Boston Fed Policy Discussion: Reducing Foreclosures

I haven’t had much time to look at this Public Policy Discussion Paper, but Christopher L. Foote, Kristopher S. Gerardi, Lorenz Goette, and Paul S. Willen seem to have taken a good look at the data – and listened to it!

It is interesting that the Boston Fed is releasing this paper on Good Friday – could it be that management is not 100% enthralled at the political incorrectness of the conclusions?


This paper takes a skeptical look at a leading argument about what is causing the foreclosure crisis and what should be done to stop it. We use an economic model to focus on two key decisions: the borrower’s choice to default on the mortgage and the lender’s choice on whether to renegotiate or “modify” the loan. The theoretical model and econometric analysis illustrate that “unaffordable” loans, defined as those with high mortgage payments relative to income at origination, are unlikely to be the main reason that borrowers decide to default. Rather, the typical problem appears to be a combination of household income shocks and an unprecedented fall in house prices. Regarding the small number of loan modifications to date, we show, both theoretically and empirically, that the efficiency of foreclosure for investors is a more plausible explanation for the low number of modifications than contract frictions related to securitization agreements between servicers and investors. While investors might be foreclosing when it would be socially efficient to modify, there is little evidence to suggest they are acting against their own interests when they do so. An important implication of our analysis is that policies designed to reduce foreclosures should focus on ameliorating the immediate effects of job loss and other adverse life events, rather than modifying loans to make them more “affordable” on a long-term basis.

… and I was pleased that somebody has finally observed:

Estimates of the total gains to investors from modifying rather than foreclosing can run to $180 billion, more than 1 percent of GDP. It is natural to wonder why investors are leaving so many $500 bills on the sidewalk. While contract frictions are one possible explanation, another is that the gains from loan modifications are in reality much smaller or even nonexistent from the investor’s point of view.

We provide evidence in favor of the latter explanation. 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. Investors also lose money when they modify mortgages for borrowers who would have repaid anyway, especially if modifications are done en masse, as proponents insist they should be. Moreover, the calculation ignores the possibility that borrowers with modified loans will default again later, usually for the same reason they defaulted in the first place. These two problems are empirically meaningful and can easily explain why servicers eschew modification in favor of foreclosure.

Turning to the data, we find that the evidence of contract frictions is weak, at least if these frictions result from the securitization of the loan.

One Response to “Boston Fed Policy Discussion: Reducing Foreclosures”

  1. […] follows the earlier Boston Fed paper, Reducing Foreclosures, which argued that it was income shocks and housing price declines, not high payment-to-income […]

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