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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I’ll pay cash for my next place. I’m going to retire a few years early and take a lump sum distribution from one of my investments.

Actually, I technically “lost” this house and all my equity a few years ago when the market collapsed through no fault of my own. It was worth 210K when I bought it in 2006; now it’s worth 80K. Now, the only advantage to me of “owning” this property is a modest tax deduction each spring.

CitiMortgage gets it’s interest payment on time each month and the portion that should be going towards my principal. If I don’t get a principal reduction, CitiMortgage will eventually they will finish the job of ripping me off by taking the rest of the property.

My point is simply that FreddieX, CitiMortgage and our economy’s managers have a vested interested in keeping me in this property. To accomplish that, they will have to make me a new deal.

The way I see it… they caused this problem and profited from it and should be in prison. But I’m a big boy; I know how the world works and I can take a licking and keep on ticking.

They are willing to go through the trouble and expense of foreclosing, bundling the property up with others like it and selling it at LESS than fair market value to corporate investors.

By allowing me to refinance at fair market value and lower rates, they lose less money. Simple arithmetic… and I’m the one they screwed.

If you don’t like arithmetic, then there is also something morally wrong about screwing somebody out of their equity in a property, then forcing them to leave by putting them in a situation where no matter what they do, they can never build equity in that property, then repossessing it and selling it at a greater loss to a corporation that will rent the property to other people who have had the same thing happen to them.

Freddie Mac is not running a socially responsive charity for homeowners who have fallen on hard times. They are financially responsible for the mortgages they have guaranteed. The best way to prevent large losses is to negotiate smaller losses.

DeMarco is a fool. I’ve never missed a payment, but I will look after my own interests. I don’t expect anyone else to do that for me.

Posted by breezinthru | Report as abusive

breezinthru, you can’t blame the bubble wholly on the banks. Without buyers eager to pay ridiculous prices, the whole bubble would have died before it began.

Why did you believe the property was worth $210k in the first place? Were your payments on the property similar to what it would have cost you to rent? Or was your cost of ownership much higher?

The real victims, if you must have one, are the hundreds of millions of people who did NOT buy during the bubble, but are suffering the economic consequences anyways. But we’re adults and will take our lumps as they come, even if we didn’t do anything to deserve them.

I do wish you the best of luck negotiating a solution that minimizes the screwing…

Posted by TFF | Report as abusive

breezinthru, so “they” caused the problem by lending you money in a contract you freely agreed on?

I hope you walk away and you end getting completely screwed. I look forward to reading your sob story in the NYT

Posted by Danny_Black | Report as abusive

The prices weren’t ridiculous at the time. I sold my modern 4 split level empty nest and down-sized to a modest one level, 1960′s rambler in a quiet old neighborhood. I got what was then a pretty good deal.

The precipitous drop in home prices is not due to the normal ebb and flow of the markets. If it was, I would just be patient and I would eventually get into the plus column again. A drop from 210K to 80K is due to ubiquitous fraud and it is not something I’ll recover from in my lifetime.

I’m not going to keep making large payments on this property until Freddie gets back on his feet. I’m not running a charity, either. And I’m not sobbing. I’m pissed that the fraudulent activity that has sent no one to prison.

I don’t get why you’re so upset at me. I’m the victim of the fraud and so are you and the rest of America and the Eurozone. All I’m doing is getting myself okay so I can retire and grow old on my own money. Would you feel better about it if I managed my affairs so poorly that I had to depend on subsidized housing and Medicaid?

I was an Army officer. I understand the concept of honor and duty. I pay my taxes. I paid off my student loans. I have always paid my bills. This is different. The people who are still making payments are like me, not like the people who worked for minimum wage and bought homes worth 450K with NINA loans. Those people washed out a long time ago.

Our judicial system has the duty to criminally prosecute the bastards who caused this problem and I’m getting a little bit tired of being walked on by people with 7 or 8 figure salaries and a lot of friends in Congress. You have a problem with that? Then you are more like them than like me and I don’t like you very much.

Posted by breezinthru | Report as abusive

@breezinthru, that isn’t quite what I asked. Comparing to rents is very different from comparing to “prices at the time”.

Check out the Case-Shiller index. The “prices at the time” were uniformly ridiculous. You probably came out ahead if you downsized at that time, since the price that you sold the “empty nest” for was almost certainly double what it was worth (just like the price you bought for).

