Credit Slips

The Case for a Consumer Financial Protection Agency

Yesterday, the White House released proposed statutory languagefor the creation of a Consumer Financial Protection Agency (CFPA).  The bill is long, but the CFPA, the brainchild of our co-blogger Elizabeth Warren, is by far the boldest part of the Obama financial restructuring plan.  I’d also venture to say that it is the most important. 

 

In this post I want to underscore why we need a CFPA.  In future blog posts, I hope to come back to what a CFPA will and won’t do.

Cuomo v. The Clearing House Association: OCC Loses Even with Chevron Deference

The Supreme Court delivered its decision in Cuomo v. the Clearing House Association today.  The issue in the case was whether the a regulation passed by the Office of the Comptroller of the Currency (OCC) preempted state enforcement of state fair lending laws against national banks.  Coming on the heels of the OCC's victory in Wachovia v. Watters, in which the Supreme Court held that a state could not exercise visitorial powers over an operating subsidiary of a national bank, many thought that the Supreme Court would extend the OCC's power to near complete preemption of any state authority over national banks. To the surprise of many observers, however, the Court ruled 5-4 (Thomas, with Roberts, Kennedy, and Alito dissenting) in favor of the State of New York (Cuomo).  

Open-Source Law Review Publication Contracts

I know this isn't standard Credit Slips fare and will probably be of little interest to most readers, but it's of reasonable concern to academic readers:  the lack of standardization among law review publication contracts. 

Too Big to Fail? Is Obama Proposing an Implicit Government Guarantee of Goldman Sachs' Liabilities?

Secretary Geithner was quoted by the Times as saying that from now on, “no one should assume that the government will step in to bail them out if their firm fails.”

Sorry, but that's just not credible.  The Obama financial reorganization blueprint basically says that there are Tier 1 FHCs financial institutions that get special regulation) that are too-big-to-fail (TBTF).  For these (today 19?) companies that the administration has decided are guaranteed a bailout.  The blueprint refers to a guarantee of liabilities only passingly in its section on special resolution powers for Tier 1 FHCs, but given how we've handled the GSEs, AIG, Bear Stearns, etc., its hard to believe that we wouldn't guarantee the debts of a failed Tier 1 FHC--the whole nature of being a Tier 1 FHC is that there is systemic risk from its failure to honor debt obligations. 

This means that for Tier 1 FHCs, their debt is as good as guaranteed by the U.S. government.  The implications of this are far-ranging and serious; I haven't worked through all of them, but here's what jumps out at me:

ABA Consumer Protection Conference: Credit Slips out in Force

Angie Littwin and I will be speaking on a very timely panel about the need for a consumer financial product safety commission Consumer Financial Protection Agency (CoFiPro=Coffee Pro?) at the ABA's Section on Antitrust 's Consumer Protection Conference at Georgetown.

The conference features appearances by numerous current and former FTC and state officials--including a greeting by the incoming head of the Consumer Protection bureau, my GULC colleague David Vladeck--as well as prominent private practitioners. Sessions cover issues including internet issues (with special attention to the perhaps surprising scope of Section 230 of the CDA), privacy, the use of empirical evidence, and the different standards applied by different regulators, including the FTC, NAD, and courts applying the Lanham Act.

Just to play with acronyms for proposed Consumer Financial Protection Agency: CoFiPro=Coffee Pro? or CoFinPro=Coffin Pro?

Skin in the Game

The proposed skin-in-the-game requirement for securitization strikes me as misguided, no matter how its structured. Different industries use securitization for different purposes, and while skin in the game might not have much of an impact in some, it runs contrary to the (legitimate) purposes of securitization in others.

Some industries securitize primarily to gain off-balance sheet and immediate revenue-booking accounting benefits and because it is a cheaper funding source than other methods. Industries like these often have significant skin in the game (e.g., the credit card industry, where a 7% vertical slice is the typical minimum requirement and it's usually much higher). Other industries, like non-GSE mortgages securitize primarily to shift credit risk. The whole point of securitization is not to have skin in the game.

The skin in the game requirement is being driven by the experience in mortgage securitization, not other types of securitization, and imposing a skin in the game requirement probably won't do much to non-mortgage securitization, where there might already be more than 5% retained interest. But for housing finance, skin in the game is really counter productive.

The Effect of Legislation of Credit Card Interest Rates...

Is a drop? 

According to Bankrate.com, credit card interest rates stayed steady for low-rate cards and dropped for some high-rate cards.  So what this means that the Credit CARD Act has resulted in lower interest rates, right? 

Of course not.  That's a pretty obvious ex-post ergo propter hoc argument that doesn't proove anything.  But you can bet we'd see exactly the same sort of argument being made if rates had gone up (and we assuredly will the next time rates do go up).  No conclusive evidence need apply.  Never mind that the legislation hasn't even gone into effect yet.  Flipping through the cable stations, I saw no less a luminary than Mike Huckabee on Fox saying that one of his interviewees was having trouble getting credit because of the legislation.  I believe in anticipatory effects, but really, what issuer would shift away from a juicy business model a minute sooner than required? 

Bank Regulatory Arbitrage and Deregulation: the Number of Bank Regulators Matters

One of the key points of debate over financial institution regulation reform is how many different bank regulators there should be and the extent of their respective bailiwicks.  Some argue that the number of regulators is a secondary issue.  It's not.  It's a first tier concern.  A critical flaw of our banking regulation system is the ability of financial institutions to engage in regulatory arbitrage, which has a corrosive effect on the quality of bank regulation.  As long as there are multiple federal banking regulators supervising essentially equivalent financial institutions there will be regulatory arbitrage, which will inevitably undermine whatever statutory framework Congress sets forth for financial institution regulation.

Interchange Legislation Overview

It's summer, so it must be interchange season here in DC.  A trio of interchange-related bills have been introduced (or really reintroduced) in Congress.  First, there is the House version of the Credit Card Fair Fee Act of 2009, H.R. 2695, sponsored by Representative Conyers.  Second, there is the Senate version of the Credit Card Fair Fee Act of 2009, S. 1212, sponsored by Senator Durbin.  And third, there is the Credit Card Interchange Fees Act of 2009, H.R. 2382, sponsored by Representative Welch.  I think it is useful to summarize what these bills would do and their approaches to interchange regulation. 

