A new research report from the Mortgage Bankers Association (MBA) has concluded that the mortgage industry needs to develop new policies to help borrowers in distress.

The study, titled “Mortgage Design, Underwriting and Interventions: Promoting Sustainable Homeownership,” is centered around using lessons gleaned from both the Great Financial Crisis and the COVID-19 pandemic to create what the MBA describes as “a more robust system of mortgage finance that proactively supports sustainable homeownership to better prepare for future periods of housing market stress.”

“The mortgage industry has faced numerous challenges that have caused mass upheaval in the housing market, and in many cases, the industry was ill-prepared to handle the significant influx of mortgage defaults and subsequent foreclosures,” said Purdue University’s Joseph Tracy, a contributor to the study and former senior Federal Reserve adviser. “The industry must continue to evolve with the changing dynamics of its customers and their needs. By examining current mortgage design and underwriting standards, the industry will be better equipped to assist distressed borrowers facing hardships.”

The paper, published by the MBA’s Research Institute for Housing America (RIHA), classifies defaults based on the borrower’s equity position and whether the borrower faced liquidity shock. There are three basic situations, according to the study, that lead to a defaulted mortgage:

• Strategic default, which happens when borrowers have the ability to pay but, because of negative equity, choose to default instead.
• Double-trigger default, which occurs if a borrower can’t pay their mortgage because of a liquidity shock, such as unemployment or other loss of income, and can’t sell because of negative equity.
• Cash-flow default, which happens if a borrower is unable to pay due to liquidity shock and still chooses not to sell the property even though they have positive equity.

Effective and efficient intervention for stressed borrowers starts with understanding those three drivers, the paper says. The aim when intervening isn’t to limit foreclosures (or even to maximize the success of the intervention), but rather to minimize the loan’s expected loss.

It’s important, then, to have estimates for the average losses if the intervention is successful and if it fails, as well as the likelihood that the intervention will be successful (and that the borrower will not re-default).

RIHA also identifies a pair of key strategies for helping distressed borrowers: mitigating cash flow constraints (via, for example, liquidity insurance) and deleveraging the borrower.

“The study’s findings can help the industry identify current issues impacting overall housing sustainability and how to prep for future housing downturns,” said Edward Seiler, executive director of RIHA and the MBA’s associate vice president, housing economics. “Creating solutions for distressed borrowers will greatly improve the efficiency in the housing market as well as provide additional ways to make sure distressed borrowers stay in their homes.”