So who drove those ridiculous prices? The banks weren’t the ones writing the P&S agreements. Their mistake was handing out money to anybody who asked. Was it the realtors? The mortgage brokers? The buyers who demonstrated no sense of perspective? The pension managers who bought up MBS like they were candy? Our lawmakers who pushed this activity? Or all of the above?

I’m not upset at anybody. Like I said, we’re all adults, we all make mistakes, and I wish everybody the best of luck in getting unscrewed. If it turns out that your situation requires that you walk away from the property, I won’t take you to task for that.

But let’s not deny our own roles in this mess. EVERYBODY involved in a real estate transaction, or in forming policy, between 2002 and 2007 played their part in creating it.

You claim that you were defrauded. Can you please explain HOW you were defrauded? Who led you astray? What lies did they tell you?

Posted by TFF | Report as abusive

P.S. My salary is $15k (though I earn another $30k through self-employment). I guess that has seven figures, if you add the cents?

Posted by TFF | Report as abusive

I was not defrauded. The purchasers of the associated CDO’s and CDS’s were defrauded. The apparatus that funneled subprime mortgages into the creators and sellers of the CDO’s assisted in the manner of organized crime and IMHO should also be charged under RICO. The fraudulent activity was integral to the real estate bubble.

I was among those who suffered the myriad consequences. I wasn’t planning to use that particular investment to buy a house, but I’m lucky that I at least can. I’ll be fine. I didn’t lose my job and I have assets. I’m still angry and that doesn’t make it any less of crime and a lot of people around the world have suffered more than I did.

I’m not a lawyer. I’m stating my opinion on the matter and you could argue the details, but I won’t be changing my mind on the crux of this issue.

Posted by breezinthru | Report as abusive

Ah, I can agree with those allegations of fraud. And yes, they were one part of the larger mess.

I still suspect you likely profited from the bubble, as did pretty much anybody who sold or downsized in 2006. If you want to calculate home equity from its peak, then we also “lost” $120k on our house since the end of 2005. But in our case it was paper gains (never realized) and paper losses (never realized). I guess that makes it easier to live with? I’m more worried about the broader implications for the country and economy as a whole.

The imprudent buyers who got us into that mess are still with us. But these days they are complaining because the banks won’t approve the loans they want to take out. Applications are being rejected for insufficient documentation, insufficient income, excessive LTV… If the banks had properly vetted the loans back in 2004, prices would never have run up as far as they did.

Posted by TFF | Report as abusive

I paid 28.9K for my first house. It was built in 1906. I was a young man with a full time civilian job and while my friends were out having fun after work, I gutted the kitchen and downstairs bathroom including the non-insulated wood lath/plaster walls… and much more. My father and I rewired and replumbed and remodeled and I sold 1 1/2 years later for nearly twice that price.

To address your assertion directly… I have never considered renting. It’s not profitable and it’s not compatible with my life and how I like to spend much of my free time… gardening, remodeling, landscaping…

I’ve done this to several homes over the past few decades and I’m still working full time. I have indeed made money in real estate, but I’m proud of the quality work I do and I made my money honestly. My last home was fairly new. I thought I might relax a little more, but I realized later that what I was doing was how I relax. I sold, took a sizable profit (surely in part due to the bubble), I decided to make my rambler nicer until I was ready to retire.

The imprudent buyers to which you refer are no longer paying timely payments on on underwater homes. As I mentioned, they are more like me.

Nonetheless, I already took losses, I can’t sell and I can’t gain equity and hell will freeze over before I bail out those bastards at Freddie Mac and CitiMortgage on the installment plan. I’m willing to deal or willing to walk but I’m not willing to kiss their crooked backsides. I really believe that a lot of underwater homeowners share my sentiment.

Some of my assumptions regarding you were mistaken. I apologize for that.

Posted by breezinthru | Report as abusive

PS – I’m worried about the broader implications for our country and economy, too. I worry about how it will be for my kids in a land where the rich and powerful are exempt from the rule of law… in a land where large corporations have the legal rights of “personhood”?

You can’t jail a corporation when they break laws and they have no real fear of the costs or consequences of civil court proceedings.

But I digress.

Posted by breezinthru | Report as abusive

@breezinthru -

Thank you for your service to the country. We all have to do what is right for ourselves within the limits of law and ethics. (It’s that last part that Wall Street and DC can’t bring themselves to face.)

