Five Points on that New Anti-Foreclosure Fraud Settlement Paper by Calomiris, Higgins and Mason.

Cheyenne Hopkins got her hands on a financial industry funded paper from Charlie Calomiris, Eric Higgins, and Joseph Mason, The Economics of the Proposed Mortgage Servicer Settlement (hence CHM) attacking proposed settlement surrounding servicing requirement. I imagine a lot of people will see this paper in the next few days, so let’s create a reader’s guide to it.  There’s two parts to the proposed settlement – a push for principal reduction in cases of duress, and guidelines for new servicing best practices, and both parts come under fire, with the settlement “cost[ing] $7 billion to $10 billion a year.”

First, readers will find a certain schizophrenia driving the argument. The first thing to know is that foreclosures are good for the economy – “delay of foreclosures, would harm the broader economy.” If that’s the case, then strategic defaults should be no big deal, because they’ll help clear to market prices. But the entire first half of the paper is worry about strategic defaulters. Maybe servicers, the middlemen between borrowers and lenders, have conflicts of interest causing unnecessary foreclosures? Foreclosures usually hit lenders pretty hard. Nope, servicer incentives are perfectly lined up.

Homeowners are dangerous, foreclosures are a great thing and the largest banks have no conflicts with and aren’t screwing up their servicing jobs as middlemen between borrowers and lenders. These are the talking points of the major servicing banks, not investors, not borrowers and certainly not communities.  CHM ignore the well-documented conflicts, assume all modifications are created equal, don’t mention the best cure for moral hazard, emphasize lowering the cost of capital at all costs, and frankly come up with small numbers anyway.  In order:

Conflicts

There’s been a pretty well-established critique that says that servicers have different priorities than lenders. For instance, see National Consumer Law Center’s Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior, (pdf) by Diane E. Thompson, which has this useful chart:

The settlement is designed to solve this conflict. How does CHM know that there isn’t a problem with these conflicts? Here’s their evidence: “As such, NPV calculations are already used by servicers, exercising their fiduciary duty to maximize the value of payouts to investors.” Servicers have a fiduciary responsibility to investors to make sure they maximize the payouts to investors. No conflict possible. The large number of foreclosures and the huge loss-given-default  are economically efficient because, at the end of the day, servicers have a fiduciary responsibility to investors.

Except that there isn’t any fiduciary responsibility. Here’s Adam Levitin previously explaining the issue:

The critical thing to realize about servicers is that they are not subject to any oversight. Investors lack the information to evaluate servicer decisions, while securitization trustees are paid far too little to want to stick out their necks and supervise servicers (with whom they often have cozy business relationships). A securitization trustee is not a general purpose fiduciary; it is a corporate trustee with very narrow duties defined by contract, and entitled to rely on information supplied by the servicer. So we’ve got a case of feral financial institutions, a sort of servicers run wild, with both homeowners and MBS investors bearing the costs of unnecessary foreclosures, all because servicers misjudged the housing market and didn’t charge enough to cover the costs of properly performing their contractual duties.

Let’s be clear. Any type of fiduciary is with the trustee, not with the servicer, which is a separate contract. Even that isn’t a fiduciary like they mean it. Their evidence for a lack of problems isn’t true. There’s no fiduciary responsibility between the investors and the servicers. And the servicers aren’t subject to meaningful market competition.  Homeowners don’t choose their servicers, and investors don’t have the tools to enact meaningful oversight. Is the idea “reputational effects” will be sufficient regulation?

What Kind of Modification?

They quote some studies from 2009 for evidence of modifications failing, perhaps not realizing that the literature has moved on extensively in the past year. Here’s Sumit Agarwal, Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet and Douglas Evanoff on “Market-Based Loss Mitigation Practices for Troubled Mortgages Following the Financial Crisis” (October 2010), which finds “[c]onsistent with the idea that securitization induces agency conflicts, we confirm that the likelihood of modification of securitized loans is up to 70% lower relative to portfolio loans.” That research also reported this crucial chart:

Check out the low rates of redefaults on principal reduction. CHM say that modifications fail because look at all these failed interest rate reduction modifications. Again, servicers love modification that increase principal and reduce interest rates because they are paid as a percent of the principal. Investors hate them, because the loss-given-default (what they are left with in a foreclosure) is so high in this recession. But this conflict isn’t in the paper.

