Fed Research Paper Concludes Loan Modifications Counterproductive and "May Increase Strategic Defaults"

To all those who insist lenders are not doing enough loan modifications, a Federal Reserve Bank of Philadelphia research paper suggests that current loan modification programs may have unintended consequences for consumer behavior, specifically, "loan modifications may increase borrowers’ incentives to default on their first mortgage while remaining current on their second mortgage."

While the change in priority of defaults between mortgage and non-mortgage debt has received a good bit of attention, this paper focuses on an issue that has not received much attention: priority of default between first mortgages and second lien mortgages on the same home.

Why might households default on their first mortgage but not default on their home equity loans? One explanation for this behavior is that households do not act strategically but rather default because they are unable to make loan payments – the “inability to pay” hypothesis.

An alternative explanation suggests a more strategic approach to default. Some households that anticipate ultimately going to foreclosure may wish to stop paying their largest debt payment, which is typically their first mortgage payment. However, since foreclosure can be a slow process, these borrowers may decide that they are better off continuing to make their home equity payments to allow them to maintain some access to credit (e.g., unused HELOCs, unused credit card lines, additional credit card or card loans). This explanation would suggest that consumers with high unused HELOCs would be less likely to default on their home equity loans, even though they have defaulted on their first mortgage.

Loan modification programs may provide incentives for homeowners to default as homeowners are not likely to be approved for a modification unless they have missed their mortgage payments. In some cases, borrowers may need to be as late as 90 DPD for their accounts to be handed over to the modification department so that their loans could be renegotiated. Since most loan modifications are modifications of the first mortgage, the availability of a loan modification may provide incentives for borrowers to stop paying on their first mortgage while staying current on their second.

Our results overall suggest that people default strategically as their home value falls below the mortgage value; they exercise the put option to default on their first mortgage. However, they tend to keep their HELOCs current in order to maintain the credit line available to them, particularly for those who have already used their credit card lines. Credit quality as reflected in the types of mortgages (prime, alt-A, or subprime) does not seem to play a significant role in determining this behavior. In addition, we find that loan modifications may increase borrowers’ incentives to default on their first mortgage while remaining current on their second mortgage. Overall, our empirical findings provide a better understanding of consumer strategic default behavior and implies that current loan modification programs may have unintended consequences for consumer behavior.