For the Next Housing Crisis, Lessons From the Last One

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Could a new study ease the next housing crisis?

When the housing bubble burst in 2008, federal policy makers thought they could limit the economic damage by helping to reduce amounts of principal owed on many mortgages, thus preventing foreclosures—especially for the millions of people who saw the value of their homes fall below the value of their mortgages.

But, according to a new working paper, lowering principal had very little effect on defaults for underwater borrowers. Moreover, it turned out to be a very expensive initiative. The federal government spent about $4.6 billion on principal reduction to prevent foreclosures from 2010 to 2016, but the policy’s impact was so small, each avoided foreclosure ended up costing taxpayers at least $800,000, says Pascal Noel, an assistant professor at University of Chicago Booth School of Business, and co-author of the paper with Peter Ganong, an assistant professor at University of Chicago’s Harris School of Public Policy.

This new research sheds light on what went wrong with the government’s efforts to help underwater borrowers in the 2007-09 recession, which by early 2010 included more than 11 million people or about 24% of residential properties with mortgages, according to Core Logic, a data and analytics company.

“If borrowers’ mortgage balances were much higher than their home value, policy makers and academic researchers worried the borrowers might decide to walk away, ” says Dr. Noel. But a more effective policy to help those homeowners and give the economy a boost, he says, might have been to temporarily lower the underwater homeowners’ mortgage payments, freeing up cash flow and thus spurring consumer spending.

The Wall Street Journal spoke to Dr. Noel about the research. Edited excerpts follow.

WSJ: Why did you decide to pursue this topic?

DR. NOEL: I was working in the Obama White House, helping design the government’s response to the foreclosure crisis, but we didn’t have the right research to make the most informed policy decisions. That motivated me to figure out what exactly would have been the most effective response to that and future crises.

WSJ: Explain the study?

DR. NOEL: It has always been difficult to tease apart the effect of principal and monthly payment reductions because prior research had studied them together. But we were able to exploit policy variation in the government’s Home Affordable Modification Program, which modified about 1.6 million mortgages between 2009 through 2016. One group of borrowers, which became our control group, received a modification temporarily reducing their mortgage payments for five years. The second group received the exact same short-term payment reduction, but also received about $70,000 in mortgage principal reduction, writing down, on average, a third of their mortgage balance.

WSJ: What did you find?

DR. NOEL: The principal reduction had no statistically significant effects on borrowers’ short-term default rates. Reducing borrowers’ loan-to-value ratio by about 11 percentage points affected default rates by less than 1 percentage point. That is within the first three years of receiving the modification.

It also had very little effect on consumption. A $70,000 reduction in mortgage principal increased borrowers’ monthly credit-card expenditures by less than $1 and their auto spending by less than $5.

The main message is that underwater borrowers during the financial crisis were much less sensitive to changes in their housing wealth than the average borrower during normal times, and that was very surprising.

WSJ: Why was it so surprising?

DR. NOEL: The link between housing wealth and consumption is very well documented empirically. But we find that relationship completely broke down. In most cases, the mortgage-principal reduction wasn’t enough to bring homeowners above water.

If, for example, a borrower owes $80,000 more on their mortgage than their home is worth and $70,000 is forgiven, the home is still underwater. There is no collateral. So a homeowner can’t take out a home-equity line of credit or a second mortgage, which is typically how housing wealth increases consumption.

We calculate that if the government spent $4.6 billion—the amount of money it used to subsidize principal reductions during the financial crisis—and used it instead to reduce short-term mortgage payments, the spending response would have been 10 times greater. It would have increased consumer spending by about $1.4 billion.

WSJ: How big a role did a homeowner’s leverage play in default rates?

DR. NOEL: During the crisis, many experts looked at the historical relationship between leverage ratios and default rates and believed there was a causal relationship between them. But our findings suggest short-term income shocks, like job loss, rather than leverage in and of itself, primarily drive mortgage defaults.

We have a new version of the paper coming out soon where we look at a different source of variation in the Home Affordable Modification Program over the same period and find a 1% reduction in monthly mortgage payments reduces default rates by about 1%. That is a much bigger effect than we get from reducing mortgage principal without changing payments.

DR. NOEL: Our results are for borrowers who are moderately underwater. About 90% of the borrowers in our data have a loan-to-value ration of 160% or below—that means that their mortgage is [as much as] 60% more than the value of their home. It is entirely possible that for people even more underwater, you would start seeing a tighter relationship between leverage and default. You might get to a tipping point where the leverage is just too high and people walk away from their homes.

WSJ: What lessons does the paper suggest in hindsight?

DR. NOEL: The main lesson looking back is that the government would have been better off if it had used the same amount of money to finance deeper reductions in mortgage payments or reduce more borrowers’ monthly payments. Still, writing down mortgage debt before borrowers are underwater might be an effective policy and is worth further investigation.

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