First, let’s start with a general premise: if a borrower has a reasonable ability to service his mortgage (and “reasonable” is in the eye of the beholder, but one has to assume it better be north of 50% of a “fair” rate) it’s better to renegotiate and keep him in place.
Now that we have the specter of large-scale foreclosures, policymakers are fixated with the idea of preventing foreclosures. Under the current fact set, I have a lot of problem with the willingness to go to extremes to salvage underwater homeowners, and some of it is due to a lack of vital information.
1. A fair number bought their homes with little to no equity. The idea that they are homeowners in the traditional sense is spurious; it’s more accurate to view them as renters who bought a home equity option. It would be useful to understand what proportion of stressed homeowners have any skin in the game. For instance, there are reports of borrowers abandoning mortgages even though they can service them because they are now in negative equity territory. Does anyone know what proportion of these voluntary foreclosures had low to no equity from the get-go?
2. Many of the recent borrowers are in trouble even before a rate reset. That means their ability to service even a lowered mortgage may be much weaker than the would-be rescuers assume. As Dean Baker pointed out:
….many of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance….. Either borrowers could not afford even the low teaser rates or they were defaulting because they realized that their homes were worth less than their mortgages…Falling house prices will cause many homeowners to find that they owe more than the value of their mortgage. This provides a temptation to just walk away, which will get larger as the gap between the size of the mortgage debt and the price increases.
And recall that the 2007 vintage subprimes were junkier than 2006.
One of the least publicized, relevant facts is that over half the subprime loans weren’t for purchases; more than half were cash-out refinances. As we discussed in a September post:
Perhaps it’s the lack of a catchy name. “Cash-Out Refinance” doesn’t exactly trip off the tongue. But its role in subprime has been largely overlooked. A June MarketWatch story mentioned it in passing:
More than half of subprime loans are actually cash-out refinance loans. Those loans are used to pay off credit cards or other debts, take trips to Bermuda, buy an unaffordable car or do some speculative investing – in the market, real estate or elsewhere.
“These loans are all about people in a tough spot,” said Matthew Lee, head of Fair Finance Watch, a Bronx, N.Y.-based community group ….
Half the subprimes were cash out refis. This isn’t implausible. Freddie Mac reported that cash-out (meaning the new mortgage was at least 5% larger than the one it replaced) refis for its borrowers were 35% in the second quarter of 2007, and noted that refinancings as a proportion of total mortgages were declining, which is typical in a rising interest rate environment.
Now why is this so significant? It gives a completely different picture of the nature of the problem. It suggests that many of the people who took out subprimes weren’t people who bought more housing than they could afford. It says they were already overstressed and overstretched financially. Using their home as a source of cash was a gamble to keep themselves out of bankruptcy, but in many cases, that bet didn’t work out.
This poses a nasty equity versus efficiency problem. Truth be told, many of these people speculated with what little home equity they had left and lost. They may not have had better options, but consider: the ease of extracting that equity may have kept them from making better choices or exploring less obvious options.
Thus to taxpayers who have been conservative with their finances, bailing out this bunch is going to be an unpopular proposition (and it also has the aura of being as much about saving the bank miscreants who created this mess as the unfortunate borrowers). It thus behooves the powers that be to do a better, more fact-based triage: who is worth saving and why.
But instead we are getting shotgun approaches and grand schemes. First over the weekend, we saw a round of applause among economists for the idea of reconstituting the 1933 Home Owner’s Loan Corporation; today in the Financial Times, Larry Summers gives us “Prevent US foreclosures“:
The right focus is on measures that will prevent unnecessary foreclosures by facilitating more efficient settlements between homeowners and their creditors. Legal changes currently being debated, to bring practice with respect to family homes into conformity with general bankruptcy practice in two areas, could make an important contribution.
First, remarkably, bankruptcy laws currently provide that almost every form of property (including business property, vacation homes and those owned for rental) except an individual’s principal residence cannot be repossessed if an individual has a suitable court-approved bankruptcy plan. The rationale is the prevention of costly and inefficient liquidations. It is hard to see why similar protections should not be prudently extended to family homes…..
Second, methods need to be found to enable creditors who accept a writedown in the value of their claims to retain an interest in the future appreciation of the homes on which they have mortgages. This is standard practice in situations of corporate distress, where debt claims are partially replaced by equity claims.
