By Mike Konczal, a former financial engineer and fellow with the Roosevelt Institute who writes at New Deal 2.0
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 de
al 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.
Yves here. We have also advocated modification of residential mortgages in bankruptcy, as is now done for commercial real estate and other types of secured loans, such as for pleasure boats. That idea was beaten back early in the reform debate.
Note also that Konczal mentions the use of Chapter 13 bankruptcies. It isn’t widely recognized that servicers and the mortgage foreclosure mills also fight the use of Chapter 13, by filing a motion opposing the bankruptcy stay. Ironically, some attorneys representing Chapter 13 clients have fought these motions by questioning the standing of the party pursuing the foreclosure (often a servicer or MERS, the mortgage registry service, rather than the trust that presumably owns the note), which is producing results to the industry far more damaging had they allowed these Chapter 13 filings to proceed.
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Cramdowns would do all the benign things Levitin said, but of course none of that’s even remotely relevant to the banksters and their government flunkies.
The obvious problem with rational modification policy is that in acting in accordance with the reality-seeking price trend (that is, downward), it directly contradicts the one and only policy imperative the kleptocracy can conceive, reflating the bubble.
As for the MERS scam, the more the light is shined on it the more it’ll be revealed how the very “property” regime no longer has a legal basis even according to their rigged laws. That’s the basic idea of Hernando de Soto’s contention that the rule of law itself has been abrogated by the systematic destruction of its physical paper records.
http://online.wsj.com/article/SB123793811398132049.html
It seems that we have all lost perspective, s only half of our population can afford houses, yet roughly 70% now own them. So, that extra 20% will eventually lose their houses by foreclosure, or, we will pay their payments for them.
I suggest we never, ever get in the way of foreclosure, but permit extremely quick foreclosures so that the house value is not lost. The better the deal is for the lenders, the better deals will be available for the borrowers. And a quick foreclosure allows new owners to get a house in good shape.
Nothing should ever be done to delay the consequences of bad choices, either for banks, mortgages, or any other business deal.
It never ceases to amaze me how the tight-assed, hard-nosed, rigorously consequentialist types are the least realistic and most deluded of all, substituting their normative fantasy of a truly “hard” reality, for the complexion and contexture of the thing itself. Perfectly liquid RE markets without transaction costs, nor the possibility of long-term imbalances between supply and demand that the deflation of a bubble, left to its own devices, would only worsen in the over-shoot? Really? And the point seems to be lost on you that principal reductions to actual sustainable market value is not just collectively social welfare optimal, as lowering aggregate transaction costs and losses, while lessening the deflationary stress on the housing market from an ever-increasing excess of supply, but is actually loss-minimizing for the lenders themselves! At least, get in touch with some actual facts with your fantasizing. Pre-bubble, the U.S. home-ownership rate was around 64% and stable, before rising above 69% at the peak of the bubble. By proposing a 50% home-ownership rate, you’re actually proposing massive intervention to restructure the housing market toward rentals, without exactly furnishing a rationale and means of doing so.
Party pooper. No sooner does someone come up with a good sanctimonious fantasy, full of table thumping and calls to “cold hard reality”, than some wiseguy like you has to spoil it with “facts” and “numbers”. Sheesh. Can’t a guy have a good time anymore?
I read here to try to understand the situations that I don’t have a good grasp of, but something seems wrong with this argument.
You say that 70% of the population has homes but 20% never really were able to afford them. Then you say, “permit extremely quick foreclosures so that the house value is not lost.”
As I see it, (if my arithmetic is right) that means 28% of existing homes have no legitimate buyers and you want to quickly empty them of their illegitimate buyers. Who’s going to buy them? If 28% of the total homes were suddenly on the market with no qualified buyers how can there not be huge value lost in the whole housing market?
Did I miss something? I don’t have any solutions but I can’t see a whole bunch of quick foreclosures helping much.
