Federal Mortgage Modification Programs

[There is] ... a tradeoff between the number of foreclosures prevented in the short term and the durability of foreclosure prevention efforts.

There have been multiple efforts to reduce home mortgage foreclosures via federal government loan modification or debt forgiveness programs since 2008. According to NBER Research Associate Casey Mulligan writing in Foreclosures, Enforcement, and Collections under the Federal Mortgage Modification Guidelines (NBER Working Paper No. 15777), despite the existence of these programs more than five million homes in the United States were either in foreclosure as a result of non-payment or were delinquent and potentially facing foreclosure in early 2009. Roughly 14 million more mortgages were "underwater" -- the amount owed exceeded the market value of the collateral, a scenario that frequently leads to loan default and foreclosure.

Through the third quarter of 2009, fewer than two million mortgages had been modified or had their payments otherwise adjusted under the federal modification programs -- including those of the Federal Deposit Insurance Corp., the Federal National Mortgage Association (Fannie), the Federal Home Loan Mortgage Corp. (Freddie), and a more recent Treasury Department effort called the Home Affordable Modification Program (HAMP). HAMP, which replaced the Fannie and Freddie programs, includes $75 billion in potential subsidies. All of these programs were created to prevent foreclosures on a large class of mortgages. Typically, a loan modification would result in lower monthly payments over a five-year period, achieved primarily by trimming interest costs, but with payments after the five-year period unchanged.

Most of the loan modifications, which are voluntary on the part of borrowers, seek to reduce the monthly mortgage payment so that no more than a target fraction of the borrower's average monthly income is devoted to total housing expense, which includes principal, interest, taxes, and insurance. Depending on the federal program, that percentage can range from 31 percent to 38 percent of gross income reported on the mortgagor's federal income tax return.

A further requirement of these programs is that the post-modification loan must have a value at least as great as the value of the collateral to the lender. Mulligan finds that the income target and collateral value tests combine to "create a tradeoff between the number of foreclosures prevented in the short term and the durability of foreclosure prevention efforts, because they make it impossible to both write down principal and offer modification to a wide range of borrowers." Another consequence of this tradeoff, he continues, "is to reduce collections, increase foreclosures and their costs, and reduce efficiency as compared to alternative means tested mortgage modification rules."

In many instances, the programs' guidelines also result in implicit marginal income tax rates in excess of 100 percent, and sometimes as large as 400 percent when principal reduction is included in the modified payment. That creates a stark incentive for borrowers to hide income in order to get lower mortgage payments. Mulligan suggests that alternative means-tested modification rules, based on a framework of optimal income taxation, might simultaneously reduce the number of foreclosures while improving collections and the efficacy of the process.

-- Frank Byrt