IMO there is no moral wrong in your walking away from your underwater property – both parties to your mortgage understood that this was an option you had under law. Go for it if it works for you. You will have to accept the hit to your credit rating, but so what? (Assuming you’re in a non-recourse state, that will be the end of the bad stuff.) You might try to talk to your bank and see if they will do a principal reduction or accept a deed in lieu of foreclosure, and maybe even re-sell or rent the home back to you once they take title – worth asking.

You are 100% on target about the criminal character of much of the financial industry. GS has already pleaded “no contest” to enough wrongs to warrant the RICO treatment IMO.

As to your children’s future – we have to clean up the mess we (Boomers) created. Among other things, that includes putting the sword to the nests of vipers on the Street and in DC that we have allowed to seize control of all levers of political and financial power. You can do your part when the time arrives. Your military background will be most needed – it’s not likely to be a conflict-free exercise.

Posted by MrRFox | Report as abusive

breezinthru, the bastards at Freddie are the taxpayer. I think you are the very last person who should be getting help from the taxpayer. Do us all a favour, walk away and use up your retirement cash to buy another place.

MrRFox, we have seen over the last few weeks how worthless your opinion is. GS probably does hundreds of thousands of transactions a day. What percentage did it plead “no contest” to? 0.001%? less than that?

Posted by Danny_Black | Report as abusive

@Danny Black

Freddie, Fanny, etc joined with the largest banks in America to create MERS. They were not “the taxpayer” then. Before that, deeds and transactions were recorded at thousands of courthouses and county buildings across the country. MERS made the profitable fraud possible.

When it all overheated and collapsed, the cost should have been borne entirely by the banks over time. Instead, their friends in Congress slid the cost onto the taxpayers. The same thing happened as far away as Ireland. The banks even got their friends in Congress shift the cost of re-regulating their industry back onto the taxpayers. I disagree with the financial community’s position on that, but I have no friends in Congress.

I’m not responsible for what happened. The banks are. I do not intend to absorb costs that the financial community should have absorbed.

I am not asking for “help”. I’m not even asking for fairness and justice because I believe our whole system is skewed in favor of those with the most friends in Congress.

The taxpayer is in trouble on this issue of underwater mortgages. I know that. That’s not how it should be, but that’s the way it is. It should be the financial industry that is in trouble on this issue. Look how fast they paid back the TARP money in order to get their bonuses rolling again.

They could have and should have been on the hook for correcting all the harm their criminal activity caused. Their should have been some federal criminal prosecutions and some people should have gone to prison. The taxpayers were trillions of dollars in the red before the fraud. The taxpayers are running a huge annual deficit. How in the hell are taxpayers going to ever absorb the costs of the biggest fraud in the history of the world? Only the financial community can generate that kind of money in such a short time.

I see your point, but I refuse to accept that Freddie needs my financial “help” to get back on his feet. That “help” should come from the financial community and Congress could make that happen if there was anyone there who actually worked in the taxpayers’ interest.

Failing that, I must either look after my own affairs or become a burden on the taxpayers in my later years. I’m going to lose the exact same amount of money whether or not I successfully negotiate a principal reduction.

The taxpayers lose less if I am successful because I will continue to make payments on the fair market value of the property and additional costs can be avoided like selling below fair market value to a rental corporation, legal fees, etc.

Again, I’m not asking for help. The idea that Freddie Mac should be providing “help” to unfortunate homeowners in wrong-headed. Freddie Mac should be negotiating with homeowners to reduce the losses that will otherwise be incurred by the taxpayers.

I am NOT going to bail out Freddie on the installment plan. I didn’t create MERS or CDO’s or CDS’s. I didn’t make hundreds of billions of dollars with that fraudulent activity and frankly, I can’t afford it. The financial community should be doing that and they can afford to do it.

In this election year, we should be seeing if there is anyone in Congress with the courage to stand up for the taxpayer on this issue or if every last one of those bastards is in the financial community’s hip pocket.

Posted by breezinthru | Report as abusive

breezinthru, the issues Freddie have are nothing to do with MERS, CDOs and CDSes. They are to do with people like you.

Posted by Danny_Black | Report as abusive

That is just plain silly.

Posted by breezinthru | Report as abusive