The Seductive but Flawed Logic of Principal Reduction

From the Federal Reserve Bank of Atlanta…

The seductive but flawed logic of principal reduction

The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die. If news stories are true, the administration, in conjunction with the state attorneys general, will soon announce that lenders have agreed to write down borrower principal balances by a grand total of $20–$25 billion as part of a deal to address serious procedural problems in foreclosure filings. Policy wonks and housing experts will greet this announcement with glee, saying that policymakers have ignored principal reduction for too long but have seen the light and are finally going to cure the epidemic of foreclosures that has gripped the country since 2007. Are the wonks right? In short: we think not.

Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders, not borrowers. It is the quintessential win-win or even win-win-win solution. The logic of principal reduction is that in a foreclosure, a lender recovers at most the value of the house in question and typically far less. This is because of the protracted foreclosure process during which the house deteriorates and the lender collects no interest but has to pay lawyers and other staff to navigate 50 different byzantine state bureaucracies to get a clean title to the house, which it then has to sell in an extremely weak market. In contrast, reducing the principal balance to equal the value of the house guarantees the lender at least the value of the house because the borrower now has positive equity and research shows that borrowers with positive equity don’t default. To put numbers on this story, suppose the borrower owes $150,000 on a $100,000 house. If the lender forecloses, let’s assume it collects, after paying the lawyers and the damage on the house, etc., $50,000. However, if it writes principal down to $95,000, it will collect $95,000 because the borrower now has positive equity and won’t default on the mortgage. Lenders could reduce principal and increase profits!

The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages. To understand why this assumption is crucial to the argument, suppose there are two borrowers who owe $150,000 but one prefers not to default (perhaps because she has a particularly strong preference for her current home, or because she does not want to destroy her

credit, or because she thinks there’s a chance that house prices will recover) and eventually repays the whole amount while the other defaults. If the lender writes down both loans, it will collect $190,000 ($95,000 from each borrower). If the lender does nothing, it will eventually foreclose on one and collect $50,000, but it will recover the full $150,000 from the other borrower, thus collecting $200,000 overall. Hence, in this simple example, the lender will obtain more money by choosing to forgo principal reduction.

The obvious response is that the optimal policy should be to offer principal reduction to one borrower and not the other. However, this logic presumes that the lender can perfectly identify the borrower who will pay and the borrower who won’t. Given that there is a $55,000 principal reduction at stake here, the borrower who intends to repay has a strong incentive to make him- or herself look like the borrower who won’t!

This is an oft-encountered problem in the arena of public policy. Planners often have a preventative remedy that they have to implement before they know who will actually need the assistance. This inability to identify the individuals in need always raises the cost of the remedy, sometimes dramatically so. A nice illustration of this problem can be seen in the National Highway Traffic Safety Administration’s (NHTSA) proposed regulation to require all cars to have backup cameras to prevent drivers from running over people when they drive in reverse. Hi-tech electronics mean that such cameras cost comparatively little: $159 to $203 for cars without a pre-existing navigation screen, and $53 to $88 for cars with a screen, according to the NHTSA. $200 seems like an awfully small price to pay to prevent gruesome accidents that are often fatal and typically involve small children and senior citizens. But the NHTSA says that the cameras are actually extremely expensive, and arguably prohibitively so. What gives? How can $200 be considered a lot of money in this context? The problem is that backup fatalities are extremely rare, something on the order of 300 per year, so the vast majority of backup cameras never prevent a fatality. To assess the true cost, one has to take into account the fact that for every one camera that prevents a fatality, hundreds of thousands will not. Done right, the NHTSA estimates the cost of the cameras between $11.3 and $72.2 million per life saved.

