Day of Action on Foreclosures: Baron Haussmann, Central Planning and Mortgage Servicing as a Critique of Hayek’s Theory of the Use of Knowledge in Society

Today is National Day of Action on Foreclosures. Occupy Our Homes has created a list events at their site. Here’s a great video on what is going on in Brooklyn, which shows the neighborhood devastation happening there:

Let’s step back for a second.  Between 1853 and 1869, Baron Haussmann tore down and rebuilt major parts of Paris according to principles of hygiene and circulation. He installed roads, sewers, and other public works and demolished neighborhoods, rebuilding them alongside modern technology. These neighborhoods became more stratified by class and function and more easily controlled by state forces.

A general critique of city planners like Haussman is that they’ve rebuilt their city in order to make it, in James Scott’s phrase, seeable by the state. This reconstruction of Paris was focused on simplification, legibility, and centralized, managerial control, regardless of the local knowledge and practices destroyed in the recreation. Critiques like this extend across modernity, especially to those Americans like Robert Moses who built highways through major metropolitan areas.

Though Scott was looking towards models of embeddedness developed by those like Karl Polyani, most people who develop these critiques invoke Hayek and the price system of the market as the superior way of planning. The profit-motive of the price system coordinates information across a vast network of agents who will never know each other. This allows for the most efficient use of society’s resources. By seeking out profit opportunities, individuals will coordinate the whole.

There have been millions of foreclosures over the past several years and there will be millions more in the next few years. They are reworking neighborhoods in much the same way Baron Haussmann once did — but this time the process is driven by the free market of financial capital rationally seeking profit rather than a central planner dreaming about how to make a city “modern.”  How are the results?

Mortgage Servicers Make a Profit

The central agents in this story are mortgage servicers. Servicers are entities that accept payments from borrowers.  They also handle when mortgages become distressed and are the entities responsible for modifying and handling distressed mortgages. They are distinct from the company that lent out the money. With the vast majority of mortgages now run through this relatively new servicing model, one created alongside the slicing-and-dicing model that took over consumer finance, this is the key type of entity responding to the profit motive in the mortgage payment market.

How do the mortgage servicers earn their profit?  At their core, they respond to three principal-agent problems in their “Pooling and Service Agreement” contracts.  As Adam Levitin and Tara Twomey argue convincingly:

[S]ervicers do not have a meaningful stake in the loan‘s performance; their compensation is not keyed to the return to investors. Second, the servicing industry‘s combination of two distinct business lines – transaction processing and default management — encourage servicers to underinvest in default management capabilities, leaving them with limited ability to mitigate losses. Servicers’ monetary indifference to the performance of a loan only exacerbates this situation….

Servicers’ incentives in managing individual loans do not track investors‘ interests. This creates three interrelated problems. First, servicers are incentivized to pad the costs of handling defaulted loans at the expense of investors and borrowers. Second, servicers are not incentivized to maximize the net present value of a loan, but are instead incentivized to drag out defaults until the point that the cost of advances exceeds the servicer‘s default income. In other words, servicers are incentivized to keep defaulted homeowners in a fee sweatbox rather than moving to immediately foreclose on the loan. Third, servicers are incentivized to favor modifications that reduce interest rates rather than reduce principal, even if that raises the likelihood of redefault.

Can we chart the logic of how servicers handle mortgages in trouble?  From the National Consumer Law Center’s “Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior,” (pdf) by Diane E. Thompson:

To expand for a second on their incentives, they include:

Maximizing fees.  As a result of the servicing “Pooling and Service Agreement” contracts, servicers have an incentive to push borrowers into default and keep them there.  The fees associated with them go straight to the servicer.  And if the loan goes into foreclosure, the servicer is paid first before the investor recoups any money.  So fee pyramiding and/or loading a loan up with fees to the point where it becomes difficult for the borrower to pay and then foreclosing without modification — a nightmare scenario for both the borrower and lending – is fantastic for the servicing firm.

Making bad modifications. If a debt goes bad, there should be a good-faith effort to successfully work it out and modify it before a foreclosure happens.  As Lou Ranieri, the pioneer of the mortgage-backed security puts it, “You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure… If we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy.” Since servicers are paid as a percent of principal, they have an incentive to make modifications that increase principal and reduce interest rates, even if these loans aren’t sustainable. This goes double if they have exposure to junior-lien debts.

Quick turnaround without proper legal attention. Since the system is designed for servicing to be a thin business model, there is no infrastructure, nor means of investors to force one to be created, to handle a troubled housing market. Proper staffing is a sunk cost that isn’t easily recouped. It shouldn’t surprise us that informants are saying that:

20% of files with phantom referrals, approximately another 35% of files had some problems in them. Those problems varied, and included among others, an ARM that had improperly adjusted up, a failure to properly account for a borrower’s principal and interest payments, and a failure to properly attribute payments between pre-petition and post-petition that led the banks to try to collect pre-petition obligations they were not permitted to pursue.

These all add to fee income.

Central Planning

So this is the fruit of the private-market securitization market that is now running our mortgage markets. What I find fascinating is that the key things that are motivating servicers in their profit-maximizing don’t aggregate widely-dispersed information in the way Hayek described in The Use of Knowledge in Society.  They aren’t signaling out, or absorbing the signals of, relative prices of scarcity or substitution. They aren’t reacting to an increase in the price of tin without having to care why it has increased, nor are they increasing the price of tin by selling less of it, influencing people they’ll never meet.