Credit Card Line Reductions and Eliminations

In the coming months and years we are likely to hear the banking industry and its supporters blame the Credit CARD Act for reductions in consumer credit availability.  That might end up being the case, but we should be skeptical of the claim (and of the magnitude asserted) until we see some data that supports such a finding.  The fact of the matter is that there is already a tremendous credit contraction going on in the credit card space.  The chart using data from Carddata.com shows the annualized rate at which card issuers are closing down accounts at their own initiative.  As of April, it was 19.01% (I understand that to mean that in April about 1.6% (=.19/12) of all accounts were closed).  Remember, this is account closings, not credit line reductions, which are occuring on top of the account closings. 

In other words, a fair conclusion is that even without the legislation, we'd be seeing credit lines cut and eliminated right and left.  That means it just won't do to rest on priors and fall back on the syllogism of more regulation means more costs means less credit available.  To be fair, there could be an anticipatory effect showing up in the account attrition data.  But the legislation doesn't start to go into effect until late August, and a lot of it doesn't go into effect until 2010.  So a profit maximizing issuer would probably want to close the accounts that are profitable under current law, but not under the new law on the day before the legislation goes into effect, rather than a few months ahead.

 

Credit Card Defaults--Piggybacked Underwriting

If you want to get a window on why credit card defaults are soaring, look at credit card underwriting.  There is virtually no income verification in the card industry--all loans are stated income loans (a/k/a liar loans), and we know how well that worked for mortgages (and there's more temptation to lie about a card as a default won't cost you the house). 

The card industry does do some ersatz income verification, however, using credit reports,but this might only exacerbate underwriting problems.  Credit reports only list debts, not income, but card issuers are able to piggyback off the underwriting of lenders that do income verification.  Thus card lenders will look at mortgage debt on credit reports to gauge income levels.  If you have/had a large mortgage, that implies a large income. 

The problem with this style of underwriting is that it relied on mortgages being thoroughly underwritten both in terms of income verification and in terms of mortgage-debt-to-income ratios.  As mortgage lending standards went out the door, so too did card lending standards.  Card issuers ceased to get the benefit of mortgage lenders' income verification and got squeezed as mortgage debt gobbled up an increasing share of borrowers' income. 

To be sure, there are other factors now pushing up credit card defaults to historic levels, unemployment being chief among them and the inability to refinance credit card debt by using home equity, but what amazes me is that even now that we know that mortgages size is a completely unreliable indicator of repayment ability, leading card issuers are still piggybacking off of mortgage underwriting.

GM's Plan: The Basic Outline

The basic outline of GM's plan to reorganize (as opposed to a plan of reorganization) as it's seeping out is pretty neat.

GM wants to separate its productive assets from its liabilities. The basic way to do this is to sell the assets (piecemeal or as a going concern). The assets can then be deployed without the debt overhang and the creditors can look to the sale proceeds, which should be what they'd get if the company liquidated or they foreclosed.

This is the strategy that Chrysler has pursued with its sale to Fiat. The problem for GM is that there's nobody interested and capable of buying its assets (maybe some piecemeal sales around the edges, but not enough to matter). Anyone want 5.5 million square feet of prime Detroit office space?

GM has a pretty nifty idea, though. If it can't find an existing buyer, why not create on? It looks like GM will create a special purpose entity (New GM) to purchase its assets. How will this entity pay for the assets? A combination of cash, notes (IOUs), and its own stock. The notes and stock are easy enough to issue; the cash will be raised through a public offering of its stock, bond issuance, and loans from the US government.

So to put the numbers on this: (Old) GM's bankruptcy petition listed $82bn in assets and $173bn in debt. Old GM will sell most of its assets to New GM. Let's hypothesize that the sale is for $82bn present value. New GM will have to raise $82bn between debt and equity. Old GM will then take that $82bn (in a combo of cash, notes, and stock in New GM) and divvy it up amongst its creditors. Any remaining assets in Old GM will be liquidated catch as catch can.

Sure, there will be some fighting about exactly what gets sold and at what price, but the sale to New GM is really the only option on the table. There will also be intercreditor fights about distribution of the sale assets, but the net result will be that Old GM's creditors (including the UAW and US government) will end up holding a sizable part of New GM's equity, as well as its debt.

The use of a sale/liquidation as a type of sub rosa plan of reorganization isn't a novel idea (and this one's a steamroller), but GM's use of a specially-created, publicly traded New GM buyer strikes me as novel. To be sure, acquisition vehicles are often special purpose entities, but they are always subsidiaries of the true purchaser. Here the purchaser will be a real stand-alone company. Anyone know of other cases where this has been done? Comments are open.

Credit Card Legislation

The most significant credit card reform legislation since the 1968 Truth-in-Lending Act cleared its last major hurdle today, when it was overwhelmingly approved by the Senate.  There are some not inconsequential details to iron out in conference (House version, Senate version), but the bill is as good as passed. 

It's worthwhile stepping back for a second to gain some perspective on this bill.  Since 1968 there has been only minimal regulation or legislation relating to credit cards.  Four years ago, the card industry pushed through the BAPCPA and then poured money into defeating Tom Daschle's reelection bid.  The industry looked invincible.  The banking industry showed that it still has significant political muscle when it defeated cramdown legislation last month. 

That there would be any regulation of the card industry today is quite remarkable.  Some of the credit goes to the card industry's greed---for all that the industry knows about consumer behavior, it didn't realize that when consumers are squeezed too hard for too long, there will be legislative pushback.  But a lot of the credit for the legislation goes to the Congressmen and their staffs that really pushed the issue, especially Representative Maloney and Senator Dodd, as well as to advocates and academics who worked very hard for the legislation.  From the consumer groups, Travis Plunkett and Ed Mierzywinski deserve particular plaudits.  And some of Credit Slips' Finest had a hand in the legislation:  Robert Lawless, Katie Porter, and Elizabeth Warren, and non-Slipster Lawrence Ausubel.  Congratulations!

Home Depot Spends More on Interchange than on Health Care

I was bowled over by a figure in The Home Depot's presentation at the Chicago Fed’s 2009 Payment Systems Conference this week:  The Home Depot paid more in interchange than for employee health care last year.  That’s astounding.  Interchange is The Home Depot’s third largest operating cost.  And this is from a company that gets comparatively low interchange rates just by being large.  Interchange is costing large, sophisticated merchants more than health care.  And the value it gives is questionable:  The Home Depot's interchange costs have risen 16% in recent years, while purchase volume has increased 10%.  [COMMENTS NOW OPEN.]