Perversly Rex, it might actually help some of these former home owners. Being forced out of their underwater (unresolvable) obligations, might leave them without a place for a couple of years. Then if they were lucky enough to have an income, they could buy their old home back for less than half the price????
Are the MBS holders better off with extend and pretend than with write-downs, at least in the short term?
Exactly!!
http://www.sourcewatch.org/index.php?title=Total_Wall_Street_Bailout_Cost
Very nice link! Thanks.
What mechanism establishes market prices for MBS? Is price modeled on expected cash flows from the underlying mortgage payments?
Lien stripping, like most other acts of reality, is never going to happen as long as bad debt can be counted as a asset on the balance sheet. The current incarnation of bk laws are specifically designed not to hold people accountable for their spending, but to keep their iou’s as assets. Assets that can offset the expenses of running a scam (bonuses, salaries, perks, etc.)
The Potemkin Recovery may be running out of steam, but that won’t stop the free market ideologues. Ever since Reagan, we’ve been governing the economy according to catch phrases and talk is cheap. The Colbert Principle is in full swing, and no liberals are in a position to influence events.
Even now, it doesn’t have to be universal. Spain’s takeover of its underwater banks might be a glimmer of hope. What’s the Spanish phrase for “grasp the nettle?”
“grasp the nettle”
Cojer el toro por los cuernos
The need for home mortgage cramdowns was so fundamental and obvious that it is simply impossible to believe that the executive branch and the legislative branch failed to recognize it.
Having eliminated the possibility that they are sufficiently stupid to have done what they did, the only other possibility is that they are sociopathic whores. I would rather not have reached that conclusion, but there it is.
It is not surprising that this administration is warming up to the Russians – we’re heading straight for a Russian style fascist oligarchy run by and for the benefit of the ivy league mafia.
“It is not surprising that this administration is warming up to the Russians – we’re heading straight for a Russian style fascist oligarchy run by and for the benefit of the ivy league mafia.”
Scamerica already is a fascist oligarchy. Its a ruling elite corporate global gang-fest on roids, the Russians have always been on board with the program. The gangs are in Full Spectrum Dominance alliance mode now eliminating the masses, they will duke it all out after they are done with the big kill off …
Excerpt;
“WASHINGTON – The U.S. government’s decision to spend 648 million dollars to buy or refurbish Russian helicopters for the Afghan National Army Air Corps has been drawing flak from some members of the US Congress.”
http://breakingnews.gaeatimes.com/2010/06/19/us-military-criticized-for-purchase-of-russian-helicopters-for-afghan-air-corps-34967/
Deception is the strongest political force on the planet.
And just like in scamerica they are using the ‘invisible hand’ of propagandizing the culture to dumb down the folks …
Excerpt;
“Russia: Creating a Nation of Poor, Sick and Ignorant
KAGARLITSKY Boris
18 June 2010
A new bill has been passed in Russia that will extensively roll back Government funding of education, the arts and social services – by introducing per capita financing – that will punish smaller towns and downgrade quality in the larger ones.
When initial reports appeared in the media that a new bill had been introduced that would alter the way the state regulates education, the arts and social services, many people refused to believe that it would actually be passed. But when deputies actually passed the bill, hope still remained that President Dmitry Medvedev would not sign it. But the law has been passed and signed.”
More here …
http://www.europe-solidaire.org/spip.php?article17781
Deception is the strongest political force on the planet.
Good article, I appreciate it.
Too bad it’s too late. Reading this stuff beginning to seem like documentation of the fall of a civilization.
If preservation of capital were the objective, it would seem that the “market” would encourage innovation. Workouts or cramdowns would be as common as cats at the dairy. I do not believe that preservation of capital is the primary objective of the mortgage servicers/trustees. Instead, their goal is income maximization, through fees, etc. There are likely larger fees available through extend and pretend and foreclosures than through workouts. Thus, even though one would expect that the servicers have a fiduciary responsibility to the bond holders, such niceties as trust and service seem to be mere marketing gimmicks these days.
