COP: HAMP Not Enough; Chapter 13 Mortgage Modification Needed

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.