Home Is Where the Money Is: A New Incentive Program Aims to Slow Rising Mortgage DefaultsPublished: September 29, 2010 in Knowledge@Wharton
As the housing market languishes in the doldrums, an astoundingly high number of homeowners in the U.S. are defaulting on their mortgages. Some of those homeowners are unemployed or have fallen otherwise on hard times and just cannot afford to make payments. Others, however, own properties that are in "negative equity" -- that is, the value of their homes is less than the amount of the mortgage -- and they have decided that it makes more sense financially to stop paying their mortgages and start fresh.
Wharton finance professor Alex Edmans is researching a new way to prevent the latter, which are known as "strategic defaults." His idea involves an incentive program, called a Responsible Homeowner Reward (RH Reward), which offers borrowers a sizeable cash reward if they repay their entire mortgages. In a paper titled, "The Responsible Homeowner Reward: An Incentive-Based Solution to Strategic Mortgage Default," Edmans suggests that the program could help both homeowners and the financial institutions holding the mortgages avoid the painful, costly process of a default. Moreover, it could benefit the entire housing market by stabilizing prices and preventing homes from being abandoned, which can affect the value of an entire neighborhood. According to a Deutsche Bank study published in January, 14 million U.S. homes were in negative equity, and the number is expected to rise to 20 million by the end of the year.
"We are in the middle of a huge housing crisis," says Edmans. "A lot of homeowners are choosing not to make their payments. Strategic defaults are a major problem for homeowners, lenders and society at large, and require an efficient solution."
His paper cites recent research finding that 31% of U.S. foreclosures in March 2010 were strategic, compared with 22% in March 2009. Another piece of research found that while only 12% of U.S. homes in 2009 were in negative equity, they accounted for 47% of all foreclosures. Edmans also points to evidence that strategic defaults can be contagious. In a survey of homeowners who stopped their mortgage payments, the majority knew someone who had done the same.
The paper notes that a default damages an individual's credit rating and leaves homeowners incurring the cost and inconvenience of moving. As a result, lenders do not need to offer 100% of the gap between the mortgage and the current price of the house to make a reward program worthwhile to the homeowner contemplating a strategic default. Thus, Edmans proposes that a homeowner with a mortgage of $200,000 and a house worth $150,000 might be offered a payment of $20,000 from the lender when the mortgage is paid in full.
As for lenders, Edmans suggests that they would be willing to offer a bonus because defaults are also costly for them. According to one study, "deadweight costs" -- such as possible vandalism when a house is left empty and the administration needed to complete a foreclosure -- can amount to as much as 30% of a home's value.
Traditionally, Edmans notes, lenders believed that homeowners wanted to hold on to their homes at all cost and only defaulted if they had exhausted other options to make payments. Today, he says, many homeowners are defaulting in reaction to the massive drop in housing prices, which results in negative equity. Even though many homeowners can make their payments, they feel the value of their homes are so far "underwater" that it makes sense to abandon them and channel the money toward more lucrative investments. In some cases, homeowners are more willing to default on their mortgages than to miss their credit card or car loan payments.
"Now, default is a conscious choice. It's discretionary. We used to think it was automatic -- either you had the money or you didn't," says Edmans. "But when the default becomes discretionary, the idea of incentives becomes relevant."
Repay or Refinance?
RH Reward is different from other mortgage default solutions because its incentive is made only after the mortgage obligation is fulfilled. In other programs, a lender may make concessions, only to have a homeowner wind up in default later. According to Edmans, the simplicity of his idea is one of its key strengths. "The rules of RH Reward are unambiguous, and so the homeowner knows what he needs to do to receive the RH Reward -- repay or refinance the loan," he writes in his paper.
While other programs focusing on "principal forgiveness" also attack the problem of negative equity, they are costly to execute, Edmans maintains. The RH Reward program is less expensive because it does not require any change to the original loan, eliminating the involvement of mortgage servicers, which can delay and complicate the process. Typically, a loan modification requires additional affidavits and other new information from homeowners. The paper notes that one financial institution using a third party to modify loans through the government's 2009 Home Affordable Modification Program found that 42% of borrowers who could have participated in the plan never completed their applications.