Obstacles to such mortgages include uncertainties about tax and accounting rules. But at a time when there are great advantages to inducing lenders to let families to remain in their homes – and when families facing foreclosure are prepared to do things they might not do in ordinary times – it would be desirable to pursue suggestions by the Office of Thrift Supervision for so-called negative equity certificates to support shared appreciation work-outs.
Bankruptcy reform alone could, on some estimates, avert 500,000 foreclosures and, by establishing templates for renegotiation, aid a wider restructuring of mortgage debts. Proper support for voluntary restructurings involving interests in future appreciation should realise still greater benefits. As with fiscal stimulus, rapid bipartisan co-operation between Congress and the administration would benefit the financial system, the real economy and millions of Americans.
This program muddles a good idea with a bad idea, and bizarrely, Summers seems to have forgotten that a mortgage is a secured credit.
The idea of letting judges reset mortgage terms is one we’ve advocated. Predictably, the mortgage industry has fought it tooth and nail, but if they can’t (or won’t, staffing up entails costs) be bothered to do mods, having courts do it is the next best option. This is hardly unprecedented; judges have this power in commercial bankruptcies, and not one seems particularly bothered that they exercise it there.
Indeed, having the threat of judge-imposed mods might get some banks and servicers off their duffs and put the heat on them to put more resources behind renegotiating mortgages. Since there are costs and stigma attached to a bankruptcy filing, it is unlikely to be used casually.
One item that seldom mentioned in the discussion of the bankruptcy law: the judge can’t change the mortgage willy-nilly, but he can (and usually does) write the principal balance down to the current value of the collateral; the rest of the balance is deemed to be “unsecured” and that is included with the other unsecured debts. Removing the negative equity overhang giver the borrower much more incentive to make payments and take good care of the house.
But no doubt missing this key element, Summers then wants to throw in the OTS negative equity certificate concept, and draws the analogy to corporate bankruptcies. Huh?
A Chapter 11 expert please speak up, but my impression is that secured creditors in a corporate bankruptcy take their collateral and run. Does any know of any examples in bankruptcies where secured creditors of any type get an equity participation (ex post facto, not as part of the initial financing)?
And of course, as many have observed, the negative equity certificates demotivate the borrower. It may sound fair, but it provides bad incentives.
If we are going to have grand schemes, I prefer Dean Baker’s “own to rent” plan:
Gives homeowners facing foreclosure the option of renting their home for as long as they want at the fair market rate. This rate is determined by an independent appraiser in the same way that an appraiser determines the market value of a home when a bank issues a mortgage.
The proposal requires no taxpayer dollars or new bureaucracies. It would be administered by a judge in the same way that foreclosures are already overseen by judges. It simply changes the rules under which foreclosures can be put into effect.
The proposal does not bail out in any way lenders who made predatory mortgages or made risky gambles in the secondary market.
There are no windfalls for homeowners. They will have the right to stay in their house, but will no longer own the home. This means that there is no real incentive to abuse the program. The plan would be capped at the value of the median house price in a metropolitan area, so it will not benefit high income homebuyers.
Rents will be adjusted in later years by the Labor Department’s consumer price index for rents in the area. If either the owner or renter believes that their rent is unfair, they can arrange, at their own expense, to have the court make a second appraisal.
After the foreclosure, the mortgage holder is free to resell the house, but the buyer is still bound by the commitment to accept the former homeowner as a tenant indefinitely.
By allowing homeowners to stay in their house as renters, this plan will help to prevent the sort of blight that often afflicts neighborhoods with large numbers of foreclosures. Homes will remain occupied, and long-term renters will have an incentive to keep up the appearance of the property. This should help to sustain property values for whole neighborhoods.
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All of this is a classic example of how people in power in both private and governmental sectors obsess over what’s called strategy in the private sector and policy in the governmental sector. The battle is consumed with alternatives ideas. And, meanwhile Rome burns.
Strategies, policies and ideas are, of course, necessary. But they are not sufficient. Results also matter. But, the linear, sequential habits of decision-makers predictably focus on the former without anything more than arguments about the latter.
Where is performance itself? Where are the results that would indicate whether any of the ideas succeeded?
