Too many homeowners today are struggling to make their monthly mortgage payments: Roughly 4 percent of outstanding mortgages are still in foreclosure or 90-plus days delinquent, compared with just 2 percent pre-crisis. Multiple mortgage modification techniques have been used over the years to cure defaults, but none has proven more compelling and controversial than principal reduction. At a recent Urban Institute panel, experts revisited the empirical evidence on the effectiveness of this modification method

Max Schmeiser, of the Federal Reserve Board and Therese Scharlemann from the Office of Financial Research at the Department of Treasury recently examined mortgage modifications over the last six years to share insights into the benefits and costs of principal reduction. Housing Finance Policy Center director Laurie Goodman moderated a discussion on these two papers with the authors and Ben Keys of the University of Chicago. Two important takeaways emerged:

Principal reduction is highly effective at reducing defaults and foreclosure

Both studies confirmed that principal reduction can be very effective in reducing the likelihood of default. Using HAMP Principal Reduction Alternative (HAMP PRA) data for over 45,000 loans, Scharlemann concluded that an “average 28 percent reduction in principal under HAMP-PRA reduced the expected default rate from 3.8 percent to 3.1 percent.” Using CoreLogic’s data on privately securitized sub-prime and Alt –A mortgages, Schmeiser compared the reduction in default rate across various modification techniques and found that principal reduction generally resulted in the largest reduction in default rate. Schmeiser added that principal reductions are more effective because they reduce “re-default and foreclosure through multiple channels—reduced principal, lower monthly payments and lower loan-to-value.”

Questions were raised as to the cost of principal reduction

While both Scharlemann and Schmeiser agreed that principal reduction can be very effective in reducing defaults, Scharlemann also showed principal reduction can come at a substantial cost. Because principal reduction improves lifetime re-default rates by about 10 percent (from 49 percent to 39 percent), that suggests about 10 loans are written down per avoided foreclosure. According to Scharlemann’s analysis, overall write down per foreclosure avoided via principal reduction was $877,000, with the government’s share being $262,000.

Given the expense involved, Keys noted that the decision to offer principal reduction should be based on an understanding of why people default so that modifications can be better targeted. If borrowers are defaulting because of temporary disruptions in income, principal reductions may not be the best modification. Better data about income shocks and consumption behaviors would allow us to better design assistance programs.