Also, there is a backside to the extend and pretend coin – government bailouts. I can easily imagine a fat-cat banker toying with the idea of creating a foreclosure crisis to rile the proletariat into demanding government intervention, with more federal dollars to the bankers to soften any principal reduction. Indeed, the failed HAMP program tried to do just that. Had it been jucier, it might have attracted more rats, er bankers.
Nothing personal Yves, but my view of bankers and the real estate business in general is much more along the lines of Mr. Potter than George Bailey.
Sensible bankruptcy laws? Has this ever been an issue before? Hold it, I found an obscure document with the following passage: “The Congress shall have Power To … establish … uniform Laws on the subject of Bankruptcies throughout the United States”.
Now why would someone put that amongst the specifically enumerated powers? Shay’s rebellion? Have we been here before?
P.S. The above is not meant to disparage in any way Mike Konczal’s excellent and informative post. My point is that I’m forever amazed at how, despite cries of “innovation”, so little is truly new. Important details change, but the basic approach to important national problems often doesn’t. Maybe we should send our genius regulators and politicians a few good books on Shay’s Rebellion and how it affected the Constitution.
How does a cram down help in situations where someone making 40k a year bought a $300,000 home using an interest-only ARM?
My point is that the housing bubble created an environment where house prices exceeded the ability of people to actually, you know, pay for them.
The larger problem is that if you actually lower the prices of homes down to where they need to be (the point where real people with real incomes will really pay the bills), you basically bankrupt all the banks and take down a bunch of pension and hedge funds along with it. And probably a few countries as well.
I’m thinking cram downs would be a great answer if it wasn’t the whole country that was messed up.
“The larger problem is that if you actually lower the prices of homes down to where they need to be (the point where real people with real incomes will really pay the bills), you basically bankrupt all the banks and take down a bunch of pension and hedge funds along with it.”
What’s the problem with bankrupting some banks and hedge funds? That’s the deal with capitalism – there are risks involved. If this bankrupts them then they are going to be bankrupted eventually anyway because we can’t afford to prop up the housing market forever. Extend and pretend ain’t gonna help, and we’ll stagnate trying it. There’s more to the economy than f’ing housing. We’ve blown so much trying to prop up housing (really the banks) that we supposedly have nothing left over for responsible people who lost jobs through no fault of their own.
As for pension funds, my 401k and IRA’s haven’t done so great either. A crashing economy will do that, and pretending it won’t will make things worse as time goes on. As for defined benefit pension plans, just how much of the rest of the economy are we supposed to screw so that the lucky duckies who have them can be guaranteed their risk free retirements?
“And probably a few countries as well.”
Tell them to default. Worked for Argentina.
Excellent point!Mortgage cramdowns would not be regional or local but national impacting millions of homes in the end folks would still have NO equity just glorified renters stuck with deflating property tied down with maintenance and taxes.
Maybe debt default is the best alternative!
Looks like Don Gonzalo Lira was dead on when he postulated one cardinal feature of the police-state: The individual is sure to be taken out to the cleaners by the “street gangs”, a.k.a. the powerful groups. That’ll happen time and again, even if it doesn’t make any sense to do so, like here.
We’ll never be able to “keep this Republic” (Franklin’s admonition) if the street gangs always prevail, no matter how rich and how many natural advantages this country has.
Mike,
I agree that mortgage modification, either voluntarily by lenders or through bankruptcy cramdown is essential. But I think it misses the point in the context of this particular crisis. This is not about financial engineering, securitization problems, bankruptcy laws, etc. It’s not about any of that. It’s about the insolvency of the banks. They simply refuse to write down the value of the loans and that’s that. Which is why, even after untold billions of bailout money, the shit is still not marked down. That is why there have been so few foreclosures. That is why the ridiculous HAMP was tried (and failed).
A while back I read a great quote somewhere on the internet (sorry, can’t remember where): “debts that can’t be paid won’t be paid.”
Ultimately it doesn’t matter; the loans will be written down because they cannot be repaid. And either the banks will go broke or the government will bear the cost.