Bankruptcy Remote ≠ Bankruptcy Proof?

"Bankruptcy remoteness" is the bedrock of asset securitization.  Bankruptcy remoteness means both that the assets will not be part of the originator's bankruptcy estate and that the securitization vehicle (SPV) will not itself file for bankruptcy.  The former is achieved by a true sale of the assets from the originator to the SPV; the later by ensuring that the board of the SPV will not authorize a bankruptcy petition and that there will not be outside, creditors who might file an involuntary petition.

The bankruptcy filing of General Growth, the second largest mall operator and the largest CMBS sponsor in the US is putting bankruptcy remoteness into question.

Chrysler and Foreclosures: the Contrast

Today it's reported that Chrysler has convinced its creditors to agree to modify its debt obligations.  Chrysler was able to do this in part because of the leverage it had by threatening to file for bankruptcy.  It's instructive to contrast the Chrysler situation to the situation of homeowners.  The voluntary home mortgage loan modifications are still not happening on the scale necessary to address the foreclosure crisis.  How different would the world look if homeowners had the leverage of bankruptcy to induce voluntary modifications? 

Why Card Issuers Engage In Rate-Jacking

The media has been abuzz recently with articles (here and here and here and also here) about rate-jacking--the often arbitrary increases in cardholders' interest rates. At first glance rate jacking makes little sense. Why raise rates on a good, paying customer? The cardholder might decide to close the account. Or the customer might not be able to service the higher rate debt and default?  Why mess with a paying customer these days?

To understand rate-jacking, you have to understand two factors about credit cards:  lock-in and the incentive to increase account volatility created by card securitization.

Interchange Fee Settlement

MasterCard settled a lawsuit brought by the European Commission's Directorate General for Competition, which alleged that MC (and Visa's) "Multilateral Interchange Fee" (MIF) an interbank fee for cross-border transactions in Europe (basically good old US interchange) was anticompetitive. While the settlement allows MC to keep charging an MIF, MC agreed to drop the weighted average of the fee from between .8% and 1.9% to .3% for credit cards and .2% for debit cards. As the Commissioner for Competition Policy noted, "MasterCard could not justify their level with any solid methodology, or explain what, if any, efficiency gains were being passed on to merchants and consumers at the end of the day." Visa has not settled in the litigation.

MasterCard's MIF was always much lower than US interchange, which is somewhere upwards of 2.0% (and that's not the full merchant discount fee, just the interchange component). But now we see that MasterCard has decided that it can survive by charging just .3% interchange on credit cards in Europe. So why are American merchants going to pay seven times as much in interchange for credit card transactions? Are American banks or merchants seven times riskier? Or is US antitrust law just seven times weaker?

Courts as Creditors

I teach my students that the days of the debtor's prison and the workhouse are long past; the only debt you can go to prison for are domestic support obligations.  But it turns out that there's another jailable offense:  failing to pay the court.  The New York Times has a story about Florida's practice of issuing writs of bodily attachment or "blue writs" for failure to appear in court.  The jail time under one of these writs is supposed to be at most 48 hours (plus a $20 fine!), but a study by the Brennan Center for Justice at NYU found that some individuals were imprisoned longer.  Florida's state constitution (like many other state constitutions) specifically forbids imprisonment for debt (excluding fraud), and there's a line of US Supreme Court cases holding that the Equal Protection Clause bars imprisonment solely because someone is unable to pay a debt. 

Technically it is jail time for failure to comply with a court order (much like failure to comply with a domestic support obligation); in that sense it's just plain old civil contempt.  But the wide-scale use of civil contempt to force payment for court fees strikes me as novel.  It's certainly been used before to effectuate things like turnover orders, but there's something very awkward about the courts in the role of creditor.

AIG Bonuses as Fraudulent Transfers

We’ve heard Fed Chairman Bernanke and Treasury Secretary Geithner say that there are no legal avenues to clawing back the AIG bonuses.  I’m not so sure that’s true.  What about good old fraudulent transfer law?  That’s a cornerstone of creditor-debtor law.  Would fraudulent transfer law apply?

Every state in the union has a fraudulent transfer law.  But there is also a special (and virtually unknown) federal fraudulent transfer statute just for the United States government, as creditor.  The federal government could, of course, proceed under a state fraudulent transfer law (I’m not sure which state’s law would apply to AIG), but why bother when it could proceed under its own law?

So would the government be able to clawback AIG’s bonuses with a fraudulent transfer action? 

Going Broke Like a Pro

There are a couple of interesting stories in the sports mags about the financial problems of professional athletes.  ESPN has a piece about Michael Vick's Chapter 11.  And Sports Illustrated has a longer piece about why professional athletes often have financial problems. 

Easterbrook: Banks Free to Gouge Consumers (at least for now)

Yesterday the Seventh Circuit upheld a district court decision permitting the retroactive application of penalty credit card interest rates to existing balances.  Writing for the court, Judge Frank Easterbrook noted that (1) the plaintiff's state law claims were preempted by the National Bank Act and (2) the plaintiff's Truth-in-Lending Act/Reg Z claim that she did not receive proper notice of the repricing was not tenable. 

Most of the opinion addresses the TILA claim.  It's very technical, but Judge Easterbrook recognized that the applicable Reg Z language as well as the Federal Reserve Staff's comment on Reg Z are ambiguous.  Easterbrook resolves the ambiguity by playing economic equivalence: 

"It would be lawful for a bank to impose an over-limit fee (say, $75) in the first month, then increase the periodic rate of interest only for successive months. As the Bank’s actual practice of back-dating the penalty rate has the same economic effect as a fee in the initial month, it is hard to see why one method should be allowed and the other prohibited.... Structuring penalty interest to have the same effect as a penalty fee in the initial month therefore does not undermine the goal of advance-notice requirements. Swanson and others in her position still can shop for better rates for future months."

Two problems with this statement. 

