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.
Foreclosure Mediation Programs Succeed Across The Country — Will Pawlenty Give Minnesota’s A Chance?
Today, across the country, mortgage mediation programs aimed at helping struggling homeowners stay in their homes are getting underway. Programs are launching in Maryland, as well as Florida’s 6th and 10th judicial circuits — encompassing Pasco, Pinellas, Hardee, Highlands, and Polk counties — while Cook County, Illinois is beginning a huge round of outreach for its burgeoning program.
In all, “the number of jurisdictions with foreclosure mediation programs is nearly double the number a year ago, with jurisdictions in 21 states now offering foreclosure mediation or negotiation programs.” Not on this list, however, is Minnesota, where Gov. Tim Pawlenty (R) saw fit to veto a program last year.
The Minnesota state senate recently passed the bill again, sending it to the state House, so Pawlenty could very well get a second shot soon. And there’s simply no reason for him to oppose the program, as mediation — during which a bank meets face-to-face with a borrower, often in the presence of a judge and housing advocates, to try and forge a mortgage modification or other arrangement that prevents a foreclosure — is one of the most successful methods of helping struggling borrowers stay in their homes.
Connecticut’s mediation program, for instance, has kept 60 percent of its borrowers out of foreclosure. Philadelphia’s success rate is also 60 percent, while Nevada claims an 85 percent success rate:
About 80 percent of homeowners at risk of losing their homes don’t engage in any efforts to negotiate with their lender. And those who do so on their own often run into a bureaucratic mess, including hours on hold, lost records, and customer service representatives who know nothing about the borrower’s situation. Mediation helps to ensure that situations like that don’t happen.
“These new protections empower our fellow Marylanders, putting them on a more equal footing with mortgage companies that too often can’t be bothered to pick up the phone before beginning a foreclosure proceeding against a Maryland family,” said Governor Martin O’Malley (D). And lest Pawlenty think this is a purely partisan issue, it has also won the praise of Gov. Jodi Rell (R-CT). “Clearly, mediation is an effective tool homeowners can use to ward off foreclosure,” she said. “This program is a beacon of hope for hard-pressed homeowners and a real alternative for lenders.”
In mediation, there’s no requirement for a lender to accommodate a borrower, but it’s often the case that preventing a foreclosure is in the best financial interest of both the borrower and the lender. As CAP’s Andrew Jakabovics and Alon Cohen wrote, “the simple act of participating in mediation consistently yields solutions short of foreclosure that are acceptable to both sides.” Hopefully, should the Minnesota legislature do the right thing and create a program, Pawlenty will allow it to stand.
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