Fixing the Next Mortgage Crisis

There has been no shortage of opinions on this topic. But according to new research, the top priority should be getting more cash into homeowners’ hands. Immediately reducing mortgage payments allows homeowners to retain their homes and continue spending, boosting the local and national economy. In fact, proactively redesigning mortgages to automatically reset to terms facilitating lower payments could head off multiple problems associated with future housing crises.

Janice Eberly, a Kellogg School finance professor who served as Assistant Secretary for Economic Policy and Chief Economist at the U.S. Treasury from 2011 to 2013, helped to shape loan-modification programs under the Obama administration. She and collaborator Arvind Krishnamurthy, a professor of finance at Stanford, wanted to provide a theoretically grounded way of comparing different housing-crisis interventions directly to see which would be most effective.

“It is easy to say, ‘We should do this or that,” Eberly says. “But there aren’t enough resources to do everything, and there was no framework to let you compare tactics. That’s what we set out to create.”

Get Cash into Hands

The researchers built a model that captures the effectiveness of a variety of interventions in improving economic outcomes. They found that tackling homeowners’ cash constraints should be the nation’s first priority during the crisis.

Specifically, because many households face liquidity problems due to lost jobs, lower (or zero) incomes, and a weaker economy during the crisis, boosting their cash flows could yield “consumption spillovers” to the local and national economies. (Indeed, recent research by Scott Baker, an assistant professor of finance at the Kellogg School, finds that income shocks cause more drastic changes in spending behavior in illiquid households.)

“If more people are spending, more people are earning,” Eberly says. For example, if people continue to buy groceries, that allows grocery-store managers and cashiers to keep working—and making purchases themselves.

The best way to get cash into homeowners’ hands, Eberly notes, is by modifying their mortgage loans to lower their payments immediately, whether through a shift to a lower interest rate for a specific term, a payment deferral, or a mortgage-term extension. That keeps people spending, and lowers their odds of default. “You need to get out in front of that issue as early as possible,” Eberly says.

Modifying a mortgage loan to immediately reduce payments is even more effective than decreasing the loan’s value—and thus the principal owed—because principal reductions spread payment benefits over the entire life of the loan, failing to get cash into homeowners’ hands as quickly as possible.

Address Strategic Default

Though cash-strapped households should be the top priority, the researchers’ model also suggests the need to address “strategic default,” or the tendency to walk away from an “underwater” mortgage (where the loan’s value exceeds the home’s value) one can still afford to pay. Here, reducing the loan’s value by either refinancing or even writing down principal can make for smart policy. A write-down appeals to homeowners, who want to stay in their house but not pay more than it is worth—as well as banks, who are spared a default that leaves them in possession of the (less valuable) house in question.

The challenge is that banks do not know who is going to engage in strategic default, or when. Even in a crisis, people often continue making their mortgage payments, so lenders have incentive to take a wait-and-see approach. In the meantime, the household may be restraining consumption and ultimately opt for strategic default. “So from the standpoint of the macroeconomy, the lender may have the timing wrong,” Eberly says. “It’s a tricky incentive problem.”

She suggests that the government encourage write-downs (perhaps through incentive payments to lenders or by easing and standardizing the modification process). Moreover, if the government itself owns the mortgage (say, through Fannie Mae, Freddie Mac, or the Federal Housing Authority), it could have a direct incentive to write down its own loans and avoid losses from strategic defaults.

Redesign for the Future

The researchers encourage a proactive approach to future crises. How? By redesigning mortgages to automatically adjust terms in the face of a major housing downturn.

“People love 30-year fixed-rate mortgages,” Eberly says. “They’re comfortable and predictable. But that type of contract can be a problem in a crisis.” Specifically, a fixed rate prevents homeowners from easily taking advantage of lower interest rates to decrease their house payments. A lower rate would also mean more homeowners may choose to keep paying their loans; their payments fall for the life of the loan, and hence the value of their debt drops.

“Automatic refinancing is powerful,” Eberly says. “If market rates go significantly lower, your mortgage rate and payment go lower.”

Automatic-reset mortgages would act as a stabilizer, immediately lowering payments, which in turn helps preserve vital broader spending during a crisis. Importantly, such contracts would enable any mortgage holder to take advantage of lower rates, not just those who manage to prepay and refinance their loan. And such mortgages would reduce the risk of default, benefiting households and lenders, and reducing the cost of automating the refinance.

“People should think of automatic-reset mortgages as similar to insurance,” Eberly says. “They may cost more, but they have benefits to lenders and borrowers, and might help you stay in your house.”

This contract-driven approach is not that different than the prepayment option currently included in fixed-rate mortgages. While federal programs like HARP and HAMP have brought payments and debt levels down for some borrowers, after seeing them in action, it is clear that they would have had more power “larger, earlier,” according to Eberly.

One big advantage of automatic-reset mortgages is their automaticity: they involve much less work (and stress) for all parties, enabling faster, large-scale change. “Imagine if you just got a letter from your lender saying your payment is going down, instead of being invited to apply, fill out paperwork, and wait for approval,” Eberly says.

The researchers’ model could also provide insights that go far beyond the housing market. Consider college loans. “You’re talking about investment in human capital [education],” Eberly says. “It’s large in scale, the government is a big player, and there’s also a parallel private market. So we can use the model to think about risk and implications for the broader economy.”

Artwork by Yevgenia Nayberg.