Rx Contract Abrogation (Use Only As Directed)

Former Credit Slips guest blogger Anna Gelpern has a nice post on AIG and contract abrogation on Nouriel Roubini's RGE Monitor.  Anna argues that there are times when abrogating contracts makes sense, but that AIG just isn't one of them.  Contract abrogation is a powerful tool that should be used sparingly and only to protect macroeconomic welfare, not to express political outrage over the behavior of a single company.  

Whatever Happened to Bankruptcy?

It's hard to remember in the midst of the bailout craze, but the United States does have legal mechanisms for dealing with insolvency.  We have the FDIC system for banks and bankruptcy for everyone else just about.  These are well-established institutions.  There's a wealth of experience and caselaw about both.  We know how they work, and both are reasonably transparent and fair.  While they have some limitations, they have served the country well for years.

And yet there has been a marked resistance in both the Bush and Obama administrations to putting banks into FDIC receivership and non-banks into the Chapter.  To be sure we had WaMu, Wachovia, and IndyMac cycled through the FDIC, and Lehman is wending its way through bankruptcy.  But the list of companies we haven't required to go through the ringer is equally impressive:  AIG, Citi, Bank of America, Bear Stearns, GM, Chrysler (and probably many of the financial institutions that took TARP funds).  

All of this raises a couple important questions:  why have some institutions been allowed to go through the established legal regimes, while others have received ad hoc treatment?  Is there something about the FDIC process or bankruptcy that the Bush and Obama administrations think doesn't work?  If so, what is it? (And let's fix it if it's a problem.)   Or is it a matter of whose ox would get gored in these processes, but not in an ad hoc treatment?  Consider--the bonuses that were specially protected per Geithner's request in the EESA would just be general unsecured claims in bankruptcy or FDIC proceedings.  And implicit recourse to banks by investors in off-balance sheet entities (like SIVs) wouldn't stand a chance in FDIC proceedings because of the O'Doench doctrine (FDIC not bound by secret deals).  

I'm bothered by the apparent lack of rhyme or reason for when we will use FDIC/Bankruptcy and when we won't.  It'd be nice to see the administration articulate why FDIC/bankruptcy aren't good options.  It can't just be a matter of funding--I'd much rather see the government as DIP lender than as the vulnerable preferred (or common) shareholder, bailing out bondholders.  

[Hat tip to Stephen Lubben for inspiring these thoughts.]

AIG--My Very Own Rick Santelli Moment

The AIG bonus episode pisses me off.  But not for the reason it ticks off most other people.  Yes, it's outrageous that the shmoes who drove AIG off a cliff are getting a bundle of cash.  But what really bothers me is that this silly episode is what gets Congress (and other people) all worked up.  For goodness sakes--it's just $165 million.  That's chump change for the federal government and especially in the scope of the bailout.  Put another way, it's about 55 cents per citizen, whereas TARP is about $2,333.33 per citizen.  

I understand the Congress is responding in part to a perceived public anger.  But there's an utter lack of perspective in the reaction to AIG.  Simply put, AIG doesn't matter.  It really doesn't.  The bonuses are disgusting, but irrelevant.  Get over it.  Lynching a bunch of Wall Street shmucks might feel good, but it doesn't help anyone.  It doesn't help people keep their homes and it doesn't restore the value of our 401(k)s and 403(b)s.  

The real question is why aren't we this outraged over things that really do matter?  Why is Congress about to leap into action (well, we'll see about that) over this piddly $165 million that has no effect on the world, when it hasn't done much of anything to help struggling homeowners?  Where is a sense of priorities?  Why wasn't Congress so energized to take serious action to help homeowners a year and half ago?  Why is legislation permitting homeowners to restructure their mortgage in bankruptcy still trying to get the Constitutionally mandated 60 votes to pass through the Senate?  

Bailouts are about economics, not moral justice.  We should be focused on what will help fix the economy.  The place to express our anger at Wall Street's excesses is not in clawing back some bonuses, but in creating a regulatory system that will prevent against future excesses. AIG is just beside the point, and if we continue to have national attention focused on things like the AIG bonus story, it only distracts from what matters.  

National Banks in Real Estate Brokerage

It appears that Congress is going to permanently ban national banks from engaging in real estate brokerage.  This is a major win for the National Association of Realtors, who worry that if banks get in the brokerage business, they will eat their lunch (in part by being able to offered bundled brokerage/lending services).

I'm uncertain how to view this.  On the one hand, there's a lot of reason, especially now, to be skeptical about the expansion of national banks into new lines of business.  The original 1863 National Bank Act kept national banks out of real estate lending.  How much happier would the financial system be today had that restriction been upheld. As banks and their affiliates expand into new lines of business, it becomes increasingly hard for banks' regulators to keep on top of the total safety-and-soundness picture of banks. 

On the other hand, there's plenty to complain about with the current state of real estate brokerage, including a variety of anticompetitive practices that sustain uncompetitively high brokerage prices.  It's unclear, however, whether the entry of national banks into the real estate brokerage business would make things more competitive in any way that would benefit consumers. 

Interesting discussion of the issue on Bank Lawyer's Blog. 

Interchange is No Laughing Matter

The Merchants Payments Coalition, a merchant alliance that is pushing for reform of the credit card interchange fee system, has a nifty little cartoon out in Roll Call and the Washington Times.

So a few words of explanation. Interchange is no small change.  I've written about it on the blog here, here, here, here, here, here,here, here and here.   Interchange is technically a fee paid on every credit card transaction by the merchant's bank to the bank that issues the credit card to the consumer.  The fee is set by the card network (MasterCard, Visa, etc.).  While interchange fees are generally in the range of a couple of percent of credit card transaction value (say 2%) it adds up to big bucks.  $48 billion last year! 

The fees depend on the type of business the merchant is in, the way the transaction is processed (card present or not, e.g.), the size of the merchant's business, and crucially, the type of card used.  Each card network has a couple of flavors of cards depending on the rewards and customer service that go with the card.  The more rewards, etc., the higher the interchange fee, as nearly half of interchange is used to fund rewards programs (and card issuers' financials illustrate this--rewards are listed a reduction in interchange revenue).  

More broadly, though, interchange is used to refer to the "merchant discount fee," the fee that the merchant's bank charges the merchant for every card transaction.  The merchant discount fee, of course, includes interchange as its major component.  Interchange sets the floor for the merchant discount fee.  If interchange is 2%, the merchant discount fee might be 2.5% or 3% or even 15% for high risk merchants (GOB sales, adult Internet sites, etc.).  

