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 US. 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 life-cycle model that clarifies that borrowers’ short-term constraints govern their response to long-term 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.
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