What's more, the reward does not necessarily have to be paid by the owner of the loan. Government agencies, mortgage insurers or banks could become involved. "Since risk is shared on most loans, multiple providers are also an option," the paper states. Edmans adds that because the program does not alter the original loan, it could be applied to both whole loans and those that have been securitized. Traditional modifications to securitized loans are extremely complicated because ownership is divided across many parties. Securitized loans represent $2 trillion in value, according to Edmans' paper.
His proposal would avoid the high costs of loan modifications, including legal and documentation fees, which the paper estimates to cost between $500 and $600 per loan. Finally, Edmans suggests that the program can be extended to cover second homes, vacation homes and investment properties. Strategic default, which could set off a wave of house price declines in a particular area, is more likely on properties that are not owner-occupied because homeowners still have a roof over their heads.
From the lender's perspective, the reward program allows mortgage holders to avoid recording an immediate charge to account for the loss of capital in a principal reduction. While lenders must eventually record the reward payment, that only happens if the homeowner pays off the loan and, because the payout is likely to occur far in the future, the accounting impact is diminished, Edmans says.
Because of the obstacles associated with principal forgiveness, he adds, only 10% of loan modifications are based on reducing the overall amount due. Further, the paper notes that Comptroller of the Currency data shows 58% of the modifications made in the first quarter of 2008 wound up in default again.
The Power of Incentives
The RH Reward program draws on Edmans' other work in incentive theory. For example, he has written a forthcoming paper for the Review of Finance on compensating CEOs with debt to align them with bondholders. Edmans maintains that if leaders are paid only with equity, they may undertake risky decisions that benefit shareholders at the expense of creditors. In the mortgage example, a homeowner is like a CEO and the bank represents the creditor, or bondholder. Foreclosure, or default, hurts "bondholders," as do risky projects.
The RH Reward program draws on a large body of literature on behavioral economics, which emphasizes that consumers' decisions are affected by how they are "framed." First, Edmans says, the program builds on the notion of "salience" by reminding homeowners participating in the rewards program about the eventual payoff. As part of the program, homeowners receive a monthly statement showing the amount of money they would receive if they paid the full mortgage amount.
The program also builds on the power of "narrow framing." According to Edmans, a principal reduction of $20,000 in the context of a $200,000 mortgage is not as meaningful as a $20,000 reward payment. "A $20,000 reduction in a $200,000 loan may seem like a drop in the ocean," says Edmans. "However, framing a $20,000 bonus separate from the mortgage makes it appear quite large, similar to a $20,000 bonus at work."
What's more, RH Reward replicates the "endowment effect." The theory behind this concept is that once a person is promised something, he or she will become attached to it and will work harder to achieve a particular goal than he would if a reward had never been promised.
The paper calls for a scalable program intended to have an impact on homeowners and lenders, given the magnitude of the current crisis in housing prices.
RH Reward is being rolled out in 45 states by Loan Value Group, a private advisory firm in New Jersey that Edmans is involved in along with former colleagues from Morgan Stanley. While many commentators have proposed solutions to the housing crisis, most of them require government intervention or taxpayer money, or have practical difficulties hindering implementation, Edmans states.
Under the RH Reward program, lenders are offering more than $90 million in rewards covering approximately $1 billion of their mortgages. Edmans notes that the effort is still in its early days; more results will be included in the paper once the program has been running long enough to gather data. Edmans will use that data to help determine which homeowners are best suited to use the incentives, and the optimal size of the incentive to curb strategic defaults.
While Edmans acknowledges that most academic papers do not require actual implementation, the magnitude of the current housing crisis has convinced him to put his research to the test. "We often hear the criticism that business school research never affects reality. This will hopefully be something grounded in incentive theory and behavioral economics, but also practical," he says. "[The program] addresses a major issue that a lot of government solutions have not been able to solve yet."