Some background
The idea of principal reduction starts with a correct premise: borrowers with positive equity—that is, houses worth more than the unpaid principal balance on their mortgages—rarely ever lose their homes to foreclosure. In the event of an unexpected problem (like an unemployment spell) that makes the mortgage unaffordable, borrowers with positive equity can profitably sell their house rather than default. The reason that foreclosures are rare in normal times is that house prices usually increase over time (inflation alone keeps them growing even if they are flat in real terms) so almost everyone has positive equity. What happened in 2006 is that house prices collapsed and millions of homeowners found themselves with negative equity. Many who got sick or lost their jobs were thus unable to sell profitably.

With this idea in mind, it then follows that if we could somehow get everyone back into positive-equity territory, then we could end the foreclosure crisis. To do that, we either need to inflate house prices, which is difficult to do and probably a bad idea anyway, or reduce the principal mortgage balances for negative-equity borrowers. So we have a cure for the foreclosure crisis: if we can get lenders to write down principal to give all Americans positive equity in their homes, the housing crisis would be over. Of course, the question becomes, who will pay? Estimates suggest that borrowers with negative equity owe almost a trillion dollars more than their homes are worth, and a trillion dollars, even now, is real money. The principal reduction idea might stop here—an effective but unaffordable plan—but people then realized that counting all the balance reduction as a cost was wrong. Furthermore, in fact, not only was the cost far less than a trillion dollars, but, as we noted above, many principal reduction proponents argue that it might not cost anything at all.

The logic that principal reduction can prevent foreclosures at no cost is compelling and seductive, and proposals to encourage principal reduction were common early in the foreclosure crisis. In a March 2008 speech, one of our bosses, Eric Rosengren, noted that “shared appreciation” arrangements had been offered as a way to reduce foreclosures; these arrangements had the lender reduce principal in return for a portion of future price gains realized on the house. In July 2008, Congress passed the Housing and Economic Recovery Act of 2008, which created Hope for Homeowners, a program that offered government support for new loans to borrowers if the lender was willing to write down principal.

While we were initially supportive of principal-reduction plans, we began to have doubts over the course of 2008. Our reasons were twofold. First, we could find no evidence that any lender was actually reducing principal. Commentators blamed the lack of reductions on legal issues related to mortgage securitization, but we became skeptical of this argument, because the incidence of principal reduction was so low that it was clear that securitization alone could not be the only problem or even a major one, (Subsequent research has shown this to be largely right: the effect of securitization on renegotiation was between nil and small in this crisis, and lenders did not reduce principal much even during the Depression, when securitization did not exist.) And the second issue, of course, was our realization of the logical flaw described above.

Negative equity and foreclosure
But aren’t we being pessimistic here? Aren’t we ignoring research that shows that negative equity is the best predictor of foreclosure? No, we aren’t. On the contrary, we have authored some of that research and have long argued for the central importance of negative equity in forecasting foreclosures. But what research shows is not that all or most people with negative equity will lose their homes but rather that while people with negative equity are much more likely to lose their homes, most eventually pay off their mortgages. The relationship of negative equity to foreclosure is akin to that of cholesterol and heart attacks: high cholesterol dramatically increases the odds of a heart attack, but the vast majority of people with high cholesterol do not have heart attacks any time in the near or even not-so-near future.

To be sure, there are some mortgages out there with very high foreclosure likelihood: loans made to borrowers with problematic credit and no equity to begin with, located in places where prices have fallen 60 percent or more. However, such loans are quite rare now—most of those defaulted soon after prices started to fall in 2007—and make up a small fraction of the pool of troubled loans currently at risk. To add to the problem, the principal reductions required to give such borrowers positive equity are so large that the $20–25 billion figure discussed for the new program would prevent at most tens of thousands of foreclosures and make only a small dent in the national problem.

Millions of borrowers with negative equity will default, but there are many millions more who will continue to make payments on their mortgages, behavior that is not, contrary to popular belief, a violation of economic theory. Economic theory only says that borrowers with positive equity won’t default (read it carefully). It is logically false to infer from this prediction that all borrowers with negative equity will default. “A implies B” does not mean that “not A” implies “not B,” as any high school math student can explain. And in fact, standard models show that the optimal default threshold occurs at a price level below and often significantly below the unpaid principal balance on the mortgage.