Merchants are likely to pass some or all of that merchant discount fee back to consumers in the form of higher prices.  Merchants can't pass it back just to card users because credit card network rules prohibit them from surcharging for credit or from discriminating among cardholders.  Federal law allows merchants to offer discount for cash, but that's not the same economically as a credit surcharge, even if it is the same mathematically.  

What's more, the problem for merchants isn't that they don't want to take credit cards. Instead, merchants want to avoid the higher cost rewards cards for which they receive no clear benefit.  The federal right to offer cash discounts doesn't help merchants avoid high cost rewards cards.    

Interchange is not just a merchant vs. bank issue.  It's an issue that affects the entire consumer credit system.  As I've written elsewhere, interchange supports and encourages reckless credit card lending and is used to fund rewards programs that encourage overuse of credit cards for payments, which inevitably results in unintentionally and expensively revolved balances and late/overlimit fees.

Interchange is transaction-based revenue; the issuer doesn't incur the consumer's credit risk.  That means that issuers can risk greater credit losses because they've already made a nice bit of money via interchange with virtually no risk.  Not surprisingly, interchange has increased over the last decade from being about 13% of card issuer revenue to being 20%.  Just as with mortgages, the shift from a lending to a fee-based business model encourages more reckless lending.  Securitization only further encourages this, although it works differently for credit cards than for mortgages, an issue about which I'll post another time.  

To be sure, issuers can argue that interchange covers the cost of the typically 20 days of float on gets on a credit card.  But if that's the case, then it's really a finance charge for a 20 day extension of credit, which would be annualized at 36.5% APR (based on 2% interchange rate).  And if we include a merchant discount fee (including interchange) of 3%, then we're talking about a 55% APR.  And that's not including the cost of then revolving a balance.  In short, credit cards are a lot more expensive then they appear.  

To be fair, there are costs associated with other payment media.  It's expensive to print and distribute cash, and the inefficiencies of the paper check system of legendary.  But these are both systems in which the government is heavily involved.  And that means that the costs are, in theory, subject to political control.  MasterCard, Visa, American Express, and Discover are, at best, subject only to shareholder control. Payments are a lot like a public utility.  They are as essential a part of the economic infrastructure as the electric grid or the water pipes.  And maybe we should think about regulating them as such.  

Shared Suffering in Airports and in Bankruptcy

Warning:  this is one of my odder posts.  Today I got a postcard in the mail encouraging me to sign up for Flyclear, a private service that for a mere $174 annual membership will provide me with a special ID card that will let me go through special airport security lines super fast.  The card works at almost 19 airports.  

I really dislike this product.  It bothers me in a visceral way because it is horrifically inegalitarian and undermines a basic civic value of shared suffering from war.  Airport security lines suck, but this is a national cost imposed by terrorism.  (I'll leave aside the issue of whether airport security lines are a sensible or the best response.)  And there is something really wrong about the costs of terrorism being borne disproportionately by American depending on their economic means.  We're all in this together and should have to shoulder the burdens alike.  It very much bothers me that TSA (or public airport administrations) is willing to countenance this sort of product.  

Flyclear is analogous to letting rich people pay to avoid the draft.  Sure, we did it in the Civil War.  For a few hundred dollars (a lot of money then), you could buy the life of a poor Irish or German immigrant who would go and live a miserable camp life and possibly be killed or maimed in your place.  In Vietnam we did it through the backdoor--rich, connected folks could get themselves places in higher education or seminaries and "Ho Chi Minh yeshivas" or fled abroad (or got into cushy air national guard units).  Maybe this doesn't bother you, but it really gets under my skin.    

I am aware of some of the counter arguments about why Flyclear is a good thing: the more people who are in Flyclear lines, the shorter the lines are for everyone else.  Flyclear lets people choose how they want to bear the burdens of terrorism, be it in their wallet or by waiting in a line.  And maybe Flyclear pays something to TSA, which thereby benefits all the rest of us.  There are responses to all of these arguments, but even if one were to concede their validity, none of them, to my mind, comes close to counterbalancing the erosion of the shared suffering principle.  

This is, of course, a bankruptcy blog, and don't worry, there's a connection with FlyClear.  Shared suffering is a key bankruptcy principle too, of course.  Unsecureds get paid pro rata.  But sophisticated creditors can opt out of this shared suffering by becoming secured or better yet entering into transactions that are not covered by the automatic stay.  

The problems that this creates in bankruptcy are the same that it creates with the "war on terror" (can we find a better phrase now for goodness sake?).  When some folks can opt out of the suffering of a war,but still have a voice in the politics of the war, it will affect how the war is prosecuted, and possibly not in a way that benefits the country overall.  Likewise, if a creditor is not bound by the stay or is secured, the creditor might not act in a way that maximizes value overall (Kaldor-Hicks efficiency) or even maximizes value in a way that doesn't make anyone worse off (Pareto efficiency).  

Let me be clear--I don't think Flyclear will destroy republican virtues.  But the sense of shared community, be it in bankruptcy or in airports, can undergo a death of a thousand cuts, and Flyclear is just another little cut.  

Congressional Oversight Panel Foreclosure Report

The Congressional Oversight Panel's foreclosure report will be out tomorrow.  I'm hoping it advances the discussion on foreclosures and foreclosure mitigation efforts and helps focus what is still a rather amorphous debate in which there seems to be too little common ground.  

Bankruptcy Bill Passes in the House

H.R. 1106, the Helping Families Save Their Homes Act of 2009, which will allow modification of all types of mortgages in Chapter 13 bankruptcy, passed the House today by a vote of 234-191.  

I haven't found a link yet with the vote breakdown or any other details, but will post more when I do.  

BS Bankruptcy Numbers

We've already seen a lot of bs numbers in the cramdown debate. The Mortgage Bankers Association keeps pushing its ridiculous figures. And now Todd Zywicki has joined the fray with an op-ed in the Wall Street Journal a couple of weeks ago.

Professor Zywicki that claimed that "A recent staff report by the Federal Reserve Bank of New York estimated a 265 basis-point reduction on average in auto loan terms as a result of the reform."

