Underwater and the Strategic Default PR Campaign, 3: What we got when we didn’t get cramdown.

A year ago a week from today I discussed the financial innovation that wasn’t. It was a look at Lewis Ranieri, the creator of the mortgage backed security, as well as one of the minds behind the 1984 Secondary Mortgage Market Enhancement Act that created the market for MBS. In the piece he warns in April 2007 and May 2008 that securitization was never meant to handle a nationwide housing bubble and would have major failures if stressed along these lines.

Portfolio lending, like the lending in George Bailey’s bank, can handle writedowns and prevent foreclosures. There’s someone there who is assigned the role of making sure you can make your payments, thus preventing the major destruction that occurs in foreclosures. Ranieri was trying to alert the Milken conference on those two days that there was real danger, and that the market couldn’t fix it. Full quotes are at the post and worth your time, but this May 2008 quote summarizes:

Lou: The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fudiciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary. And part of our dilemma here is “who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?” And what we need here is financial innovation in the first instance because you can’t do this loan by loan, you are going to have to scale this up to a bigger level and we are going to … have to cut the gordian knot of the securitization of these loans because otherwise if we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy.

Moderator: How optimistic are you Lou? You used crisis, you used Great Depression a few minutes ago. That’s a little strong…

Lou: It’s not strong. I believe we know what to do because it is not remarkably different than what we’ve done in the past in the context of the housing bubble. If we are allowed to do it. We know how to restructure loans. The process has not changed and technology has made it easier….it will work because of the financial technology and internet technology…I don’t think this is an issue of the government, in fact we’d be better left to do what it is we actually know how to do, we know how to deal with housing crisis…but the difference between a foreclosure and a restructuring is frequently over 30% and because of the feedback loop that foreclosures create you keep taking a 30% loss on a smaller number. It doesn’t get to be fun. So no this isn’t a government issue, it is something the market needs to do…

And the market has failed. There are no major restructuring efforts through the private market. The legal conflicts and perverse incentives of middlemen servicers has devastated the housing market. The “nudge” philosophy of what the government can do – give the middlemen a little bribe to do the right thing – has also failed. A government action was clearly needed, and a government action was not delivered. Ranieri was wrong thinking that financial engineering would get them out of this legal mess, and growth and unemployment are suffering accordingly.

Representative Brad Miller is a blog reader, so I think he would have seen this writing on the wall in 2007. And I do know that Representatives Brad Miller and Linda Sanchez offered their “lien stripping” (the proper term for what has become known as cramdown) amendment in December of 2007, back when everyone first realized what a major problem we had in securitization (TPMCafe and dailykos).

Mortgage Modification

How well would this have worked? It’s worthwhile to explain, once again, all the strengths of this approach. From Adam Levitin’s Resolving The Foreclosure Crisis: Modification of Mortgages in Bankruptcy:

In light of market neutrality, the Article argues that permitting modification of home mortgages in bankruptcy presents the best solution to the foreclosure crisis. Unlike any other proposed response, bankruptcy modification offers immediate relief, solves the market problems created by securitization, addresses both problems of payment-reset shock and negative equity, screens out speculators, spreads burdens between borrowers and lenders, and avoids the costs and moral hazard of a government bailout. As the foreclosure crisis deepens, bankruptcy modification presents the best and least invasive method of stabilizing the housing market….

In a perfectly functioning market without agency and transaction costs, lenders would be engaged in large-scale modification of defaulted or distressed mortgage loans, as the lenders would prefer a smaller loss from modification than a larger loss from foreclosure. Voluntary modification, however, has not been happening on a large scale for a variety of reasons, most notably contractual impediments, agency costs, practical impediments, and other transaction costs.

If all distressed mortgages could be modified in bankruptcy, it would provide a method for bypassing the various contractual, agency, and other transactional inefficiencies. Permitting bankruptcy modification would give homeowners the option to force a workout of the mortgage, subject to the limitations provided by the Bankruptcy Code. Moreover, the possibility of a bankruptcy modification would encourage voluntary modifications, as mortgage lenders would prefer to exercise more control over the shape of the modification. An involuntary public system of mortgage modification would actually help foster voluntary, private solutions to the mortgage crisis.

