Policy Finance & Accounting Dec 1, 2014

Fix­ing the Next Mort­gage Crisis

What if mort­gages could be refi­nanced automatically?

Based on the research of

Janice C. Eberly

Arvind Krishnamurthy

How should the U.S. gov­ern­ment and banks han­dle a mort­gage-cred­it cri­sis like the one that began in 2008?

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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.”

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 ‚” 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.

Featured Faculty

Janice C. Eberly

John L. and Helen D. Russell Professor of Finance and Faculty Director, Kellogg Public-Private Initiative

About the Writer

Sachin Waikar is a freelance writer based in Evanston, Illinois.

About the Research

Eberly, Janice and Arvind Krishnamurthy. “Efficient Credit Policies in a Housing Debt Crisis.” Brookings Paper on Economic Activity, Presented at the Fall 2014 Brookings Panel on Economic Activity (revised October 13, 2014).

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