Performance-driven approaches don’t wait. They quickly establish results and goals that answer, “What would success look like for strategy X or policy Y?” — and they get into the market and see what happens.
More over, performance-driven approaches recognize that contexts matter. Markets — and the solutions that work for markets — inevitably differentiate across a rainbow of different contexts and market situations and segments. There is never ‘one totally right idea’.
Many things are tried; all quickly. Indeed, ‘time to market’ with possible solutions is a dimension to the question, “What does success look like?” Results themselves then guide further innovation, modification and adjustment. Patterns emerge — and, where appropriate, get copied.
The fires — the many different fires — get put out differently. Rome stops burning.
Instead, we are now well into at least a year since a critical mass of folks recognized the crisis. And, we’ve had far too few results-driven, performance-driven efforts. Even some of the few things that have supposedly been ‘tried’ (Paulsen’s efforts) are more characterized by continued negotiation to save positions than actual efforts in the markets themselves.
One defining characteristic of this pattern is the either/or nature of the battle over ideas. Folks worry about the ‘one right way’ instead of taking a both/and approach to let many solutions emerge. Interests and power express themselves through blocking results-driven action instead of spurring it.
Rome burns. And so-called leaders attend meetings about strategies, policies and ideas.
“By allowing homeowners to stay in their house as renters, this plan will help to prevent the sort of blight that often afflicts neighborhoods with large numbers of foreclosures. Homes will remain occupied, and long-term renters will have an incentive to keep up the appearance of the property. This should help to sustain property values for whole neighborhoods.”
Great. I can buy a rent-controlled house with a section eight tenant already installed! Talk about slum-lord heaven. Your water heater is on the blink? Tough bananas, bubba. Tough bananas.
Sorry but this scheme is just as bonkers as all the rest.
Who, exactly, is going to suddenly become landlord of suburbia?
* one way apartments/condos function is to have similar appliances purchased in bulk at discount rates. Who would even attempt to bother maintaining widely disparate properties with unknown levels of decay?
* My complex picks up individual trash bags daily from outside every dwelling so as to eliminate dumpster diver seediness. What non-owner is going to bother with staying current with the (decently expensive) trash stickers?
* Electric and utilities. If you don’t own your place and anything gets turned off, whose fault is it? Yes, there’s a legal system to answer these questions, but in the meantime whatever delta of value was added for the non-resident owner was destroyed.
To sum, we have a plan sounding good for the *current tenant* – but who’s picking up the tab?
I love the own to rent idea.
Who would be the landlord? At first it would be the banks, but since they don’t want to be in the business, they would likely sell off to professional landlords. Who would want to be that professional landlord? Well I think that depends on the price.
REALITY CHECK
People hate lawyers until they need one, then there are no atheists in foxholes:
F E D E R A L I S M
Learn it. Live it. Know it.
Real property law is the ULTIMATE example of laws left to the several states. THEORETICALLY under the commerce-prohibiting technique Congress can pre-empt some of this, but I wouldn’t bet on how much (please google FDR and court-packing and realize there is nothing new under the sun and a lot of the New Deal was ruled unconstitutional on this ground).
Show of hands. Who here thinks that anytime soon legislation can be drafted that implicates 50 states’ recording statutes, lien statutes, landlord tenant law, on and on and on.
None of this nitwit ideas can be done in the context of securitization; PUHLEEZE understand the tax laws re REMICS are a mess of complexity but do NOT contemplate shared participation in negative equity certificates and operating rental real estate.
Ugh.
Either everyone behind this is totally brain dead or this is all just stalling smoke and mirrors to appear to be taking action.
HERES A CLUE:
The reason the banks WILL cave on Chapter 13 cramdowns is simple…
Chapter 13 cramdowns ultimately are operating independent of the consent of the mortgage lender to the extent of the overcollateralization.
If a securitized loan goes into Chapter 13, then at the end of the day what happens is not up to the securitization trustee holding the loan, but up to the judge.
Otherwise, in a voluntary workout, the more the securitization trustee gets creative, the more likely he/she is exposed to liability for breach of fiduciary duty (just imagine what happens if a trust takes a short refi plus a certificate, thus screwing over the income beneficiaries or, worse, exposing them to an unfunded tax liability).
