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Jan 10 2013

Real Estate Special Luncheon Speaker Event

Columbia Business School’s Professor Tomasz Piskorski visits Kellogg and presents his interesting research on residential mortgage modifications and their implications on borrower behavior. Kellogg students see first-hand how Professor Piskorski integrates theoretical and practical knowledge of real estate.

By Sean O’Grady '14


“More than five million homes have been lost to foreclosure in the United States since 2007. The housing crisis is both unprecedented and not over”, opened Professor Piskorski of Columbia Business School to a group of Kellogg students. He stated that millions of foreclosures could still be on the horizon and that policy makers have yet to agree on the most effective solution.

Professor Piskorski explained that the foreclosure process is not just costly for borrowers but also for lenders and society as a whole. Lenders incur significant legal fees and carry costs, especially in states with lengthy foreclosure procedures. Brokerage fees and depressed resale values due to the stigma surrounding foreclosure only add to these costs. He said that, often, a modification with either a write-down of the loan amount or lower interest rate would be less costly for a lender.

Professor Piskorski also elaborated on the negative externalities of foreclosure on society as a whole. He provided a hypothetical example of a neighborhood with a high concentration of foreclosed and unmaintained homes. Property values for the entire neighborhood would almost certainly drop, causing tax revenues to decline. As a result, the budgets of local civil services, such as fire and police departments and school systems, would become constrained causing the quality of life for all residents to suffer.

“So, if loan modifications create value for lenders, borrowers, and society as whole, why are we not seeing more modifications?” asked Professor Piskorski.

He held that while policy makers have indeed discussed broad-based mortgage relief programs, these programs are difficult to implement because of the challenge that policy makers and lenders face in defining which at-risk borrowers should qualify for a loan modification. Permitting all currently defaulted borrowers to qualify for a loan modification would theoretically provide an easy solution. However, he explained, policy makers and lenders fear that opportunistic borrowers would then strategically default in order to obtain a loan modification. This behavior has been pervasive in the CMBS market, where special servicers can only discuss a loan modification after a loan has gone into default (typically 60-days delinquent). In response to this provision in CMBS pooling and servicing agreements, CMBS borrowers have strategically defaulted by deliberately missing interest payments, even in cases where property cash flow is sufficient to cover debt service.

The question and concern for policy makers is whether this behavior would occur in the residential market. Professor Piskorski has said, “the nightmare scenario for every policy maker is that you try to help five or six million at-risk borrowers and you put 40 million borrowers into delinquency because everyone starts missing payments in order to default and reap its benefits.”

Working with his colleagues at Columbia Business School and Columbia Law School, he tested the hypothesis that people would be willing to strategically default in return for a potential loan modification. He and his colleagues decided that Countrywide Financial’s mortgage modification program, which the company rolled out as part of its deceptive lending practices lawsuit settlement, presented an ideal test case.

With unprecedented access to mortgage default data, they were able to distill the delinquency rates of Countrywide borrowers who were offered the modification program from other lenders’ borrowers who were not offered a modification. Their results indicated that the Countrywide’s modification program induced a significant increase in strategic delinquency. According to their research, the number of Countrywide delinquencies rose by 13% relative to non-Countrywide borrowers who did not have the modification option. Interestingly, the effects were strongest among borrowers with the most available credit and above-water homes.

These results suggest that modification programs may not necessarily help borrowers most in-need of relief. Professor Piskorski concluded that this research highlights the challenges associated with modifying mortgages in the presence of strategic behavior. In order to inhibit strategic behavior and to ensure that the most in-need borrowers obtain relief, mortgage modification programs would need to implement expensive verification procedures based on likely “manipulable” criterion.

The policy debate continues. As Piskorski said “do we want to have simple programs that extend help quickly but risk strategic behavior, or do we want to spend more money and time on costly verification procedures to limit strategic behavior?”

About the Author

This article was written by Sean O’Grady '14.