Mortgage modification would deal cleanly with the issues of refinancing, servicing conflicts and perverse incentives, second liens and other junior mortgages, getting rid of all the problems of mortgage securitization expert Ranieri identifies above.

Bankruptcy modification also would deals with the specifics of negative equity and unemployment income shocks without benefitting speculators, removing a real and worrisome issue for helping consumers who need it without helping those who don’t.

This is because in Chapter 13, debtors must bear their finances to the public, have money and time transaction costs, and live on a court-supervised, means-tested budget for three or five years. Chapter 13 also insists on full repayment of certain debts. Chapter 13 filers must have less than $1,010,650 in secured debts, so million-dollar mortgage holders or multiple property holders couldn’t rush to take advantage of this. It keeps speculators out.

This is not a magic solution. There will be those who can’t afford their mortgages even at market clearing rates, for which Right To Rent is a perfect solution. But these are fair and efficient and a proper response for this crisis rather than the costs of other options. And it is important to remember that there still are options for the government to pursue rather than a lot of loud talk about blaming evil runaway homeowners. By any conceivable measure, homeowners are under-strategically defaulting, not over. They are doing this because they want to stay in their homes and communities. It would be a wise idea to have clear government solutions to get them to do so.

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6 Responses to Underwater and the Strategic Default PR Campaign, 3: What we got when we didn’t get cramdown.

  1. Franklin says:

    I believe speculators may already have a remedy through Chap. 7.

    Not 100 percent sure about this, but my recollection is that one of the controversies surrounding the 2005 Bankruptcy Reform and “Consumer Protection” Act is that it removed protection for a primary residence — leaving a more burdensome path through Chap. 13. However, for someone holding a 2nd, 3rd, 4th, or etc, etc property as an investment or vacation home a debtor could still seek relief under Chap. 7 (e.g. a liquidation sale). I believe the cram-down option is currently available under Chap. 13 for a variety of real estate including multi-family primary residence (e.g. a house with a basement rental); or other kinds of investment property.

    (See page 6 from Adam Levitin’s article in the Harvard Law Review).

    Click to access Levitin_HLPR_011909.pdf

    A cynical, but probably accurate take: When industry lobbyists rewrote the 2005 law they effectively put restrictions on the most common form of debt likely to be owned by constituents of representatives who signed off on the law — they made sure to carve out exceptions for the kind of debt likely to be held by the representatives who rubber-stamped the measure.

  2. Matt H. says:

    “And the market has failed. There are no major restructuring efforts through the private market.”

    Mike, if the big banks had been allowed to fail and their assets liquidated — would not the MBS have been sold to new private owners for 15 or 20 cents on the dollar and would not those new private owners be doing precisely the restructuring you so desire to see?

  3. Mike says:

    Franklin : That Bankruptcy Bill, in retrospect, is so awful. I think there’s a future in determining how much it encouraged using MBS as security in repo markets and the replacement of generic trade agreements with “swaps”, so basically urging liquidity runs in the capital markets. That’s research I hope to work on in the future.

    Matt H: Great point. There’s two problems. One is the servicers are poorly aligned and incentivized to writedown mass mortgages; there’s “tranche warfare” and not clear delegation of powers, as well as perverse incentives – servicers might get paid more for bankruptcy rather than a good writedown, or get paid more for redefaults (as they have to show up twice). The Levitin paper Franklins links to above is good on that, and thats the market failure.

    Pile on top of that the issue of the valuation of second liens. Many mortgages have a second mortgage on them, or a HELOC, and half of that $ amount sits on the four biggest banks sheets. The stress test priced them at 86 cents on the dollar. There’s a lot of debate over (a) whether or not that is an overestimate and (b) the extent servicers are grinding people to pay the seconds to get them cleared, or encouraging them to extend-and-pretend (with HELOCs) in particular and (c) whether or not a housing pickup will clear this or a downturn will explode this, and how much it matters.

    The first paragraph here gives a sense of where the debate was a few months ago, it hasn’t changed much. This is something, in a better world, Treasury would be on top of and public, as it involves the entire country and all that.

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