MORTGAGE DEFAULTS: Evidence from Florida on the benefits for all of mandatory mediation between borrowers and lenders

Mandatory mediation between mortgage borrowers and lenders when there is the possibility of default and foreclosure on a loan increases the likelihood that the conflict will be resolved in a way that benefits both parties. That is the central conclusion of research by Michael Collins and Carly Urban, published in the December 2015 issue of the Economic Journal.

Their study finds that mediation for borrowers in mortgage default increases the amount of information the borrower provides to the lender, as evidenced by a 1% increase in the number of mortgage contract renegotiations to modify the loan terms. What''s more, minority race borrowers, who historically have less experience in mortgage markets and may withhold more information, benefit more from mediation: African-American borrowers are 7% more likely to obtain a loan modification when mediation is available.

Lenders also seem to benefit from the clearer information obtained in mediation. They are better able to calibrate what modifications in loan terms they should grant to borrowers with a mediator: borrowers who received modifications under mediation have 20% lower one-year redefault rates than borrowers who had loans modified without mediation.

But lenders also learn negative information about borrowers through mediation: they are 3% more likely to file foreclosure on loans where the borrower had access to mediation.

The researchers begin by noting that mortgage borrowers who have trouble making payments face a thorny problem. If they let their lender know how much trouble they are in, the lender might accelerate their efforts to repossess the home. If they reveal they have income or savings, the lender may assume that can be used to pay the loan.

Ideally, the borrower wants the lender to cut a deal to lower interest rates or fees – or forgive some of the loan. But given the litigious nature of foreclosures in the United States, revealing just the right amount of information is hard: many borrowers decide it is best to stay mum.

A lender managing a mortgage in default has limited options. Foreclosing can be costly, but a modification of loan terms might also add to those costs if it is not well calibrated to the borrower''s willingness (and ability) to pay. The borrower has incentives to offer the lender limited information skewed towards lowering monthly payments and reducing the principal, while also bluffing about their intentions to repay under new loan terms.

An honest negotiation might make both parties better off, but there is ''information asymmetry'' such that lenders cannot easily assess the borrower''s level of ''cheap talk''. One solution is for the two parties to be compelled to meet with a third party – a neutral mediator – before beginning the formal and adversarial legal process.

Such policies for mortgage foreclosures or other disputes have not been widely used in the past, in part because it was not clear mediation would help. This study makes the claim that mediation can influence both borrowers and lenders, and potentially make both better off, at least in some cases.

Three foreclosure courts in the state of Florida implemented a mandatory mediation policy in which mediation sessions were automatically scheduled with the initial mailing of an intent-to-foreclose notice by the lender. This provides a fortuitous opportunity to see if mediation changes the flow of information and leads to differing outcomes.

The researchers follow loans before and after mediation was made available, including loans in the same housing market where mediation was not available. The policy was implemented in just three jurisdictions with a long-established local non-profit organisation, creating a clean way to study loans in the selected jurisdictions versus loans on other areas. The study uses a ''difference-in-differences'' strategy that compares loans subject to mediation to loans in the same metropolitan area for which courts did not implement mandatory mediation.

Overall, the research offers insights into how parties share information in contract disputes, as well as how policies can facilitate the sharing of information that can make both parties better off. The findings have applications to a variety of financial and non-financial settings where creating a way to reveal information can help consumers deal with conflicts.

''Mandatory Mediation and the Renegotiation of Mortgage Contracts'' by Michael Collins and Carly Urban is published in the December 2015 issue of the Economic Journal. Michael Collins is at the University of Wisconsin-Madison. Carly Urban is at Montana State University of Munich.