When it comes to making decisions regarding mortgage foreclosures, a bank doesn’t know what it doesn’t know.

In the wake of the 2008 financial crisis, foreclosures rose at an alarming rate and persisted for nearly five years. Part of that can be attributed to a rather sticky variable: information asymmetry. In other words, the bank might make a foreclosure decision based on a formula or algorithm, without the benefit of information from the borrower that could potentially sway the bank – one way or the other.

“Institutions didn’t know exactly who needed the aid and who didn’t,” said Lauri Kytömaa, assistant professor of applied economics and policy and Torgalkar Faculty Fellow in the SC Johnson College of Business.

“The borrower knows, ‘Oh, I’m going to lose my job’ or ‘I have an upcoming divorce that’s going to be very costly,’” Kytömaa said. “Or, they might have access to lending from family that will allow them to make mortgage payments. Lenders can’t go to everyone’s house and figure out their secrets, so there are just some things institutions cannot know.”

Information friction plays an central role in the decision to grant mortgage assistance or initiate a foreclosure, said Kytömaa, the author of “The Roles of Borrower Private Information and Mortgage Relief Design in Foreclosure Prevention,” published Nov. 9 in The Review of Economic Studies.

The paper weighs the role of information against the transaction costs associated with foreclosing, and the amount of aid it might take to keep a financially distressed homeowner afloat.

To address these competing factors, Kytömaa developed a model in which banks decide whether to offer debt relief when processing that relief is costly and borrowers hold private information about their financial well-being. His model gauges the impact of the Federal Home Affordable Modification Program (HAMP), which offers reduced monthly payments to struggling homeowners, on mortgages originated prior to 2008.

Kytömaa modeled the strategic interaction between borrowers and loan servicers as a game of debt relief that ends in either repayment or foreclosure. His model – using a sample of 162,000 Fannie Mae-guaranteed loans originated in California from 2004-07 – allows borrowers to hold private information about both their willingness to temporarily miss debt obligations and become delinquent on their loan, and their willingness to default on the loan.

Key results of his exercise: HAMP incentive payments decreased foreclosures by 3%, but friction caused by information asymmetry increased total foreclosures by 22%, compared to an outcome where all of a borrower’s information was available.

“What I can say is, there’s a distribution of information that affects your ability to pay,” Kytömaa said. “Things like your options for housing, the importance of the school system if you have young children, would even shape how hard you’re going to fight to stay in that home.”

Foreclosure is obviously painful for the homeowner, but it can also come with a hefty cost to the lending institution, which sometimes must absorb a significant financial loss when a borrower’s home is repossessed and sold. In spite of those pitfalls, U.S. loan servicers foreclosed 7.8 million homes between 2007 and 2016.

“People may wonder why were there so many foreclosures at this time, and that’s because the financial institutions doing these foreclosures were also losing tremendous amounts of money,” Kytömaa said. “They were losing, on average, around 40% of the value of the principal balance owed to them. It begs the question: Why couldn’t they offer a reduction in the mortgage payments to some degree – maybe not 40%, but 10% or 20%? Maybe that gets the borrower at a mortgage that’s more affordable, and now we all win.”

Kytömaa said that while foreclosures have been at historically low levels for the past several years, there has been a recent uptick in the last year or so with the recent housing market slowdown.

“It’s nowhere near the 2008 crisis,” he said, “but things are trending in a direction where we’re going to see more foreclosures, and one of the main drivers is that property prices go down. If they go up, you can just sell your house and cover the debt. You do have to move, but you don’t get evicted by the sheriff.”

He said that a goal of zero foreclosures is unrealistic and unwise. But for lenders, making smarter, more informed decisions regarding mortgage relief should be the objective.

“Foreclosure is always going to be part of the toolkit – that’s the lever lenders have for recovering the debt that’s owed to them,” he said. “But part of the lesson from ’08 is that you probably shouldn’t mass foreclose, especially when property prices are coming down, because that’s just going to make your losses worse.”