FDIC and FRB Symposium on Mortgages and the Future of Housing Finance – Part 3

Recently I attended a two-day symposium on mortgages and the future of housing finance  on on October 25 and 26, 2010, hosted by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve System. (Here’s the link to the agenda: www.fdic.gov/bank/analytical/cfr/oct2010-conf.html.)

There were three sessions that I personally found particularly interesting that I’ll be summarize over the next few days; (1) loss mitigation and loan modification practices and performance, (2) adverse selection in mortgage securitization, and (3) mortgage default decisions including strategic default. In this second post, I’ll focus on strategic defaults.

This session started out with an intriguing paper which I can’t provide a link to, that was written by Kenneth Brevoort (Fed Board of Governors) and Cheryl Cooper (Urban Institute). It ran through the post-foreclosure experiences of individual borrowers in great detail. Here are some of the interesting factoids:

• The higher the FICO credit score prior to foreclosure, the bigger the drop in post-foreclosure FICOs. This kind of makes sense, because after foreclosure, the FICO has to at least drop through the 680 threshold. So for example, they find that homeowners who start out at 780 drop an average of 160 points (to 620), whereas those who start out at 680 drop only 85 points (595). Of course, there’s also a lower bound to FICO scores (300).
• It takes seven years for a foreclosure to be removed from a borrower’s credit record, but scores can bounce back quite dramatically right after the foreclosure event. They find that the recovery trajectory for prime borrowers is slower than for subprime borrowers, and recent recovery rates have been slower than historical rates.
• Few get all of the way back to pre-foreclosure scores even over many years, and they tend to remain delinquent in some way for years (e.g., credit cards or auto loans).

Tomasz Piskorski presented a paper he co-wrote with Christopher Mayer, Edward Morrison and Arpit Gupta, that sought out evidence of strategic defaults using information from a legal settlement involving Countrywide Financial Corporation. As part of the settlement, Countrywide had to implement a streamlined modification program that offered expedited, unsolicited modifications to all borrowers who were at least 60 days delinquent. The authors found abundant evidence of strategic defaults, in this case defined as borrowers who stopped making payments to exploit the new modification program.

The Piskorski et. al. paper is still in the “preliminary and incomplete” stage, so it’s not yet available for wider distribution. However, in the discussion that followed, one cautionary note was expressed, in that coincidentally, what looked like strategic default behavior was driven by reset dates on the predominantly 2/28 hybrid adjustable-rate mortgages (ARMs) that were offered by Countrywide.

The paper presented by Jane Dokko focused on the potential influence of negative equity on strategic default:

We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to -62 percent of their home’s value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the “double-trigger” theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest.

In the discussion that followed, it was mentioned that expected home price dynamics (expected changes and volatilities) could usefully be incorporated into the analysis.

And that’s all for my coverage of the FDIC-FRB Symposium!

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

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