“It’s not about any of that. It’s about the insolvency of the banks. They simply refuse to write down the value of the loans and that’s that.”
But isn’t that part of Mike’s point, that a change in bankruptcy laws would force them to write things down in many cases, but that they won’t have to write them down as much as they ultimately would otherwise, because it minimizes the vicious cycle of foreclosure. Of course forcing the banks to do anything other than extend and pretend is exactly why we won’t see this …
“And either the banks will go broke or the government will bear the cost.”
Or both. Banks that go broke have to be taken into receivership, and that will cost government money. On the whole though I think it will be cheaper.
Search in Mike Shedlock’s blog:
http://globaleconomicanalysis.blogspot.com/
A young couple with two small children in town (Sonoma) purchased in 2004 a 550K home with 100K down. He lost his job 18 months ago and his wife is a part time preschool teacher so they have been trying to get a mortgage mod. The home might be worth 350K to 450K today so tell me how does an unemployed construction worker make payments on a 450K mortgage? Would it make any difference at 350K? This idea of mortgage cram downs makes no sense at today’s mortgage debt levels.
Well again this has little to do with the topic, but I thought post some of my favorite quotes today via Calculated Risk:
From Paul Krugman on the half percent move of the Yuan;
“And all indications are that watching the future movement of the renminbi will be like watching paint dry.”
this form Stuart Miller CEO of Lennar Homes on the recent slump in home sales;
“The entire market knew there’d be a slowdown as we came off the tax credit,” Miller said on a conference call with investors today. “It’s just that the reality of it doesn’t feel good.”
And finally this gem from Barbara Desoer, president of B of A’s home-loan and insurance unit on foreclosure(?);
“Given the depth of the nation’s recessionary impacts on homeowners, a considerable number of customers will transition from homeownership over the next two years.”
Myself – I’m trying the transition from reality before the paint dries.
pleasant dreams
Yesterday’s inaction by the Senate to extend unemployment may speed up the process of increased mortgage default. Dylan Ratigan makes a cogent argument for “strategic default”: http://www.huffingtonpost.com/dylan-ratigan/who-pays_b_624149.html
Cram downs will neither ease nor solve the problem.
If the borrower’s loan balance is greater than the currently obtainable price of the home, the borrower’s best interest is to default.
When the borrower defaults, the lender’s best interest is to consider loan modification if and only if, the borrower can service a loan that is predicated on a 70% loan to current price basis. If the borrower can’t make that payment, the lender should foreclose and expect a 50% to 60% loss against the outstanding balance of the loan.
Now post foreclosure, the lender might be able to mitigate his loss by operating the home as a rent property. Says easy, does hard.
What complicates the lender decision is that the current owner of the note is not the party that wrote the mortgage. The owner of the note may well be three or more transactions removed from the origination of the loan. In that case what has to occur is that owner has to seek recourse to the party who sold the note to the current owner the note. Just back it up to the originator. But then he is nolonger in business and has no assets from which a claim might be settled.
See, we have a lovely mess to deal with.
Observation: in most cases the underwater loan shouldn’t have been made in the first place. The losses against that fact should be borne by the party that originated the loan and all subsequent parties who thought the loan was worth owning.
The more one looks at this problem the clearer it becomes that this problem is not about home ownership, it is about excess credit money seeking an opportunity.
At origination it was a failed transaction, liquidate it and the sooner the better.
Will that screw up the economy, yes there will be ample pain for all to share in. It’s that sharing thing that pisses me off. I have to endure distorted prices because some thief wrote a mortgage and sold it some ninny who’s great at gaussian and bayessian statistics and has the morals of a $2.00 whore. And the statistics thing, that black box crap and the CDO nonsense, please explain to me how it is that income streams attributable to first loss bonds can be bundled into some thing that has a credit rating, let alone AAA. The aggregate bundle of paper that the CDO has claim to has an expected value of near zero.
Where this not so serious as a financial and more critically as a social problem, this would all be quite farcial.