Also, goodbye Q election (that’s the thing that keeps them off balance sheets so long as there’s no active management other than “brain dead” administration.
Not a bad day’s work. Loss of REMIC pass-through tax status, loss of Q election, liability for breach of fiduciary duty, certificates that may not be legally liens in many states, unrecordable in some, thus eliminating any possibility of title insurance…
Sigh.
There aren’t good choices here, only bad versus less bad. In my view, this falls in the “less bad” category. I certainly prefer it to the “let’s have the government buy crappy mortgages on a large-scale basis and negotiate mods individually.”
Have any of you lived in rental home? The landlord does not pick up the garbage for you. When I was growing up, due to the frequency with which we moved (father transferred a lot), we did upon occasion. The houses were decent houses. The owner never once showed up, nor did he have a manager. They usually have an approved plumber and electrician to call if there is a problem. If you live in a house, whether you own it or not, problem resolution is usually slower than in an apartment. That’s the nature of the beast.
I agree that there won’t be a lot of people who’d want to buy these apartments, but there is a market in NYC for rent controlled, occupied apartments. And rent control is VERY tenant friendly here (people are hard to evict), which therefore makes a investment less attractive. Most places make it easier to evict tenants that have fallen behind on payment, which should make investing in these properties more promising. But I agree, the market will be thin. These will mainly sit with the banks.
However, turnover ex financing is higher than you might think. Roughly 20% of Americans move every year, so these might not be as long-term a liability as feared.
Banks are already in the business of sending bills and collecting checks, so that aspect is in line with current skills.
The leases could also be triple net, that would take the bank out of the maintenance role. After all, as homeowners, the borrowers were already responsible for maintenance, so there should be not objection to this.
And in some buildings in NYC, people spend A LOT on fixing up their rent-stabilized apartments, precisely because they have some property rights (you cannot be denied the renewal of the lease if you pay on time, and your right to sublet is better than in a coop). One woman spent over a million dollars, and I know personally of several others who’ve spent in the $50,000 to $200,0000 range. So it isn’t a given that renters will trash their places either, particularly if it is a place they like and they are glad to have it.
Yves
Then de facto, rent control operates as a substantial restraint on alienation with respect to the fee owner.
I live in NYC too. You ever TRY selling a rent controlled (more likely stabilized) apartment building? They come with huge plant issues as owners have little motivation for capex (unless it puts the apartments over the destabilization threshold, but let’s not put everyone to sleep).
I agree with you that if we “have to do something” then anything that leaves the USE in the current owner but the ECONOMIC BENEFIT (gain/loss) with the screwed over lender is better, sure.
I just don’t see anyway to make this work in this legal system without depression-era emergency Congressional preemption.
Even the New Deal didnt happen overnight.
Speaking of which, is setting the rent on the home within Congressional power?
Is it any different than setting wage and prices on chicken processing (cf NRA, Schechter, and US v. Lopes).
Federalism is NOT dead and the idea that new entities will somehow acquire mortgages from REMICS and short refi them and become landlords is…
And if it’s not done that way, tell me how REMICS, which are creatures of state law, get told (assuming any of this happens in the first place) how to rent stuff out…
By covenant running with something?
But then there’s that pesky federalism issue again.
Basically, our politics are different, but we agree on this being SO FAR better than other bad ideas…
I just don’t see any way it works legally.
fmo,
Agreed that both the negative equity certificate and the “own to rent” concept are in the land of “waive a magic wand.” I guess my comment that I regarded it as a “grand scheme” wasn’t clear enough.
However, per the Hope Now Alliance plan, this Administration takes the view that they can do that, that if Treasury backs a program, that gives servicers enough headroom to beat back legal challenges (that is, if Treasury and the American Securitization Forum agree to something, it has some legal standing. I’ve been shocked that the press has treated that assertion with a straight face).
Of course, Hope Now was also so narrowly drafted as to limit it to circumstances in which it could be argued that the rate freeze wasn’t a worse outcome for investors. Presumably plans could similarly be sufficiently tailored under these concepts if anyone cared to (but as Tanta suggested, by the time anyone figures that out, the mortgage crisis will likely have passed…..)
Oh, and your comment made me realize something I hadn’t considered…..those negative equity certificates would probably need to be recorded locally. Otherwise it might be possible to effect a title transfer without satisfying it.
