Study: Short-Term Aid Best Approach to Avoid Foreclosure

Short-term assistance to ease the immediate effects of job loss and other financial crises may be a more effective way to help homeowners than loan modifications and other efforts to reduce long-term debt. That's the conclusion of a new study released by several Federal Reserve economists.

The study, whose authors include two senior economists and policy advisors with the Boston Federal Reserve Bank, takes a skeptical look at the cause of the current foreclosure crisis and what is being done to stop it. It suggests that direct aid to homeowners may be a more effective way of preventing foreclosures than current efforts aimed at refinancing or amending mortgage terms to make them more affordable.

The authors argue that "income volatility," i.e. unemployment or a temporary financial crisis such as a medical emergency or a divorce, is a bigger factor in foreclosures than the commonly derided practice of borrowers taking on risky loans in the first place.

"Unaffordable loans" a minor factor

The study found that so-called "unaffordable loans," in which borrowers assumed high levels of debt relative to income, were unlikely to be a major factor in defaults. Instead, a combination of reduced personal income and falling home prices were found to make foreclosure an attractive option from an economic point of view, despite the social stigma attached to it.

Current administration policies have focused on helping homeowners in financial difficulty refinance or modify mortgages to make them more affordable. While the study does not criticize such efforts directly, it implies that a more effective approach would be to assist homeowners in getting through their immediate financial crisis.

Income assistance proposed

It proposes that the government might replace a portion of lost income for one or two years, or provide a program or loans or grants to distressed homeowners. For more permanent setbacks, such as unemployed persons who are unlikely to return to their former standard of living, it suggests that a good policy might be to help homeowners transition to becoming renters by supporting short sales or other procedures.

The report was posted on the web site of the Boston Federal Reserve Bank. The authors include two senior economists and policy advisors with the Boston Fed, Christopher Foote and Paul Willen; University of Geneva professor and former Boston Fed economist Lorenz Goette; and Atlanta Fed research economist and assistant policy advisor Kristopher Gerardi.