Short-term liquidity is a key factor in driving mortgage default, according to a research by the JPMorgan Chase Institute. The research, titled, Falling Behind: Bank Data on the Role of Income and Savings in Mortgage Default, measured the impact of a mortgage payment and principal reduction on default and consumption.
It revealed that a 10 percent mortgage payment reduction decreased default rates by 22 percent. However, for borrowers who remained underwater, a reduction in the principal amount had no effect on default or consumption.
The research which was conducted by Diana Farrell, President & CEO, Kanav Bhagat, Director of Financial Markets Research, and Chen Zhao, VP, Financial Markets Research, at JPMorgan Chase Institute also found that defaults were mostly correlated to a drop in a homeowner's income.
The findings also revealed that for borrowers who defaulted on their mortgage, did so regardless of their level of home equity, while recovering from mortgage default was associated with recovering from a negative income shock; homeowners who experienced deeper and longer duration drops in income became increasingly delinquent.
"Deeper and longer duration negative income shocks were associated with increasing delinquency, whereas to the extent their income recovered quickly, homeowners promptly resumed making their mortgage payments," the researchers said. "Homeowners with savings used their financial buffer to delay mortgage default following a negative income shock."
The researchers found that default rates for homeowners with small financial buffers were higher regardless of income level or payment burden and recommended that building and maintaining a financial buffer may be a more effective tool to help borrowers avoid default than meeting total debt-to-income (DTI) standards at origination.
Based on these findings, the research drew implications for policy along three dimensions—default prevention, helping homeowners facing a negative income shock, and mortgage design.
The researchers said that establishing and maintaining a financial buffer was an important component for avoiding default in the face of a negative income shock even for higher-income homeowners. The default rate for borrowers with less than the one mortgage payment equivalent held in reserve (2.54 percent) was seven times higher than the default rate for borrowers with at least four mortgage payments in reserve (0.36 percent).
"The public and private sector should consider ways to provide new borrowers with an incentive to build and maintain a reserve fund associated with their mortgage that could be drawn down in the face of a negative income shock to avoid default," the researchers recommended.
To help homeowners facing a negative income shock the research recommended early intervention and that mortgage modification programs aimed at reducing default rates should "focus on providing homeowners who are struggling to make their monthly mortgage payments with material payment reduction, regardless of their previous income level or home equity."
"Our analysis has implications for housing policymakers as they consider the trade-offs between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs)," the researchers said while making their third recommendation on mortgage design. "The connection between negative income shocks and default suggests that ARMs, which automatically adjust their interest rates and mortgage payments in accordance with the Federal Reserve's interest rate target range, can serve as a way to help stabilize the economy during the recession."
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