One other thing…
Any transaction which leaves the homeowner a renter de facto in that the risk of loss is removed and all possibility of gain is removed is arguably a realization event.
If this program brings in serial refi’ers then some of them no doubt have cost bases lower than fmv, so they get to pick up the gain? I realize there’s a capital gain exclusion but still…
The devil is alwyas in the details (ps by SO FAR better i meant so far to date based on whats been run up the flagpole, not that its SO MUCH better).
Not to be a pest, but as we agree more than we disagree…
First of all, I’m a quantitative tax and securities lawyer and not a RMBS/REMIC lawyer so I don’t claim mastery and I can make mistakes believe me but…
REMICs, to preserve their tax status, have to operate within rules. To the extent the trust is off balance sheet, accounting standards (this is the Q stuff) require the trust to operate within certain rules.
The two sets of rules certainly overlap, but they arent identical sets.
Generally, the Q rules require that the trust be run “brain dead,” meaning that the trustee (and delegated servicer) must only operate mechanically as provided in the trust documents.
The SEC flap is on the issue whether approving workouts for loans that appear to be in trouble, particularly but not exclusively where there is no such language in the PSA (trust document), is too far removed from “brain dead” and thus is active management and therefore destroys the Q election and the stuff must come back on balance sheet.
INDEPENDENTLY of this is the 1,000 year old (ok 800 but close enough) concept of fiduciary duty…when anything discretionary is done by a trustee it had better be done with utmost fidelity to the ultimate beneficiary. When there are beneficiaries with adverse interests (income vs gain, present vs remainder), its litigation bait.
Arguably (but falsely, I promise you), the idea here is that if ASF says “everyone does it or can do it,” somehow that overrides both the accounting Q issue and the state law fiduciary issue.
The FASB would argue otherwise. They don’t even want to maintain SIV status.
So would most state court judges, who won’t like or accept the idea that because some flacks said its ok then its ok and they have nothing to say about it.
NONE of this has anything to do with REMIC tax law.
REMICs are not supposed to be buying and selling assets except in rare cases as required by non-discretionary workouts. To allow REMICs to do this would require changes in tax law too.
Any REMIC operator who went along with this without a change in tax law or a PLR or some clear proof that the Service will not come in and squish him would be insane, as the tax liabilities that would spring up would (you knew this was coming) be a breach of fiduciary duty.
As I said, we can agree on what’s desirable, but so much would have to be done that by the time it got done it probably wouldn’t matter anymore.
Perhaps if you have to do own to rent the only way thats workable is to create a quasi GSE that buys the loans and keeps the risk of gain and loss and passes back to the loan seller not only the purchase price of the loans but the rent, which gets a surgical amendment to the tax code to allow the receipt of such rent not to be “rent” such as would destroy the REMIC status but to be deemed “interest” on the loan it no longer owns.
SOMEONE has to consider the implementation details.
Of course, such an entity would be one giant real estate landlord company.
Call it a WPA. :)
Incidentally, I made another post on CR going on at length about the tax consequences to the REMIC or to its holders on sales like this…
Not pretty.
Again, massive work to amend the code if that’s what you’re going to do, but ask yourself this:
(a) where does the loss go? obviously there’s a loss recognized on sale of the loan. normally gains and losses go to the residual piece but that was not contemplated for this stuff as this stuff was not contemplated on this scale.
(b) is the “new loan plus certificate” received a single or bifurcated instrument?
(b)(1) if its a single instrument, then its a contingent payment debt instrument and some tranche holder is going to wind up picking up phantom income (an unfunded tax liability).
(b)(2)(a) if its a bifurcated instrument, there is simply no precedent for treating that certificate as equity, it would almost surely be considered by itself a zero coupon contingent payment debt instrument; see above for the mess it creates (in your terms, it would be a zero coupon [balloon] shared [100%] appreciation mortgage)
(b)(2)(b) otherwise, if it is equity, who gets the gain (remember, in REMICs, gain goes to the residual, but in this case that gain economically should belong to the income tranche holders)
furthermore, i GUARANTEE you there are many states (Florida i think being one) which would not allow the recordation of this if it were not presented as a mortgage…and if it were, then you’ve got that annoying phantom income contingent payment debt issue again
and
who decides when to sell it (remember theres supposed to be a market for these things)
so all REMICS are now actively managed REITS?
theres taht pesky fiduciary duty issue again.