The problem of asymmetric information
Ultimately the reason principal reduction doesn’t work is what economists call asymmetric information: only the borrowers have all the information about whether they really can or want to repay their mortgages, information that lenders don’t have access to. If lenders weren’t faced with this asymmetric information problem—if they really knew exactly who was going to default and who wasn’t—all foreclosures could be profitably prevented using principal reduction. In that sense, foreclosure is always inefficient—with perfect information, we could make everyone better off. But that sort of inefficiency is exactly what theory predicts with asymmetric information.

And, in all this discussion, we have ignored the fact that borrowers can often control the variables that lenders use to try to narrow down the pool of borrowers that will likely default. For example, most of the current mortgage modification programs (like the Home Affordable Modification Program, or HAMP) require borrowers to have missed a certain number of mortgage payments (usually two) in order to qualify. This is a reasonable requirement since we would like to focus assistance on troubled borrowers need help. But it is quite easy to purposefully miss a couple of mortgage payments, and it might be a very desirable thing to do if it means qualifying for a generous concession from the lender such as a reduction in the principal balance of the mortgage.

Economists are usually ridiculed for spinning theories based on unrealistic assumptions about the world, but in this case, it is the economists (us) who are trying to be realistic. The argument for principal reduction depends on superhuman levels of foresight among lenders as well as honest behavior by the borrowers who are not in need of assistance. Thus far, the minimal success of broad-based modification programs like HAMP should make us think twice about the validity of these assumptions. There are likely good reasons for the lack of principal reduction efforts on the part of lenders thus far in this crisis that are related to the above discussion, so the claim that such efforts constitute a win-win solution should, at the very least, be met with a healthy dose of skepticism by policymakers.

Photo of Chris FooteChris Foote
Senior economist and policy adviser at the Boston Fed

Photo of Kris GerardiKris Gerardi
Research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta

Photo of Paul WillenPaul Willen
Research economist and policy adviser at the Boston Fed