One little problem. That's not what the Fed staff report found. Professor Zywicki was off by 250 basis points (a doozy of a mistake!), as well inserting a causal link not supported (and arguably contradicted) by the Fed staff's study. The study states that "The decline in the average auto loan spread was 15 basis points lower after BAR for unlimited exemption states, a 5.7 percent decline relative to the mean over all states (265 basis points)." In other words, the average rate spread is 265 bp. The decline in rates, to which Zywicki was referring was only 15bp, and that was only in states with an unlimited homestead exemption.  That it was not 265 bp was abundantly clear from the regression tables.

But that's not all. It's not as if Professor Zywicki simply mistook a 15 bp drop for a 265 bp drop.  That 15 bp isn't what it appears to be.  The study used two statistical specifications and looked at states with limited and states with unlimited homestead exemption to see what impact there was on auto loan rates post-BAPCPA, which enacted an anti-auto cramdown provision (the infamous "hanging paragraph" that says that there's no bifurcation of claims for cars purchased primarily for personal use in the previous 910 days).

In one specification it found nothing with statistical significance regardless of the homestead exemption level, which means that it couldn't rule out the possibility that the change in rates was random.

In the other specification, post-BAPCPA there was a marginally statistically significant 15 bp drop in five-year auto loan rates in states with unlimited homestead exemptions. There was no statistical significance in the drop in other states. What's funny about this is that homestead exemptions have no bearing in Chapter 13--exemptions are only available in Chapter 7. So if the study had aggregated all states for its regression, it seems unlikely that it would have gotten stronger statistical significance.

So we have at best very weak evidence of a 15bp drop in rates. But it doesn't follow that the drop was due to the anti-auto-cramdown provision. The study also found a significant decline in auto-loan delinquencies in the short period after BAPCPA. The most plausible story, I think, is that surge in bankruptcy filings before BAPCPA's effective date cleared out the pipeline of troubled loans so that post-BAPCPA auto loan default rates were lower. My guess is that they've climbed right back up.  Notice that this has nothing to do with cramdown. This has to do with moving forward some filings that would have happened later. So we have a 15bp drop that might not even be statistically significant and only in some specifications and only for states with unlimited homestead exemptions, and it probably isn't attributable (or at least most of it) to the anti-cramdown provision, but instead to BAPCPA causing a filing pile-up. So where did Professor Zywicki get this 265 basis point number from? That's the spread that exists between five year auto loans and five year Treasuries. It has nothing to do with bankruptcy.

Sometimes a little common sense is needed when looking at numbers, too. In December 2005, auto loan rates were at around 6.63% (663 bp). If 265 bp was right, it would have been a 40% decrease in auto loan rates! Whatever impact bankruptcy has on credit costs, I don't think there's anyone who could honestly argue that 40% of the cost of auto loans is due to the ability to cram down loans on cars purchased primarily for personal use within the previous 910-days with a purchase money security interest. There just aren't that many folks filing for Chapter 13 bankruptcy, much less who fit into this particular set of circumstances, to have this kind of impact on pricing, regardless of the loss severities.

Yet another case of baloney numbers shaping the bankruptcy debate. I hope the WSJ runs a correction on this.  Now there's some fact-checking for you. 

[Update 3.6.09: Based on correspondence with Don Morgan, one of the NY Fed study's authors and Professor Zywicki, a few new points emerge:

First, I misread the study too.  The 15bp finding is in a regression that measure the "difference-in-differences" in the spread between auto loans and Treasuries pre- and post-BAPCPA for states with and without unlimited homestead exemptions.  The study does not report the post-BAPCPA rate drop in auto loan rates.  The author, however, tells me that it turns out to be 46-56 bps, and to have strong statistical significance. So let the record stand corrected on this.  

Second, regardless of whether the number is 15, 46, 56, or 265bps, the finding of a correlation does not mean there's causation.  But that's precisely what Professor Zywicki was pushing in the WSJ.   Unfortunately, it's just not a tenable claim.  

It's possible that BAPCPA resulted in lower auto loan rates.  But in order to make a reasonable causation argument, one must first explain the similar or larger rate drops in 2000-2001 and in 2003 and in 2007 that have nothing to do with BAPCPA.  Otherwise, the causal argument is reduced to the fallacious post hoc ergo propter hoc variety.  

The chart below, taken from the NY Fed study shows with the solid and dotted lines the spread between auto loan rates and Treasury's for states with and states without unlimited homestead exemptions.  They move in sync, and they clearly fall after BAPCPA.  But they also fall equally sharply before and after BAPCPA.  Auto loan rate spreads over Treasury jump around a lot, and the mere fact that they fell after BAPCPA doesn't prove anything.    

(fwiw, Chart 5 appears to be incorrectly labelled in the study.  The study says that the "Left axis measures interest rate on new automobile loan (5 year) minus rate on government bond (5 year)."  If so, then 15bps would appear to be roughly the right measure.  Instead, the rate spread must be the right axis in bps, and the left axis must be measuring the difference in the auto-loan-treasury spread between limited and unlimited homestead exemption states.)  

The problems with Professor Zywicki's causality argument don't end there.  Any causality argument must also distinguish between general impacts of BAPCPA (e.g, delinquency pipeline cleared out) and the auto-cramdown provision.  This type of event study cannot provide support for that.  The rate drop could be due to the hanging paragraph, but there's no responsible way to make that claim without addressing these other factors, and the NY Fed study doesn't attempt to do that. The fact that Professor Zywicki was off by 209-219 bps, rather than by a full 250 bps (something he couldn't have known from the study) doesn't absolve him of making an untenable causal claim. 

The  bankruptcy policy debate should happen on the basis of the best possible evidence.  If more restrictive bankruptcy laws result in cheaper credit, that's a very important policy consideration, and for the integrity of the policy debate, we need to be working off the best numbers available. I've updated this post to make sure that the correct numbers are clear.  I'm still hopeful that Professor Zywicki will make clear that he doesn't stand by either his 265 bp claim or his untenable claim of causality.]

[Updated 3.7.09

Professor Zywicki has corrected on the 265 bp claim.  He still seems to be making causal assertions, however, such as that the study finds "the impact of eliminating cramdown was a reduction in interest rates of 56 or 46 basis points."  That's not quite right.  The study can't test the elimination of cramdown; it can only test the impact of BAPCPA as a whole.  In fairness, Zywicki later refers to the study finding the impact of BAPCPA, rather than the specific cramdown provision.  Regardless, Professor Zywicki still has no response to all of the equally large jumps up and down in the auto loan rate to Treasuries before and after BAPCPA, which casts serious doubt on any causal story.]