Do you agree that theres a lot here thats clearly beyond the intellectual ability of a lot of the people proposing it to think through before they shoot their mouths off (I’m not talking about you, but about the ones proposing these things)?
fmo,
This is all very helpful, one of my continuing frustrations in covering these topics is that most of the discussions are at 30,000 feet. Although I am not at all an expert in this area, it’s pretty obvious that messing with structured credits is a non-trivial activity, yet everyone acts as if this can be made to happen by fiat.
I think the unspoken assumption is (to the extent anyone considers details), of course, the IRS will go along, it’s part of the Treasury and since OTS is also trying to push these ideas along, any IRS rule changes will automagically happen. No one considers that that will require a good deal of thought and crafting so as not to create unintended consequences.
One is happy to be of service. I merely wanted to point out that, as Tanta would say, there’s a lot to be done and far more than anyone thinks or is likely do-able in time.
If I may, “the IRS will go along” is a concept. My “job” is to explain to anyone who cares that what this really means is that to the extent that statutory changes are required (they are, big time), it’s up to Congress, not the Service, and to the extent there are regulations to be issued, you have NO idea how long it takes to issue those things, publish them in the Federal Register, and so on.
I’m not saying this stuff can’t get done, I’m saying that…if you’ll forgive the testosterone…
(and I think this is what you’re getting at yourself)
In the Tom Clancy novel “Clear and Present Danger,” but not the film, Jack Ryan’s rescue of the US soldiers captured by the drug dealer involves the use of Coast Guard ships for operation of VTOL aircraft.
There’s a funny chapter in the book where Ryan lands on the ship and explains to the Captain all the grand scheme of how they’ll land the aircraft on the ship, then take off and so on.
After he’s finished, Ryan says to the Captain, “So what do you think?”
The Captain takes the pipe out of his mouth and says, “You should have checked the weather.”
(A huge hurricane was approaching.)
Im just saying.
In concept, the problem is that we have a tax and legal system that revolves around “realization” and federalism and to imagine how nice it would be to exchange A for B has to be matched with the reality of “and where do the taxes go and how do we make sure state laws are not implicated and we don’t accidentally break something important.”
Remember, or you tell me you’re more into this stuff in some ways, CRA pressure is considered instrumental in the “innovation” that allowed this toxic mortgage crap to get done…(the Community Investment Act, kind of “encouraging” [like Tony Soprano would] banks to make loans in bad areas])
The Law of Unintended Consequences.
Here’s another example, a la ABK:
The reason “only” $3B MAY be enough (not to me, IMO the ratings agencies are stupid AND whores) is because they need enough capital to have loss coverage ratios relative to their expected losses, which are low in muni land, at least in recent history.
However, this little bit of capital here changes the total balance sheet values of assets by hundreds of billions???
That’s because of a multiplier effect, where each market participant (particularly institutions like insurers who hold muni bonds but can hold only so many if theyre not rated AAA) has to revalue according to a very different formula…
In other words, you thousands of market participants suddenly downvaluing or forced selling all kinds of stuff because of this one change.
See, an investor holding $1B of these munis, say all of one issue, now A instead of AAA, has to revalue them down by, perhaps, $100M…
And 1000 of those investors makes this a $100B writedown all for the want of $3B in capital.
That’s because they’re not writing down by an increment in loss expectation due to the rating drop from AAA to A (assuming a bust monoline) whereas the monoline needs only $3B to avoid downgrade?
This is idiotic, but its because the holders of the munis are not able to use a correlation model to aggregate their loss expectation, whereas ABK is.
It’s much more complicated than this, and I’m a life actuary not a bond actuary (whatever that is), but you get the point.
So now we have a system where owners of ABK can hold a gun to everyone’s head and say, “We all know that munis don’t default hardly ever, in fact our profit margins are 50%, way higher than MSFT ever dreamed of, but if we go down then everyone goes down 100x worse, so give us money and let us keep upstreaming our dividends and paying ridiculous salaries we don’t earn or…”
Remember the National Lampoon magazine cover, “Buy this magazine or we’ll shoot this dog?”