Paulson Pleads for Bulk Mortgage Modifications

Henry Paulson is becoming the spokesperson for half-baked proposals, first the SIV rescue plan, and now his idea for what sounds like standard-form loan modifications for stressed mortgage borrowers.

Paulson’s fondness for Big Schemes That (Purport To) Fix The Problem With A Master Stroke may be a sign of grandiosity. Doesn’t he understand that the Treasury secretary has little power? Overusing his bully pulpit, one of the few tools at his disposal, will quickly erode its effectiveness. However, Paulson appears to get some support for his notion from the deal cut by California Governor Schwarzenegger with four mortgage servicers to have them maintain teaser rates for certain mortgage borrowers for five years. But the California plan has yet to be implemented, and Paulson is no Guvernator.

From the Wall Street Journal:

U.S. Treasury Secretary Henry Paulson, concerned that millions of homeowners aren’t being helped quickly enough, is pressing the mortgage-service industry to help broad swaths of borrowers qualify for better loans instead of dealing with mortgage problems on a case-by-case basis.

In an interview, Mr. Paulson said the number of potential home-loan defaults “will be significantly bigger” in 2008 than in 2007. He said he is “aggressively encouraging” the mortgage-service industry — which collects loan payments from borrowers — to develop criteria that would enable large groups of borrowers who might default on their payments to qualify for loans with better terms.

That’s a shift from his previous view that the problems didn’t warrant a group approach. Mr. Paulson said his outlook has evolved as he has learned more about the problem.

“We’re never going to be able to process the number of workouts and modifications that are going to be necessary doing it just sort of one-off,” Mr. Paulson said. “I’ve talked to enough people now to know there’s no way that’s going to work.”….

While he stopped short of endorsing a proposal by Sheila Bair, chairwoman of the Federal Deposit Insurance Corp., to have mortgage companies freeze the interest rate on the two million mortgages due to reset to higher rates between now and the end of 2008, he said that’s “one idea.” Mr. Paulson said he supports finding some way to develop “standard criteria that’s going to allow for modification and workouts.”….

Mr. Paulson said he understands Mr. Coburn’s concerns, but notes: “This is not business as usual. This is an extraordinary situation.”

He also called the Senate’s failure to pass legislation overhauling mortgage giants Fannie Mae and Freddie Mac “very frustrating,” saying that the two government-sponsored entities need to be playing a bigger role in the housing market.

“If we ever need them it’s during times like today, and they’re most valuable when there is distress in the mortgage market,” he said. “I’d like to see them playing an even bigger role.”

Fannie and Freddie, however, have recently posted losses that could hamper their ability to buy mortgages, since they are required to keep a hefty capital cushion.

It is interesting to observe Paulson’s frustration with his powerlessness and the desperate tenor of his comments about the state of the mortgage market.

Yet he rejects case-by-case loan mods, apparently because he believes there are too many that need to be done relative to processing capacity (gee, it may not have occurred to him that between restrictions in the servicing agreements and more important, the financial condition of the borrowers, there may not be as many mods as he thinks that are viable. This is a huge unexamined assumption whenever the scary factoid “2 million homeowners will lose their homes” is bandied about.” Some can be saved, but for others, it would be the equivalent of keeping them on life support. Remember, Dean Baker told us that:

Most of the news reporting on the subprime meltdown has focused on the problems that borrowers face when their loans reset from low teaser rates to much higher fixed rates. While this is a big issue for millions of borrowers, resetting subprimes are just a single wave in an ocean of bad mortgage debt.

This can be seen from the fact that 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.

Since no mortgages had reset at the 10-month point, clearly there were other problems. 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. The latter problem will only get worse as house prices continue to decline in response to the glut of housing on the market (the inventory of unsold new homes is 50 percent above the previous record and the number of vacant ownership units is almost twice the previous peak) and tightening credit conditions curtailing demand.

But here Paulson is, throwing solutions at a problem that he doesn’t fully understand. In too many cases, defaults aren’t the result of a reset. Instead, the mortgage was a huge stretch from the get-go, and all it took was a minor mishap or borrower miscalculation to push it over the brink.

More troubling is that Paulson is prescribing the same medicine that created this mess in the first place. Tanta at Calculated Risk has waxed eloquent many times on how the difficulties that the mortgage industry is suffering now result from a relentless drive for efficiency at the expense of prudent, well-tested procedures. Everyone went for maximizing throughput of their mortgage factories and lowering costs, with no concern as to the rate of defects, since that was the chump investors’ problem. But because it might cost money and take time to make intelligent decisions, the powers that be are going to push even harder with the same flawed model that created this mess in the first place.

As I have said before, it is not a sign of intelligence to persist in a course of action that isn’t working.

Now I could see an approach using some elements of standardization as having merit. It makes all the sense in the world to do triage on a standardized basis. There are some borrowers you can probably ascertain are hopeless by applying a few simple criteria. There may also be a subset who can be salvaged without the work and cost of a negotiated mod (for example, someone misses one payment, makes all subsequent payments, but never makes up the missed payment, and keeps getting hit with late fees and other charges due to that one mishap. Write off the extra charges, add the missed payment to the balance, and be done with it. Technically, this is a mod, but it isn’t highly labor or thought intensive). But I don’t see how you can get around assessing the quality of the borrowers’ income, their other obligations, and their commitment to seeing it through. You can’t determine that from a FICO score.

Finally, I wonder even if a methodology could be developed, whether it is possible to implement it across diverse mortgage pools. Even if each servicer was so fortunate as to not have his standard form agreement negotiated very often (i.e,, the terms really are very consistent across deals), with all these funky mortgages, I imagine how the structures work (the allocation of principal and interest payments to the servicer and to each of the tranches) is not terribly standard. Large scale changes in significant numbers of mortgages in any pool will wreak havoc in who gets what and will create what in the industry is called “class warfare.” I don’t see how you surmount this problem (and this exists with individually negotiated mods too, BTW, but the classes that suffer the most might tolerate that process better, since they’d have more confidence that an earnest effort was made to extract the most that was realistically possible under the circumstances from the borrower).

So, like the SIV rescue plan, Paulson’s latest baby sounds great on a high-concept level but breaks down under inspection. But again like the SIV rescue plan, a program may be put in place irrespective of whether it will really help much simply because the prestige of the Treasury is now on the line.