Rewriting Frankenstein Contracts

A bit of shameless self-promotion:  former Credit Slips guest blogger Anna Gelpern and I have a new paper, "Rewriting Frankenstein Contracts:  Workout Prohibitions in Residential Mortgage-Backed Securities" posted to SSRN.  Increasing attention has been paid to the problems securitization contracts (pooling and servicing agreements) pose to modification of troubled mortgages.  Our paper situates RMBS contracts in the contract theory literature and argues for eliminating workout prohibitions through targeted legislation and administrative mandates.  En route to this conclusion, we try to construct a typology of contract rigidities (formal-structural-functional), and review New Deal jurisprudence on rewriting payment-in-gold clauses in contracts, breaking up utility holding companies, and stopping farm foreclosures. The abstract is below the break.  

Credit Cards in the 2007 Survey of Consumer Finances

The Federal Reserve has released its much anticipated triennial summary of the Survey of Consumer Finances.  There's a lot to digest in this important report.  I fear, though, that the 2007 SCF is already hopelessly dated because of the economic turmoil of the past year. 

I'll just offer a brief observation about what the SCF showed for credit card debt.  The SCF is notorious for underreporting credit card debt levels--in the past, the total revolving debt reported in the SCF from voluntary interviews is off by a factor of two from what card issuers report to the Fed for its G.19 statistical release.   Consumers seem to either lack awareness or be in deep denial of their debt levels.  Whether this underreporting has continued in the current report is unknown, but there's not reason to think there'd be a sea change in the nature of voluntary responses. 

So, with the caveat that consumer credit card debt is likely underreported in the 2007 SCF, consider this: 
"Overall, the median balance for those carrying a balance rose 25.0 percent, to $3,000; the mean rose
30.4 percent, to $7,300."  Balances for revolvers grew by somewhere between a quarter and a third in three years.  Wow.  This bespeaks a rapid leveraging up in credit card debt for a large segement of Americans.  And this was at a time when a lot of people were paying down credit card balances by doing cash-out refis on their homes.  One can only imagine what credit card debt would look like absent the tapping out of home equity to pay down cards.  As Paul Krugman noted today, we have a serious consumer overleverage problem, and it's going to be hard to get things on track without addressing consumer debt.   

Mortgage Servicing Problems for Prepayments

With all the problems in the mortgage industry caused by defaults, it's easy to forget that the traditional bugbear of mortgage lenders isn't credit risk, but prepayment risk.  If a lender contracted for a 6% return and the loan is prepaid, there's a chance that the best return the lender can get now is say 4.5%. 

As it turns out, prepayments can cause just as many problems for servicers as defaults.  Recently, one of my relatives laid into me with this story about her problems getting her servicer to correctly credit her prepayments.  The servicer has been crediting them all to interest, not to principal, so the loan balance isn't getting paid down (and the servicer is making more money that way, at the expense of the investors).  What's worse, is that the servicer says it can't correct the problem because some of the prepayments were made before it acquired the servicing rights.  And, the servicer says that if it corrected the problem, it would result in the account being listed as 30-days late and credit reported because the servicer did not make an automatic withdrawal one month because it treated the prepayment as a regular (but partial) payment (even though the total prepayments should put the loan way ahead on its original amortization schedule). 

Put another way, the servicer is saying that they cannot produce an accurate payoff balanceand that if the homeowner demands one it will result in her being credit-reported incorrectly. 

This aggrevating situation illuminates what a mess the mortgage servicing world is in.  For all of the attention justly paid to mortgage servicing problems with defaulted homeowners and servicing fraud in the context of default, my relative's case makes me wonder whether the rot in the servicing industry extends all the way up the tree, to an inability to properly handle transferred servicing rights and an inability to properly handle prepayments. 

And here's the real problem: consumers trust financial institution creditors to be competent and fair.  They trust that balances are right, that APRs are properly applied, that amortization schedules are correct, etc.  Without that trust, the entire system of financial intermediation cannot work.  Financial institutions trade in trust.  Absent that trust, every consumer would have to subject every credit card bill, auto loan bill, mortgage bill, and student loan bill, etc. to a forensic accounting.  That would be astonishingly inefficient.  We shouldn't want consumers to have to be so careful.  It's one thing to expect consumers to look at their bills to make sure that there are no unauthorized line items.  It's another to expect them to run interest and amortization calculations.

For the most part the system works, as it's all highly automated.  But when it doesn't, the power imbalance between the financial institution and the consumer puts the consumer at a serious disadvantage.  We really need a better system for resolving consumer disputes with financial institutions.  I'm not sure what it is, but maybe the trick is to avoid the disputes by making sure the FIs get things right. The least cost avoider of the errors is the financial institution, and we should really have stronger incentives for FIs to get it right. 

Treasury Recognizes GM/Chrysler Loan SNAFU

It seems like Treasury now realizes that it did a terrible job structuring its loans to GM and Chrysler, as I wrote at the time. (Of course, this assumes that the government was looking to recover the loans, not just make a gift to the auto companies.)  The loan agreement gives the government a second or third priority security interest.  That's not the safest spot in the world, especially on collateral that is pretty worthless outside of the auto companies as going concerns (who else wants a 200,000 sq. foot plant in Flint, Michigan?), and there's a good chance that the companies would eventually liquidate in bankruptcy.

Now Bloomberg reports that the government hired Cadwalader last month to help establish its place at the front of the line for repayment.   They hired a law firm after they lent the money?!!!  WTF?!!!   I mean, it was pretty apparent from the GM/Chrysler term sheets that the Paulson Treasury department either wasn't getting competent bankruptcy advice or was just ignoring it.  But even within the standards of the Paulson Treasury, entering this sort of multi-billion dollar distressed deal without good bankruptcy counsel is shockingly negligent.  Paulson Treasury really embodied the term SNAFU.

