How Government Mortgage Modification Programs Are Incentivized for Failure
With the intentions of preventing foreclosures and strengthening the financial system, the FDIC and the U.S. Treasury have created guidelines for modifying mortgages. They require that the guidelines be followed for a large class of mortgages. The guidelines include an income share target (for housing expenditures), a NPV test, and voluntary participation by borrowers. This paper shows how actual modifications that do little to reduce principal, are still outnumbered by foreclosures and add to borrower uncertainty- that they might be the direct result of incentives created by those very guidelines. Through their income share target and “NPV test,” the federal modification programs have manufactured a tradeoff between the number of foreclosures prevented in the short term and the durability of those foreclosure prevention efforts. That's because they make it impossible to both write down principal and offer modification to a wide range of borrowers. Another result of this tradeoff is to reduce collections, increase foreclosures and their costs, and reduce efficiency as compared to alternative means-tested mortgage modification rules.