Means-Tested Mortgage Modification: Homes Saved or Income Destroyed?
This paper uses the theories of price discrimination and optimal taxation to investigate effects of underwater mortgages on foreclosures and the incentives to earn income, and the degree to which those effects are shaped by public policy. I find that the federal government's means-tested mortgage modification plan creates a massive implicit tax that may be significant even from a macroeconomic perspective. An alternative of modifying mortgages to maximize lender collections would also feature means tests, but with less effort distortion and perhaps fewer foreclosures. The paper also considers the consequences of a public policy that left mortgage modification to lenders, subject to a requirement that modification would not be conditioned on borrower income.
I appreciate comments by Gary Becker, Kevin Murphy, a number of University of Chicago students, and conference participants at the University of Illinois Chicago Campus. I will provide updates on this work on my blog www.panic2008.net. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.