
almost always result in lower sales prices than market sales. Thus, market
values have been driven lower and lower forcing more and more people into
the negative equity situation and the cycle perpetuates itself. In California,
approximately 35% of all homeowners have no equity in their home. In Nevada,
approximately 60% of all homeowners have no equity. The negative equity
loop was described as follows:
Homeowners with negative equity are also constrained in their ability to
move, absent abandoning the house to foreclosure. There is a wide range
of inevitable life events that necessitate moves: the birth of children,
illness, death, divorce, retirement, job loss, and new jobs. When one
of these life events occurs, if a homeowner has negative equity, the primary
choices are between forgoing the move, finding the cash to make up the
negative equity, or losing the house in foreclosure. Many have chosen
the foreclosure route.
Unfortunately, as the Panel has previously observed, foreclosures push
down the prices of nearby properties, which can in turn result in negative
equity that begets more defaults and foreclosures.21 A negative feedback
loop can develop between foreclosures and negative equity. To the extent
that negative equity alone may produce foreclosures, progress in addressing
loan affordability will have a limited impact on foreclosure rates over
the long term.
The Panel noted that the only way to stop the negative equity foreclosure
loop is to make a way for a substantial number of borrowers to fix their
negative equity problem. HAMP currently provides an option for lenders
to reduce principal balance to solve the negative equity problem, but
lenders are almost never taking advantage of that option. One option would
be to mandate principal reductions under HAMP, but the Panel noted this
would create a perverse incentive for borrowers because there was little
cost to the borrower to get the principal write-down. The Panel then noted
that Chapter 13 revision might be the way to resolve that issue by authorizing
mortgage modification in Chapter 13. That would involve significant cost
to the borrower due to the rigor and negative credit effect of going through
bankruptcy, but would allow a significant amount of principal reduction
that would help to stabilize values. The Panel said:
Negative equity can only be eliminated through principal write-downs, but
this raises a number of difficult and complex issues. When principal is
written down, it impairs the balance sheets of the owners of the mortgages.
In many cases, this means the impairment of the balance sheets of the
very financial institutions whose stability is an essential goal of the
EESA. To be sure, if principal write-downs actually increase the true
value of the loans, by reducing redefault rates, then principal write-downs
might cause more immediate losses, but they would produce more realistic,
and therefore more confidence-inspiring, balance sheets.
One concern related to the idea of principal reduction is the incentives
it may create. Witnesses at the Panel?s foreclosure mitigation field hearing
were asked about this matter. Dr. Paul Willen, Senior Economist at the
Federal Reserve Bank of Boston, testified that the "problem with
negative equity is basically that borrowers can?t respond to life events."
Borrowers with positive equity simply have "lots of different ways
they can refinance, they can sell, they can get out of the transaction."330
He noted that although most borrowers with negative equity are likely
to make their payments in the present or over the next couple of years,
they still remain "at-risk homeowners" and may face more serious
issues several years down the road should a life changing event, such
as unemployment, occur.331 In that sense, Dr. Willen offered that principal
reduction may have some virtue. He also noted, however, that most borrowers
with negative equity make their mortgage payments, and that if principal
reduction is provided as an option, one runs the risk of incentivizing
borrowers, who would otherwise continue to make their mortgage payments,
"to look for relief" even when it is not necessarily needed.332
In this sense, according to Dr. Willen, mandating a principal reduction
option under HAMP could put additional pressures on the program, and ultimately
reduce its overall effectiveness. However, in response to a question from
the Panel, Dr. Willen agreed that revising bankruptcy laws to permit principal
modification was a clear way to address the idea that there should be
a cost for receiving a principal reduction.
Other witnesses at the hearing also argued that the incentive "to
look for relief" may be reduced if the costs to the borrower of opting
for principal reduction were significantly greater.333 For example, revising
Chapter 13 bankruptcy to include a cramdown or a principal reduction component
could be one way to impose more significant costs. Because of these costs,
such a revision could provide borrowers with the option of principal reduction
without creating the potential perverse incentives to other borrowers
that may occur by mandating principal reduction as an option under HAMP.
Filing for bankruptcy is not an appealing choice to any borrower; however,
to the borrower facing certain foreclosure it may be the only choice.
Whereas mandating principal reduction as an option under HAMP may attract
a larger than desired group of borrowers, allowing principal reduction
as an option under Chapter 13 is more likely to attract only those borrowers
who are truly in need of such assistance. In this sense, Chapter 13 bankruptcy
could be used as a tool to employ the benefits of principal reduction
to borrowers in need without attracting other borrowers and putting any
additional pressures on HAMP.
I think this makes a great deal of sense and that Chapter 13 mortgage modification
could help to stabilize home values.