SOURCE: Federal Reserve Bank of Atlanta


88 Responses to “The Seductive but Flawed Logic of Principal Reduction”
  1. John Hart says:

              Let’s start our journey of discovery with the purchase of a home and subsequent steps in the financial process through th life of the “mortgage loan”.  It all starts at the “closing” where we gathand buy something, you are then making a purchase with a “Note” (a promise to pay).  There is absolutely no gold or silver backing the Federal Reserve Notes that we refer to as “money” today.
         When you sit down at the closing table to complete the transaction to purchase your home aren’t you tendering a “Note” with your signature which would be considered money?  That is exactly what you are doing.  A “Note” is money in our monetary system today!  You can deposit the “Federal Reserve Note” (a promise to pay) with a denomination of $10 at the bank and they will credit your account in that same amount.  Why is it that when you tender your “Note” at the closing that they don’t tell you that your home is paid for right on the spot?  The fact is that it IS PAID FOR ON THE SPOT.  Your signature on a “Note” makes that “Note” money in the amount that is stated on the “Note”!  Was this disclosed to you at the “closing” in either verbal or written form?  Could this be the place where the other players come into the transaction at or near the time of closing?  What happens to the “Note” (promise to pay) that you sign at the closing table?  Do they put it in their vault for safe keeping as evidence of a debt that you owe them as you are led to believe?  Do they return that note to you if you pay off your mortgage in 5, 10 or 20 years?  Do they disclose to you that they do anything other than put it away for safe keeping once it is in their possession?
         Unknown to almost everyone, there is something VERY different that happens with your “Mortgage Note” immediately after closing.
    Your “Mortgage Note” is endorsed and deposited in the bank as a er with other people that are “involved” in the process to sign the documents to purchase our new home.  Do we really know what goes on at the closing?  Are we ever told who all the participants are in that entire process?  Are we truly given “full disclosure” of all the various aspects of that entire transaction regarding what, for most people, is the single largest purchase they will make in their entire life?
         Let’s start with the very first part of the transaction.  We have a virtual stack of papers placed in front of us and we are instructed where we are supposed to start signing or initiling on those “closing documents”.  There seems to be so many different documents with enough legal language that we could read for hours just to get through the the first time, much less begin to fully understand them.  Are we given a copy of all these documents at least 7 days prior to the closing so we can read and study these documents so w fully understand what it is that we are signing and agreeing to?  That has never happened for the average consumer and purchaser of a property in the last 30 years or more if it ever has at al.  WHY?  We have a stack of documents placed before us at the “closing” that we haven’t ever seen before and are instructed where to sign or initial to complete the transaction and “get our new home”.  We depend on the real estate agent, in most cases, to bring the parties together at the closing after we have supplied enough financial data and other requested information so tat the “lender” can determine whether we can qualify for our “loan”.  Obviously we have the “three day right of rescission” but do we really stop to read all the documents after we have just purchased our home and want to move in?  Is the thought that there might be something wrong with what we have just signed a primary thought in our mind at that time?  Did we trust the people involved in the transaction?  Are we naturally focusing on getting moved into our new home and getting settled with our family?
         Who are the players involved in the transaction from the perspective of the consumer purchasing a property and signing a “Mortgage Note” and “Deed” or similar “Security Instrument” at the closing?  There is, of course, the seller, the real estate agent(s), title insurance company, property appraiser who is supposed to properly determine the value of the property, and the most obvious one being who we believe to be “the lender” in the transaction.  We are led, by all involved, to believe that we are, in fact, borrowing money from the “lender” which is then paid to the current owner of the property as compensation for them relinquishing any “claim of ownership” to the property and transferring that “claim of ownership” to us as the purchaser.  It all seems so simple and clear on its face and then the transaction is completed.  After the “closing” everyone is all smiles and you believe you have a new home and have to repay the “lender”, over a period of years, the money which you believe you have “borrowed”.
         Everything appears to be relatively simple and straightforward but is that really the case?  Could it be that there are other players involved in this whole transaction that we know nothing about that have a very substntial financial interest in what has just occurred?  Could it be that those players that we are totally unaware of have somehow used us without our knowledge or 
    consent to secure a spectacular financial gain for themselves with absolutely no investment or risk to themselves whatsoever?  Could it be that there is a hidden aspect of this whole transaction that is “standard operating procedure” in an industry where this hidden “aspect of a transaction” occurs every single banking day across this country and beyond?  Could it be that this hidden “aspect of a transaction” is a deliberate process to unjustly enrich certain individuals and entities at the expense of the public as a whole?  Could it be that there was not full disclosure of the “true nature” of the transaction as it actually occurred which is required for a contract to be valid and enforceable?
         The two most important and valuable documents that are signed at a closing are the “Note” and the “Deed” in various forms.  When looking at the definition of a “Mortgage Note” it is obvious that it is a “Security Instrument”.  It is a promise to pay made by the maker of that “Note”.  When looking at a copy of a “Deed of Trust” such as the attached Exhibit “A”, which is a template of a Tennessee “Deed of Trust” form that is directly from the website, it is very obvious that this document is also a “Security Instrument”.  This is a template that is used for MOST government purchased loans.  You will note that the words “Security Instrument” are mentioned no less than 90 times in that document.  Is there ANY doubt it is a “Security”?  When at the closing, the “borrower” is led 
    to believe that the “Mortgage Note” that he signs is a document that binds him to make repayment of “money” that the “lender” is loaning him to purchase the property he is acquiring.  Is there disclosure to the “borrower” to the effect that the “lender” is not really loaning any of their money to the “borrower” and therefore is taking no risk whatsoever in the transaction?  Is it disclosed to the “borrower” that according to FEDERAL LAW, banks are not allowed to loan credit and are also not allowed to loan their own or their depositor’s money?  If that is the case, then how could this transaction possibly take place?  Where does the money come from?  Is there really any money to be loaned?  The answer to this last question is a resounding NO!  Most people are not aware that there has been no lawful money since the bankruptcy of the United States in 1933.
         Since House Joint Resolution 192 (HJR 192) (Public law 7310)
     was passed in 1933 we have only had debt, because all property and gold was seized by the government as collateral in the bankruptcy of the United States.  Most people today would think they have money in their hand when they pull something out of their pocket and look at the pape that is circulated by the banks that they have been told is “money”.  In reality they are looking at a “Federal Reserve Note” which is stated right on the face of the piece of paper we have come to know as “money”.  It is NOT really “money”, it is debt, a promise to pay made by the United States!  If you take a “Federal Reserve Note” showing a value of ten dollars 

