Wednesday, November 18, 2009

If only we knew ...

The basic problem with valuing underwater loans is that borrowers are heterogeneous. Some borrowers are going to walk away from their mortgages; from the standpoint of financial institutions, it would be better to simply write down their mortgage balance, swap the value of the debt above the mortgage balance for equity, and avoid foreclosure.

But other borrowers insist on paying their mortgages, no matter what. These mortgages continue to be worth something like their par value. Financial institutions do not want to modify their loans. But if those who pay their mortgages know that those who don't will get a modification, they will change their behavior.

So the optimal program (from the lender's perspective) would be one that identifies those who wouldn't repay, and then grant those people a secret modification. I can't figure out how to either (1) how to do the identification or (2) write to contract binding the borrower to secrecy.

9 comments:

Austin Kelly said...

why not demand a share of ultimate appreciation (if any) in return for a loan modification. Someone who can make the payments and plans to stick around will find the requirement to give up a substantial chunk of any future gains to be a serious disincentive. But someone planning to head to foreclosure won't attach any value to the future appreciation that they are sacrificing, since, absent the loan mod, they wouldn't be sticking around for the appreciation anyway.

David Barker said...

You are describing price discrimination - cut prices for those with elastic demand, hold the line for those with inelastic demand. In other words, shift consumer surplus from consumers to producers. We do something similar now by using tax money to subsidize banks. As you say, optimal for the bankers, maybe not for the rest of us.

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Bank CD Rates said...

I would say that whatever David has said here is coorect I would like to go with him.

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