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.”

Please consider Strategic Default on First and Second Lien Mortgages During the Financial Crisis by Julapa Jagtiani and William W. Lang.

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.

We investigate the role of loan modification further by examining default behavior both before and after (re-default) the modification. Focusing on modified loans only, we find that, on average, about half of these modified loans were delinquent (at least 60 DPD) prior to the start of the modification and most of them returned to the current status after the completion of modification. However, a large portion of these loans actually re-defaulted within six quarters after the modification – specifically, 47 percent of these loans became at least 60 DPD and 38 percent became at least 90 DPD within six quarters following the modification.

Conclusions and Policy Implications

Interestingly, there is little evidence that many borrowers have decided to strategically default on second liens while maintaining payments on first mortgages. Instead, our results indicate a significant declining trend (for 2008-2009) for defaulting on the second lien while keeping the first lien current, controlling for risk characteristics of the borrowers and loan types.

We also find that negative equity, proxied by LTV and/or CLTV exceeding 90 percent, has been the primary reason for homeowners to default on their mortgages overall. Negative equity is a necessary but not sufficient condition for strategic mortgage default. While some of these homeowners default on both first mortgages and second lien home equity lines, a large portion of the delinquent borrowers actually keep their second lien current. This behavior is generally more common with people who have HELOCs (rather than HELOANs) and is more common when there is a larger unused line of credit.

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.

Default Rates Across Financial Products

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Note: LPS Applied Analytics (McDash), consists of all mortgage loans issued by nine of the top ten mortgage servicers in the U.S., covering approximately 75 percent of outstanding mortgage loans as of year-end 2009.

Home Equity Loans vs. Home Equity Lines of Credit

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One look at that second chart tells you all you need to know about why second lien holders (specifically, HELOC lenders) do not want to speed up foreclosures or accept any modification agreements that would wipe them out.

People would rather give up their house than their autos or their credit lines. Moreover, the longer the delays, the more incentive there is for homeowners to make strategic defaults on their mortgage.

The proper conclusion is that efforts to delay foreclosures by loan modifications simply makes matters worse, a position I have taken since the beginning as a matter of plain common sense.

Mike “Mish” Shedlock
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