The Effect of Debt on Default and Consumption: Evidence from Housing Policy in the Great Recession

This paper empirically and theoretically analyzes the effect of debt reductions that reduce long-term but not short-term obligations. Isolating the effect of future obligations allows us to test alternative explanations for borrower default decisions and to analyze the consumption response to mortgage principal reduction for underwater borrowers. Our empirical analysis uses regression discontinuity and difference-in-differences research designs on de-identified bank account and credit bureau records from participants in the U.S. government’s Home Affordable Modification Program. We find that mortgage principal reductions worth an average of $70,000 have no impact on default or consumption for borrowers who remain underwater. Our results are sufficiently precise to rule out economically meaningful effects. We develop a quantitative lifecycle model that clarifies that borrowers’ short-term constraints govern their response to longterm debt obligations. When defaulting imposes utility costs in the short-term, default is driven by cash-flow shocks such as unemployment rather than by future debt burdens. When principal reductions do not push borrowers sufficiently above water so as to relax collateral constraints, consumption is unaffected because borrowers are unable to monetize increased housing wealth. Collateral constraints drive a wedge between an underwater borrower’s marginal propensity to consume out of cash and their marginal propensity to consume out of housing wealth. Our results help explain why policies that lowered current mortgage payments were more effective than principal reductions at stemming foreclosures and increasing demand during the Great Recession. ∗ganong@uchicago.edu, pascal.noel@chicagobooth.edu. We thank Alex Bartik, David Berger, Laura Blattner, John Campbell, Gary Chamberlain, Raj Chetty, Gabriel Chodorow-Reich, Joao Cocco, John Coglianese, Marco Di Maggio, Will Dobbie, Emmanuel Farhi, Avi Feller, Xavier Gabaix, Edward Glaeser, Paul Goldsmith-Pinkham, Adam Guren, Sam Hanson, Nathan Hendren, Kyle Herkenhoff, Larry Katz, Rohan Kekre, David Laibson, Yueran Ma, Laurie Maggiano, Atif Mian, Kurt Mitman, Bill Murphy, Vijay Narasiman, Charles Nathanson, Elizabeth Noel, Christopher Palmer, Jonathan Roth, David Scharfstein, Therese Scharlemann, Andrei Shleifer, Mark Shepard, Jon Spader, Jeremy Stein, Amir Sufi, Larry Summers, Adi Sunderam, Owen Zidar, and Eric Zwick. Thanks to the team at Heterogeneous Agent Resource and toolKit (HARK, https://github.com/econ-ark/HARK) for sharing simulation code. Technical support was provided by the Research Technology Consulting team at the Institute for Quantitative Social Science. This research was made possible by a data-use agreement between the authors and the JPMorgan Chase Institute (JPMCI), which has created de-identified data assets that are selectively available to be used for academic research. All statistics from JPMCI data, including medians, reflect cells with at least 10 observations. The opinions expressed are those of the authors alone and do not represent the views of JPMorgan Chase & Co. While working on this paper, Ganong and Noel were paid contractors of JPMCI. We gratefully acknowledge funding from the Joint Center for Housing Studies, the Washington Center for Equitable Growth, the Hirtle Callaghan Fund, and the National Bureau of Economic Research through the Alfred P. Sloan Foundation Grant No. G-2011-6-22 and the National Institute on Aging Grant No. T32-AG000186.