    • l vent says:

      Isn’t our Government wonderful? They deceived and betrayed us, sold out our country and then stuck it to all of us. Why? Because foreign elite secret societies are really running the show because treasonists within our own governmental structure put money , power and greed before their people and country. . They used us up, then kicked us to the curb. Kinda like what a pimp does. The reason we are all here today is because of a secret plan these eliteists hatched over 100 years ago to upsurp our Government and take over the world. They are the New World Order/ the U.N. Do not be fooled about who the main players are hiding behind the scenes of this. They are mostly foreign and they intend to do us permanent harm No one is safe, they are the vatican assassins and they are hiding behind the scenes of this entire Financial/ Foreclosuregate cisis and they have many faces and many cohorts.

    • l vent says:

      We are here because of Keneysian economic policies put in place by the elite so they may be able to create countries full of debt slaves. Paper currency is A FRAUD. We have nothing but worthless paper. With the value of this paper as worthless as it is, we would never be able to pay back any debt with this for many lifetimes. They have put us in the preverbial “trick bag”. This money is backed by 0. Gold and silver are the only currencies that never lose its MONETARY value. They knew this. They screwed all of us..Paper money has put all of us in a debtor’s prison. We the people owe NO allegiance to this falsely created foreign debt. It was a SCAM by the NEW WORLD ORDER to own and control the world by creating massive falsely induced, fraudulenlty created debt. They RANG US UP. WE THE PEOPLE ARE NOT PAYING FOR THE FRAUD BORN OF CORRUPTION. WALK AWAY FROM ALL OF THE DEBT. Taxes are more falsely induced and unsubstantiated falsely created debt slavery. America needs aNationwide tax revolt. A REAL TEA PARTY.

  2. l vent says:

    There are going to be no principal write downs and no loan mods. Fannie/Freddie are going away is what Timothy Geithner said today. The banks have no one to guarantee/back the fraudulent inducements. The banks don’t want to take the risk on of us defaulting. If we default they will probably not be able to cash in their credit default swap insurance, that is a risk they are not willing to take. The national default rate is the direction this is going. The more defaults drives the default rate to 0. That means to the bank no one is defaulting and they can no longer fraudclose if technically no one is defaultling. I hear strategic default is the new trend among homeowners. Way to go America. Let’s bring them down. They robbed us with impunity and it was intentional.

  3. Pamela says:

    I vent, it appears to me that alot of lawyers are reading from cookie cutter texts either due to the fact they are uninformed or scared because they are not up to speed.This is very daunting not just for us but for SOME of them as well.The ones that actually do have thier clients best interest at heart are scared of being run out of town on a rail if they do not suceed.Should this excuse them never but to an extent I understand.What I don’t understand is when faced with all the ammunition we have why we still can’t get anywhere?My only answer is that it’s all rigged and they are complicit with everything and they are not going to rock the boat.Somewhere there has to be some lawyer or judge that should do something.But it is not wide spread and pervasive yet.I agree it is pay back time,now how to carry that out and bring to fruition?

