PASADENA, Calif., December 14, 2017 — You can’t say the U.S. government doesn’t have a big heart.
After the 2008 financial collapse, the federal government provided about $4.6 billion in principal forgiveness from 2010 to 2016 to help homeowners, owing more on their mortgages than their homes were worth, avoid foreclosure.
As an example, if a homeowner owed $600,000 on a home that had a market value of $500,000, the government might have reduced the homeowner’s principal by, say, $50,000, leaving a $550,000 mortgage balance. With a smaller balance, policymakers thought homeowners would continue making their monthly mortgage payments. By 2010, approximately 24 percent of all U.S., residential properties were underwater, according to Core Logic, a data and analytics company, so it was critical that the government’s response was effective.
Despite the program’s good intentions, however, each avoided foreclosure ended up costing taxpayers $800,000. Those are the findings of a new study by Pascal Noel, an assistant professor at University of Chicago Booth School of Business and Peter Ganong, an assistant professor at University of Chicago’s Harris School of Public Policy.
Preparing for the next crisis, the study’s authors wanted to know whether the government’s response had been the best use of public funds.
Turns out it wasn’t. A more effective program, according to the authors, would have been to temporarily lower the underwater homeowners’ mortgage payments, freeing up cash flow and thus spurring consumer spending to help lift the country out of recession.
After analyzing some 1.6 million underwater homeowners who received principal reductions (reducing their loan-to-value ratio), Noel and Ganong found that foreclosure rates decreased by less than 1 percent.
One of the reasons that the principal reduction program was so ineffective was that in spite of the government’s intervention, the majority of homeowners were still underwater on their mortgages, leaving them unable to qualify for a home equity line of credit or a second mortgage — money that could have been pumped back into the economy to stimulate consumer spending.
Job loss and other income shocks that affect cash flow are what prevent most people from keeping current on their mortgage, the study found. Having a smaller mortgage balance, in and of itself, doesn’t have much influence over whether you will pay your mortgage.
Had the government instead provided mortgage payment relief over the same period, defaults would have decreased by 1 percent for every 1 percent reduction in monthly mortgage payments, the authors concluded.
“That is a much bigger effect than we get from reducing mortgage principal without changing payments,” Dr. Noel said.
While it’s comforting to know the U.S. government has a big heart, it will feel even better to know that in the next housing crisis, financial assistance will be directed at where it can do the most good — reducing the homeowner’s monthly mortgage payment.
Lesson learned: It’s not the principal that counts!