Two New York Times Editorials on the Foreclosure Crisis

Two editorials on the foreclosure crisis in the New York Times. The first is by nakedcapitalism’s Yves Smith, How the Banks Put the Economy Underwater:

When mortgage securitization took off in the 1980s, the contracts to govern these transactions were written carefully to satisfy not just well-settled, state-based real estate law, but other state and federal considerations. These included each state’s Uniform Commercial Code, which governed “secured” transactions that involve property with loans against them, and state trust law, since the packaged loans are put into a trust to protect investors. On the federal side, these deals needed to satisfy securities agencies and the Internal Revenue Service.

This process worked well enough until roughly 2004, when the volume of transactions exploded. Fee-hungry bankers broke the origination end of the machine. One problem is well known: many lenders ceased to be concerned about the quality of the loans they were creating, since if they turned bad, someone else (the investors in the securities) would suffer.

Another editorial from today, More on the Mortgage Mess, laying out the mechanisms on which the servicers have a conflict of interest.  The bolded is the best, short description of what the conflicts are:

Servicers are obligated to manage the loans in the best interest of the investors. That means modifying a troubled loan, if reduced payments would bring in more money over time than a foreclosure. Or foreclosing if a borrower cannot make the payments on a modified loan.

If only it worked that way in practice.

Take, for example, underwater borrowers — the millions of Americans who owe more on their loans than their homes are worth. For them, the best modification is often to reduce the loan’s principal balance, lowering the monthly payment and restoring some equity. That could be best for investors too, because even reduced payments are often better than a foreclosure sale. A bank’s servicing fee is based on the principal balances of the loan — a strong incentive not to reduce a troubled borrower’s balance.

Another conflict occurs when the bank that services a primary mortgage is also the owner of a second lien on the same property. Resolving a troubled first mortgage generally requires a write-down of the second lien, a step that banks have been loath to take.

Banks also profit from late fees and other default-related charges assessed on borrowers. And there is an additional incentive to pile on charges, since the bigger the loan balance, the higher the fee to manage the loan. A group of prominent investors — including Freddie Mac, the Federal Reserve Bank of New York and Pimco, the world’s largest bond fund — recently accused Bank of America of fee-padding. The bank denies wrongdoing.

High default charges harm homeowners because they make it increasingly difficult to catch up on late payments and avoid foreclosure. They also disadvantage investors, because the servicer collects the charges from the foreclosure sale before the investors see any money. Everyone loses, except the bank.

Again, the servicers at the banks are supposed to be middle-men between investors and borrowers. This system, as Yves Smith notes, is brand new, 30 years old at most, and really only 10 years in its current form. It has never had its tires kicked, and now that we’ve kicked the tires for the first time, the car has exploded.

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2 Responses to Two New York Times Editorials on the Foreclosure Crisis

  1. noompa says:

    From Yves Smith’s piece:

    “The large banks, no doubt, would resist; they would be forced to write down the mortgage exposures they carry on their books, which some banking experts contend would force them back into the Troubled Asset Relief Program. However, allowing significant principal modifications would stem the flood of foreclosures and reduce uncertainty about the housing market and mortgage securities, giving the authorities time to devise approaches to the messy problems of clouded titles and faulty loan conveyance.”

    I’m guessing that you are one of the banking experts that she refers to, given your work on the valuations of second liens in the original stress tests. Perhaps a follow-up, looking at what the balance sheets of some of the TBTF banks would look like if a proposal like Smith’s were forced through today, might be in order?

  2. Ed says:

    Oh, Mike, that’s so 2008. We’ve moved past the foreclosure crisis as a society and we are once again ready to embrace free-market solutions.

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