Foreclosures, Enforcement, and Collections under the Federal Mortgage Modification Guidelines

Federal mortgage modification initiatives, targeting millions of borrowers, are intended to prevent foreclosures of underwater home mortgages. Those initiatives discourage principal reductions in favor of interest reductions, despite the possibility that the former would be a more durable foreclosure prevention tool. The programs also impose marginal income tax rates substantially in excess of 100 percent. Using the framework of optimal income taxation, this paper shows how alternative means-tested modification rules would simultaneously improve collections, efficiency, the number of foreclosures, and their total cost. As a result, lenders have an incentive to foreclose on borrowers deemed modification eligible by the federal programs.

The paper is here . Much of the paper is difficult reading for non-economists, but the following excerpt from page 10 is clear enough:

"For a modification that is expected to be mortgage’s the final modification, a marginal dollar earned in the base year raises mortgage payment obligations by 31 cents in each of the following five years, if not beyond. If, say, 2009 income were used to calculate the payment meeting the income share target for the years 2010-14 and the interest rate were zero, then the marginal tax rate would be at least 155 percent for 2009 (5 times the formula’s 0.31 limit on the payment to income ratio, plus any effect of base year income on payment obligations after year five). At the annual interest rate of 6 percent used in the proof, the year zero marginal income tax rate is between 131 and 396 percent.

The income share target is based on the borrower’s gross income prior to the modification, and borrower’s federal personal income tax return is the most important document for verifying this income. The payments specified by a modified loan are set in dollars (of much the same form as specified in the original mortgage contract), and is not adjusted for the borrower’s income in years after the modification occurs. Future modifications to the loan may occur, but (assuming the program exists in the future) are at the borrower’s discretion. Thus, a borrower whose income grows after the modification will not have his payments adjusted upward as a result of that growth: the marginal tax rate imposed by a year 1 modification on incomes earned in years 2 and following is zero."

Thank you for posting this. This type of article has direct impact on my job. This was an attempt at a summary.

1. 2 Criteria Set under FDIC and HAMP Programs:
a. Income Share Target: PITI must be below a set share of income at time of modification
b. NPV Test: Net-present value of the modified loan must be worth at least the updated value of the collateral.
2. Effects
a. There is a range of income that simultaneously satisfies the two targets.
i. A borrower wanting modification has insufficient income to satisfy (1b) even at the maximum level allowed under (1a).
ii. Borrowers with large incomes and/or small payments satisfy (1a) and (1b) without need for modification.
iii. Modification done with principal reduction reduces the income range that satisfies (1a) and (1b). Under the Federal programs, a modification usually involves a reduction in PI for five years but a reduction in principal would represent a permanent reduction in PI therefore the constraint (1b) becomes more binding. But since the permanent reduction in PI reduces the incentive for a borrower to exercise his “put option” for the entire term of the loan such modifications have better chance of long term success. Trade off between helping the most borrowers now vs. how likely the modification will work in the long term.
1. My note: If housing prices recover before the 5 year period is over then the borrower might be back in a positive equity position although in the hardest hit areas that is highly unlikely.
b. The greater the negative equity the larger population eligible for a modification satisfying (1a) and (1b).
c. Because of (1a) the “marginal income tax rate” is over 100%
i. Under the 5-year plan, a dollar of extra income results in 31 cents more mortgage payment over 5 years with reasonable discount rates represents more than a dollar in present-value terms.
ii. A permanent reduction in payment from principal reduction would have “marginal tax rates” of up to 400%.
iii. With these incentives, borrowers have the incentive to underreport income or reduce work effort in the year they considering modification reducing the range of borrowers who can meet criteria (1a) and (1b).
iv. Only borrowers with the minimum income that satisfies (1b) will agree to a modification.
d. Because of the lack of durability and the type of borrower who would agree to a modification, servicers have an incentive not to participate. Since not participating is not an option, random selection of defaulted borrowers into those who will be offered a modification and those who would foreclose on would be optimal.

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