Cost-effective mortgage modification program to reduce mortgage defaults

What is the most cost-effective mortgage modification program to reduce mortgage defaults? To shed light on this question and evaluate the Home Affordable Modication Program (HAMP) initiated in 2009, we present a quantitative model where home-buying households can take out a mortgage loan whose price is endogenously determined to reflect the mortgage contract terms—maturity, per-period payment, and amortization scheme—as well as the default risk. We conduct an experiment in which (i) a series of house price shocks are plugged into the model economy to generate the housing market crash, mirroring the recent financial crisis, and (ii) three alternative government-funded mortgage modification programs, each associated with a change in maturity, per-period payment, or amortization scheme, are introduced and compared. We find that the amortization reschedule is the most cost-effective way of implementing a modification program, followed by the payment reduction and the term extension.