The promise of a loan modification based on delinquency status induces some financially proficient borrowers to intentionally fall behind on their mortgage payments, according to a study commissioned by the National Bureau of Economic Research in Massachusetts and conducted by researchers at Columbia University.
Led by Christopher Mayer, senior vice dean and professor of real estate at Columbia Business School, the research team examined the modification policies of Countrywide Financial.
In 2008, as a result of lawsuits brought by a number of states, Countrywide agreed to offer modifications to seriously delinquent borrowers with subprime mortgages throughout the country.
The researchers found that Countrywide's relative delinquency rate increased 13 percent per month immediately after the program's announcement.
According to the analysis, default rates increased the most among borrowers least likely to default, including those with substantial liquidity available through credit cards and low combined loan-to-value ratios with some equity in their homes.
The researchers say their findings suggest strategic behavior should be an important consideration in designing mortgage modification programs and developing eligibility criteria.
The common approach has been to extend benefits only to homeowners who are delinquent, usually by at least two payments. This approach, however, can prompt homeowners to default even though they have the means to stay current, the researchers explained.
An alternative, they say - one which alleviates the risk of strategic default - is to offer modifications only to homeowners who undergo a rigorous audit that verifies they are likely to default, or have defaulted, as a result of adverse conditions.
Such an audit, according to the research paper, would assess the home's value and the homeowner's current income and credit rating.
There is a trade-off to deterring strategic behavior, however. The study notes that because this costly verification approach is time-consuming, it may fail to extend benefits to homeowners before they enter foreclosure or decide to exit their homes, and as a result could lead to higher costs for both borrowers and lenders.
Countrywide committed to offer expedited, unsolicited loan modifications to borrowers who were at least 60 days delinquent. The researchers note three distinct features of the Countrywide settlement: its unexpected public announcement in advance of its implementation, its nationwide coverage, and its requirement that a borrower be delinquent in order to receive benefits.
Data show that defaults soared immediately after the announcement - up as much as 20 percent for some borrower and loan types - with most of the increase the result of strategically planned defaults by homeowners who had access to significant liquidity and positive equity.
"Although our results document strategic behavior in response to mortgage modification policies...that use simple but manipulable eligibility criteria," the researchers wrote, "we cannot say whether the economic costs of strategic behavior are large relative to the potential gains to borrowers, lenders, and neighborhoods from these policies. Our results instead highlight a trade-off."
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Zillow contributed data and research support for the study.
Author: Carrie Bay