As Thompson puts it, “How servicers get paid and for what is determined in large part by an interlocking set of tax, accounting, and contract rules.” At their core, they are reacting to laws we use to restructure debt in bankruptcy, the prioritization of multiple liens in distressed debt, REMIC tax law, standardized contracts with poor monitoring of agents, a lack of enforcement of foreclosure laws and, most importantly, the ability to skim off the top. If you look at the chart of incentives for servicers above, none of them are really relevant to either taking in or sending out information about the mortgage market.

We shouldn’t think of any of these things that force homeowners into bankruptcy as reflecting any marginal information about housing, homeowners’ ability and willingness to pay, or the availability of capital. They are a combination of laws we’ve chosen for ourselves about the managing of private property in housing and debt and a standardized contract among a handful of big financial firms that have ended up in a vicious battle over monitoring of the servicers themselves.  And that doesn’t even get to the externalized costs of a foreclosure to the community. The model is driven not by an abstract invisible hand but by the very real laws and contracts in which they are embedded. When those laws and contracts are faulty — as they are here — no useful information or allocation happens.

Which is all to say, if we had a central planning team of Baron Haussmann, Robert Moses, Le Corbusier, and Lenin running the United States mortgage market, I can’t imagine they’d do more damage to our neighborhoods and communities than Bank of America’s servicing arm is currently doing.

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10 Responses to Day of Action on Foreclosures: Baron Haussmann, Central Planning and Mortgage Servicing as a Critique of Hayek’s Theory of the Use of Knowledge in Society

  1. I think you should look up the Russian famine of 1921 if you think Lenin couldn’t do worse than Bank of America.

    • Heather says:

      Are you implying that if Lenin were alive today and in charge of the housing policy or the mortgage market, that we would end up with something equivalent to the Russian famine of 1921? Sounds like the fundamental attribution error…

    • #Fail!! Not the least of which because you didn’t update your URL field with your new employer.

  2. Sebastian says:

    The house of cards will fall when the last debtor can no longer pay . . . and then we will see Mad Max in the Western World.

    http://djia.tv/press-tv/whoops-why-everyone-owes-everyone-no-one-can-pay-by-john-lanchester-epilogue-12-05-2011/

  3. Philip says:

    How is this a critique of Hayek’s point? It seems like a confirmation. As you note, a combination of public policies created a system of incentives for corporations in which they had no need to adjust to real world factors; as a result, local knowledge stopped effectively feeding back into our collective knowledge through the price system, and things got very screwed up as a result. We would have certainly been better off if the price system were allowed to function (or regulated so as to ensure that it would, if you prefer). Why on earth would you set this up rhetorically as if Hayek or Scott would disagree with you? Neither “The Use of Knowledge in Society” or “Seeing Like a State” gives any impression that the author would be happy with centralized decision-makers ignoring local factors if only they were private; indeed, quite the contrary.

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  5. Edwin Herdman says:

    Following Philip, I think the evidence is clear that in the current case, it’s the subversion or weakening of governmental processes by these interests that is in large part responsible for the current mess. We don’t have to go so far afield to Russia to find somebody who would have disagreed with this policy; FDR instituted the HOLC (not a moratorium) on foreclosures through 1933-1936 to assist homeowners (contrasted with the credit pool for lenders tried by the Hoover Administration – which seems somewhat eerily similar to the ineffectual measures of the current Administration).

    Incidentally, despite what some modern people might have expected, FDR apparently thought seeking a moratorium on foreclosures would have been a dubious tactic, and in any case it was roundly criticized. The current crisis is not so much the mere notion of a foreclosure, but the reality that so many foreclosures are being handled improperly. If the banks and servicing corporations were forced to follow the rules, they certainly would lose money, but it’d do less damage to the financial system than simply instituting a moratorium, at the very least. I am not totally convinced a moratorium would be counterproductive, but that argument is being made as well. A lot of ground could be covered by simply changing the rules for loan servicers.

    As for the traditional Scottian critique of the 1870s rebuilding of Paris, I don’t really see the significance for this case. It is clear that it did a lot of harm by displacing people, but decrying the damage to “local knowledge and practices” seems like crying foul at modernity itself. More was at stake than traditional crafts and picturesque (but cramped) storefronts. This critique completely ignores the practical implications of not attacking antiquated infrastructure: Without wide boulevards, Paris might have been more difficult to occupy for the anti-Commune forces, or for Hitler, but it also would have exacerbated dysfunctional traffic patterns in the many other years of peace, up to and beyond the present day. Furthermore, what about the case of sewers and other public utilities?

    I can look a lot closer to home than Paris to find a great example where anti-foreclosure, anti-urban streamlining does not present a workable model. The city of Detroit, losing population, simply cannot afford to maintain and patrol some of the hardest-hit outlying parts of the city. When you “shrink a city” (Detroit lost 25% of its population through the 2000s, hovering just above three-quarters of a million in 2010) you aim to respond to the actual facts of urban life, and to improve the consistency of services for those who remain.

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