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Publication Date

August 2009


Lei Ding, Roberto G. Quercia


Ford Foundation

The problem of underwater mortgage borrowers whose house is worth less than what they owe on it has defied solutions. The ability to reduce the amount owed through a loan modification has been proposed to address this issue. Unfortunately, not much is known about the impacts of principal reduction on redefault risks within the dynamic framework of continued house price changes.

In this study, we examine the desirability of principal reduction in loan modifications using two different measures: redefault risks and net present value calculations.

Overall, we find that by tailoring loan modifications to the specific characteristics of the market, the borrower has the highest likelihood of succeeding in the long run. For instance, in several markets, loan modifications are more likely to be successful if they include principal reduction than if they rely on interest rate reductions exclusively.

Our analysis suggests that it is possible to develop a set of criteria to guide loan modification that make full use of all options, including principal reduction.


Topics(s): Default, Bankruptcy, & Foreclosure, Housing Policy, Mortgage Finance