Ed DeMarco and the spectre of strategic modifiers

By Felix Salmon
April 12, 2012
Ben Walsh covered Ed DeMarco's speech in the Counterparties round-up yesterday, I got a very smart note from the undisputed kind of the housing blogosphere, Calculated Risk:

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After Ben Walsh covered Ed DeMarco’s speech in the Counterparties round-up yesterday, I got a very smart note from the undisputed kind of the housing blogosphere, Calculated Risk:

I think DeMarco made a key point about “strategic modifiers” as opposed to what people have been calling “strategic defaulters”.

In the 2nd case, these are people who can afford their mortgage, but walk away because they are so far underwater that continue to pay makes no sense.

DeMarco is talking about people who will want to keep their home, but default for the purpose of receiving a principal reduction.

I think this is more likely than the classic strategic defaulter (something I’ve played down for years).

The reason is Fannie and Freddie will have to make the program guidelines clear and public. People are very good at figuring out how to game the rules. So, unless the rules are very tight, there will be more “strategic modifiers”.

Certainly this is something that DeMarco is worried about: in his speech, he defines a “strategic modifier” as “a borrower that either claims a financial hardship or misses two consecutive mortgage payments in order to attempt to qualify for HAMP and a principal forgiveness modification.” If there are enough of these borrowers, he says, then the financial benefits of principal reduction could go away quite quickly.

DeMarco’s worries are not entirely unfounded, given, as he says, that three quarters of the Enterprises’ deeply underwater borrowers are current. But the distinction between a strategic defaulter and a strategic modifier is a very subtle one, given that their actions — defaulting on their mortgage while being capable of making payments in full — are indistinguishable.

The difference is not in what they do, but rather in their motivation: the strategic defaulter expects to lose the house at some point, while the strategic modifier expects to retain the house, and the mortgage, but get a principal reduction along the way.

Personally, I don’t believe that the problem of strategic modifiers (over and above the problem of strategic defaulters) is likely to be huge. One reason is that I’ve been writing about the upside of strategic default for a long time, and it really hasn’t caught on, outside a few second homes and the like. Strategic default is not something that Americans like to do, and one of the main reasons is that they really care about their credit rating. Even if a strategic modifier keeps her house, she’ll suffer the same hit to her credit rating as a strategic defaulter would. And people don’t like that at all.

On top of that, the strategic modifier will still be running the risk of getting far behind on her mortgage payments, being unable to make them up, and then for some reason not qualifying for a principal reduction or indeed any other kind of modification. DeMarco is right that the principal-reduction program would be broadly publicized. But it will be publicized to people who are having real difficulty making their mortgage payments. If you can’t make those payments, then applying for a principal reduction is a no-brainer: it’s all upside and no downside. But if you can make those payments, the calculus is a lot more complex.

Even if principal reduction were made available to people who hadn’t missed a single mortgage payment — and I doubt that it would be — it would still constitute a write-off of a large chunk of debt, and would likely be considered a default as far as FICO was concerned. And if you do have to be in default to apply for a principal reduction, then not only do you suffer the hit to your credit rating, but you also run the risk of falling into a major mortgage-related nightmare which might well end up with you losing your home.

CR is right that people like to game rules. But he misses a crucial point here, which is that any principal-reduction program would be run by mortgage servicers. And the one thing that everybody knows about mortgage servicers is that they’re incompetent. No one will trust the servicers to play the game perfectly by the rules.

I, for one, would be petrified of playing this game, because I would have no faith at all that my mortgage servicer would do the right thing and give me that principal reduction, rather than having its left hand lose lots of paperwork while its right hand started foreclosure proceedings.

So let’s try principal reductions in the real world, and see what happens. If they turn out to be incredibly expensive, then we can revisit the issue. But my guess for the most likely outcome is not a wave of strategic modifiers. Rather, it’s that the program turns out to be much like all other government attempts to deal with underwater borrowers: a damp squib where very little happens at all.

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