Are 'Affordable Mortages' a Myth?
An interesting research paper released last week by researchers at the Federal Reserve Bank of Boston takes a critical look at the nation's foreclosure problem, and finds evidence that conflicts directly with what many have assumed is common knowledge -- the idea that borrowers are stuck in 'unafforable mortgages,' and need strong government intervention in modification efforts to make their mortgages more affordable. The paper's authors -- the Boston Fed's Christopher Foote, Atlanta Fed's Kristopher Gerardi, University of Geneva professor Lorenz Goette, and the Boston Fed's Paul Willen -- argue that mortgage "affordability", defined in the study as the borrower's DTI ratio at origination, is an exceptionally poor predictor of a future default. "While a higher monthly payment makes default more likely, other factors, such as the level of house prices, expectations of future house price growth and intertemporal variation in household income, matter as well," they write. "Movements in all of these factors have increased the probability of default in recent years, so a large increase in foreclosures is not surprising." The authors argue that the affordability of a mortgage matters, but not nearly as much as other factors. More from the research team: "Ultimately, the importance of affordability at origination is an empirical question and the data show scant evidence of its importance. We estimate that a 10-percentage-point increase in the DTI ratio increases the probability of a 90-day-delinquency by 7 to 11 percent, depending on the borrower. By contrast, an 1-percentage-point increase in the unemployment rate raises this probability by 10-20 percent, while a 10-percentage-point fall in house prices raises it by more than half." Foreclosure might be the best option Consumer advocates have gained plenty of traction in the past year decrying foreclosures as a 'lose-lose' solution, and by suggesting that everyone -- borrowers and investors -- have the most to gain by modifying a mortgage and keeping a borrower in their home. And the same advocates have largely pointed the finger at servicers, either overstaffed or unwilling to modify achieve what seems to be such an optimal solution. One problem: loan modifications might not really be the win-win that so many assume. "First, the typical calculation purporting to show that an investor loses money when a foreclosure occurs does not capture all relevant aspects of the problem," the authors write in the study. "Investors also lose money when they modify mortgages for borrowers who would have repaid anyway, especially if modi?cations are done en masse, as proponents insist they should be. Moreover, the calculation ignores the possibility that borrowers with modi?ed loans will default again later, usually for the same reason they defaulted in the ?rst place. These two problems are empirically meaningful and can easily explain why servicers eschew modi?cation in favor of foreclosure." The authors derive a simple econometric model that explains why it often costs a servicer/investor more to modify loans than to simply foreclose on a property, and suggest that in certain circumstances, "a good policy might help homeowners transition to rentership through short sales or other procedures." Read the full study here. Write to Paul Jackson at firstname.lastname@example.org.