The Principal Principle: Optimal Modification of Distressed Home Loans
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The Principal Principle: Optimal Modification of Distressed Home Loans

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Why Lenders should Forgive, not Forsake Mortgages ...

Why Lenders should Forgive, not Forsake Mortgages

The current housing crisis has resulted in several homeowners defaulting on their mortgages. Foreclosure lings numbered 321,480 during May 2009 (approximately 1 of every 400 homes), up 18% from the previous year. 2 When dealing with failing borrowers, lenders need to decide between modifying the loan or foreclosing. Modification results in a lowering of the present value of
the loan. Foreclosing incurs deadweight costs that reduce the recovery value of the home. This paper develops a framework for reducing foreclosure losses by loan modification, and how best to implement it. Foote, Gerardi, Goette and
Willen (2009) estimate that loan modification versus premature foreclosure will save $180 billion, or 1% of GDP a year.

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The Principal Principle: Optimal Modification of Distressed Home Loans The Principal Principle: Optimal Modification of Distressed Home Loans Document Transcript

  • 320 220 Loan Value (in 000s) Loan Balance (in 000s) 300 210 280 200 260 190 240 0.050 0.050 34 34 0.055 32 0.055 32 ) ) Lo 0.060 30 ars Lo 0.060 an 30 ars an Ra (ye Ra (ye 28 rity 28 ity te 0.065 atu te 0.065 tur M Ma 26 26 0.070 0.070
  • 205 200 Loan value (000s) 195 190 rL=0.050 rL=0.054 185 rL=0.060 26 28 30 32 34 T (years)
  • 245 240 235 Loan value (000s) 230 225 220 215 rL=0.050 rL=0.054 rL=0.060 26 28 30 32 34 T (years) 165 160 Loan value (000s) 155 150 145 rL=0.050 rL=0.054 rL=0.060 26 28 30 32 34 T (years)
  • 190 170 185 165 180 160 Loan value (000s) Loan value (000s) 155 175 150 170 145 165 rL=0.050 rL=0.050 rL=0.054 rL=0.054 140 rL=0.060 rL=0.060 26 28 30 32 34 26 28 30 32 34 T (years) T (years) 155 140 150 135 145 Loan value (000s) Loan value (000s) 130 140 125 135 120 130 rL=0.050 rL=0.050 115 rL=0.054 rL=0.060 rL=0.054 rL=0.060 26 28 30 32 34 26 28 30 32 34 T (years) T (years)
  • 300000 300000 250000 250000 House Value and Loan Balance House Value and Loan Balance 200000 200000 150000 150000 100000 100000 50000 50000 Default boundary Default boundary Loan balance Loan balance 0 0 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Months to Maturity Months to Maturity