Moral Hazards

So they spend the paper with the priorities backwards: they assume the big servicing banks, presumably the ones paying the bills for the paper, have no problems whatsoever while strategic defaulters are going to appear in waves, when well-documented theorectical and empirical evidence shows the servicing banks to be a cesspool of a failed business model and no evidence whatsoever for strategic defaulters. (Federal Reserve Board: “The fact that many borrowers continue paying a substantial premium over market rents to keep their homes challenges traditional models of hyper-informed borrowers.”)

The paper is very concerned with “moral hazard”, the idea that people will default to take advantage of a modification who could otherwise pay. As the October 2009 COP report said we can design any settlement to remove moral hazard by putting pressure on borrowers:

Third, program eligibility rules are designed to prevent borrowers who do not have genuine financial difficulties from obtaining any loan concessions. In other words, borrowers are screened to minimize moral hazard. Applicants for modifications must document their income, in order to prove that they cannot afford their full contract payment without modification. Borrowers who can already afford their mortgage will not receive a modification. The documentation requirements have been demanded by investors precisely to prevent moral hazard issues from arising. They can create difficulties for homeowners with a genuine need, but the extra transaction cost is justified on the basis that it will minimize moral hazard for undeserving borrowers.

If this is a concern we can amplify the filtering mechanism. Remember if we really want to eliminate moral hazard, make sure that creditors are acting in a collective manner, make sure that those who see the upside first absorb most of the downside as well as put the correct emphasis on the ongoing value of keeping someone in their homes we have this amazing technology called the bankruptcy code. As others have pointed out to me, CHM should be all about mortgage cramdown if they are this worried about moral hazard.

Lower the Cost of Lending at All Costs!

Here’s a peek into the conservative worldview. Felix Salmon has a particularly brutual take on this paper, and he catches this argument:

As for the authors’ attempts to quantify the costs of the settlement, they use numbers in the CFPB report uncovered by Shahien Nasiripour which says that “effective special servicing of delinquent loans would have cost 75 bps/yr more than the actual costs incurred” — except the way they put it is very different:

The CFPB recently estimated that five servicers avoided $24 billion in costs between 2007 and 2010, yielding a 75 basis-point reduction in interest rates.

Er no, the CFPB nowhere says or even hints that there was any kind of reduction in interest rates as a result of the banks’ broken servicing operations. (And it wasn’t five servicers, it was nine.)

Ouch. But actually think this through: What the CFPB is estimating there is the estimated costs of the servicers actually doing their job.  If they hired enough people, paid them well, put the infrastructure in place, and actually kept track of who owned what in line with the strictest interpretation of trust law. They didn’t do this, and even the biggest bank supporter must think the banks probably could have been more careful with how they kept track of their documents.  The entirely of their existence, from securitization law to REMIC tax code, depended on it, and they failed.

Instead of something regrettable, CHM celebrate it!  By cutting all those corners with actually keeping track of documentation, etc. think of the savings that were passed onto consumers. They also assume it was all passed onto consumers, but leave that aside for a second. By being incredibly irresponsible, by shoving the risks into the tail, the banks were able to lower the mortgage rate. Awesome except for the ravaged economy.

For what it is worth, the best empirical evidence tells us that cramdown wouldn’t raise the cost of capital because we are talking about something that is going to be in default, and take a huge hit, anyway.

Numbers

Also, last point. Given how hard they go into this paper, given that all their assumptions (“We use a 25 percent increase in strategic defaults for illustrative purposes only…For simplicity, we assume all strategic defaults result in foreclosure”) are very favorable to their results, is anyone else kind of disappointed that they highest number they massaged is a cost of $10 billion?

Because the costs to the economy of unnecessary foreclosures add up quite quickly. Marcus Stanley from Americans for Financial Reform and myself came up with the following in two emails. Two million modifications (see their footnote #43). 30% cure rate, 50% redefault rate of those leftover (see pages 3, 9) – both very conservative numbers – leaves us with 700,000 modification. Let’s grab a number from Mortgage Loan Modification: Promises and Pitfalls, Joseph Mason (same guy) “The cost of a typical foreclosure has been estimated to be about $60,000, or about 20-25 percent of the loan balance (legal fees alone can cost $4,000), and those costs are expected to be higher in times of home price depreciation.” So $60K times 700 K is $42 billion in costs to investors, which is a far worse prospect than the $10 billion they find in costs.

Meanwhile the costs to homeowners, local governments and neighbors are estimated around $30,000 per foreclosure. So that’s $21 billion in costs to communities!

See, not hard. So where’s my financial services industry research paycheck?