    • l vent says:

      The more people that default brings the default rate to 0. It is like no one is defaulting then the banks cannot fraudclose. A lawyer told me this. We need those default numbers. This is an important number.That is when the fraudclosures stop. We also need a nationwide tax revolt. That is how we will be heard. Our money talks and then their bullshit walks.

  4. Pamela says:

    I vent so in essence what he was telling you was we have a judicial pricing clearinghouse running here. I’ll bet that DOCX and lps have price sheets for :Criminal Fraud….200.00 Oh you’ve been a very bad bank ….100.00 and so on .Thats why thier not afraid of us is because they know that its only a monetary penalty and thats it.

    • l vent says:

      @Pamela: That is the angle the lawyer obviously wants to avoid because the fraud is an obvious joke to the judges and the banks. Apparently the judges are making a mockery of our claims of fraud. Anyone hear what the nationwide default rate is in America right now? An attorney back a few months ago told me the more defaults will bring the default rate to 0 and then the banks will no longer be able to FRAUDCLOSE because that will mean the exact same thing as NO ONE is defaulting.WE NEED THOSE NUMBERS.. Bloomberg is having a special report tommorrow on the rising rate of Strategic Default in America, they are calling it “Keeping up with the Joneses” Way to go America!!!!! We got set up and robbed. by the Casino PERPS, THE WALL STREET/BANKER CABAL and hiding behind the scenes of that are the foreigners , the vatican assasins and the aristocrats, The sheeps in wolves clothing who were the masterminds behind the whole PONZI SCHEME ROBBERY. Time for the AMERICAN PEOPLE TO DEFAULT ON ALL OF THE FRAUDSTERS. THEY SCREWED ALL OF US. IT IS PAY BACK TIME. .

  5. Pamela says:

    we had a place run what is know as a forensics on our mortage, this helped identify the fraud,predatory
    lending,TILA,RESPA,&HOPEA violations within this refi. Original mortage is even worse. Without
    this forensics investigation we would have had no clue about all the illegalities. What is needed to
    make theses work are doc to back them up which we have. County doc’s,original mortage doc’s,etc…
    Hopefully this just might work?????

    • l vent says:

      @Pamela and losing my home in florida: I forgot to add that in my fraudclosure summons my pretender lender is trying to hide behind MERS/U.N. and the fraudsters are using them as a nominee. Last I checked, my house has been inactive in MERS/U.N. since 2007. Aren’t they scumbags?

    • l vent says:

      @Pamela, The attorney I spoke with yesterday told me that the forging of my mortgage docs will only result in a $200.00 fine for the criminals, a mere slap on the wrist from the judge.. He told me I am better off using that whole package of fraud as leverage to negotiate with the pretender lender than try and nit pick it with the judge.. The whole loan is fraudulent from start to finish.

  6. Pamela says:

    I vent just a note in reference to original doc’s I checked my original mortgage doc’s and found a place that said we weren’t supposed to make a payment until 4/1/11.My loan originated inJuly of 2005.So how did I go into default inJan. of 2010 if my first payment is not due till 4/1/11?

    • l vent says:

      @Pamela: The further we dig, the more we find out that they deceived and robbed us all blind. There is alot of fraud in our mortgages. Maybe we should be taking this stuff to the criminal lawyers and the appellate courts if the judges in the chancery division are all corrupt. I think there is definite proof of criminal liability here. I think this all may just have to go all the way up to the Supreme Court level if the people cannot get the justice they truly deserve. We can’t continue to be left defenseless by a corrupt bunch of lawyers and judges who are aiding and abetting the criminals. They are stealing our country right out from under us. This is Nazi Germany warfare against the American people right here in America. The judges and the their lawyer are their commrades and they must have a hell of a deal cooking with the Nazi’s. What a disgrace. The judges and the lawyers are stealing our whole country from their own people and giving our homes to the FOREIGNERS ON A SILVER PLATTER. These are the very same crooks that set us up and robbed us and they are now posing as lawyers and judges, they are all completely CORRUPT TREASONISTS!!!!!. They are not Americans, they are imposters!!

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