So what's Cadwalder going to do?  Is there any way to improve the government's priority?  The time to get priority was when the government had the greatest leverage--before it inked the deal.  Good luck now trying to convince the senior lenders to surrender priority.  I don't think the government's threat of forcing the companies into the Chapter is viable.  Is President Obama really going to let GM/Chrysler fail in the first months of his presidency?  Seriously?  Maybe the government is thinking about putting GM and Chrysler into the Chapter with an aim of doing a roll-up on its prepetition loans as part of a DIP?  That's a pretty big gamble, and I dare say raises some real questions about whether the government is acting in good faith if it calls the loans to force BK so it can do a role up.  Methinks those might be grounds for equitable subordination of the government's claim. 

Probably the surest course is for the government to just buy out the senior lenders' positions.  If the new new TARP goal is to buy up troubled assets, this might fit the bill. (But is Cerebus a "financial institution"?  If GM and Chrysler are, then surely Cerebus is, right?)  The government does have some leverage at least with the banks because of its other deals with them, but we could see the strange situation in which the government goes from making a bridge loan to being the major lender to GM and Chrysler. 

And we still have to ask, what good is first priority when there is very limited liquidated value from GM and Chrysler's assets?  There just isn't a market for most of their specialized equipment or real estate?  Is anyone looking for a huge fancy HQ building in Detroit?  First priority might not be enough to protect the government in a liquidation. 

The lesson to be learned here is one of the most fundamental rules of secured credit and bankruptcy:  get priority before you lend.  Duh.

What the Credit Crunch Looks Like

The Maryland suburbs where I live have been fairly insulated from the economy's problems overall.  The federal government provides a steady economic anchor for the region, so we aren't too badly hit with layoffs. We don't have a major negative equity problem in the close-in suburbs, and not too many foreclosures.  And yet here, over the past few days the economic grim reaper's work is evident:  several GOB sales in downtown Bethesda, numerous 60% off clearance sales, and my bank branch has cut all weekend hours. I've seen several stores that are noticeably poorly stocked, and visibly fewer shoppers in a lot of stores.  I can only imagine how much worse it must be in some parts of the country.

But anecdote isn't the singular of data, so let me show a data graphic (from Carddata.com) that charts the credit crunch quite visibly:  the involuntary attrition rate on credit cards. This is the annualized percentage of card accounts outstanding that have been closed by the card issuer. That is, these are lines of credit that have been revoked. Note that starting in the summer/fall of 2007, card issuers began ruthlessly eliminating lines of credit, while consumers stopped closing their accounts voluntarily. This is a picture of consumers wanting credit and financial institutions turning off the spigot. I'll leave the issue of whether or not this was wise for another day, but let the graph speak for itself.

Big Brother Is Looking After You

The NYTimes has a story about how American Express is analyzing where its cardholders are making purchases and using that information to determine whether to likely to default and adjusting credit limits and rates accordingly.  

This sort of behaviorally-based pricing is nothing new in the card industry.  We've seen a form of this for quite a while in the form of cross-default clauses and their successor any-time/any-reason term change clauses.  It's also popped up in litigation.  For example, the FTC's complaint against CompuCredit for unfair and deceptive acts and practices (settled for $350 million and a consent decree).  FTC alleged that CompuCredit was changing terms on cardholders depending on whether they used their card for things like marriage counseling, tire retreading, or massage parlors.  The NYTimes story indicates that Amex is not just analyzing on-us transactions, but also looking at things like home prices in your area and your mortgage lender. 

None of this is surprising.  The card industry probably knows more about consumer behavior than any other industry in the country; they have access to an unparalleled source of data on consumer consumption--there's really no other industry that can see as broad of a swath of consumer purchases as the card industry.  What's more, the industry invests significant resources in behavioral research and analysis, designs, markets, prices and reprices products based on this research.  This knowledge and analysis of consumer behavior has both positive and negative features.  

Bankruptcy Modification and the Emperor's New Clothes

A new argument being advanced against bankruptcy modification is that it will result in trillions of dollars of losses and the collapse of the financial system.  This is the "the sky will fall" argument.  

Leaving aside the grossly inflated numbers, let's be really clear that these are not losses that would be caused by bankruptcy modification.  These losses exist with or without bankruptcy modification.  All bankruptcy modification does is force these losses to be recognized now, rather than at some point down the road.  Bankruptcy modification doesn't change the underlying insolvency of many financial institutions.  One way or another, there are a lot of financial institutions that have to be recapitalized. 

Financial institutions want to delay loss recognition as long as possible.  Maybe they're hoping that the market will magically rebound.  Maybe they think that 2006 prices are the "real" prices and "2009" prices are a very short-lived aberration.  But here's the crucial point:  homeowners bear the cost of delayed loss recognition by financial institutions.  Delayed loss recognition means homeowners floundering in unrealistic repayment plans and then losing their homes in foreclosure.  Delayed loss recognition means frozen credit markets because no one trusts financial institutions' balance sheets.  Delayed loss recognition means magnifying, shifting, and socializing losses.  We only make matters worse when we try to pretend that these losses don't exist.  

We all know the story of the Emperor's New Clothes, and how everybody plays along with the emperor's conceit until a little boy points out that the emperor is stark naked.  To suggest that widespread financial institution insolvency would be caused by bankruptcy modification is akin to blaming the little boy for the emperor's nudity. 

Cramdown and Future Mortgage Credit Costs: Evidence and Theory

I've written extensively (see here, here, e.g.) on why permitting modification of mortgages in bankruptcy would generally not result in higher credit costs or less credit availability. As the debate over bankruptcy reform legislation to help struggling homeowners and stabilize our financial system moves to the fore, it's worth repeating some of the key points and making some new ones.

(1) The key comparison is bankruptcy modification versus foreclosure. Opponents of bankruptcy modification often misframe the issue, whether deliberately or ignorantly. It is not a question of bankruptcy losses versus no losses, but bankruptcy losses versus foreclosure losses. If bankruptcy losses are less than foreclosure losses, the market will not price against bankruptcy modification. This is an empirical question, and to date, my work with Joshua Goodman is the only evidence on it. Opponents of bankruptcy modification have only been able to respond with plain-out concocted numbers (e.g., the Mortgage Bankers Association) or insistence on applying economic theory that looks at the wrong question.

(2) Economic theory tells us that cramdown is unlikely to have much impact on mortgage credit costs going forward. The ability to cramdown a mortgage (reduce the secured debt to the value of the property) is essentially an option borrowers hold to protect themselves from negative equity. It is a costly option to exercise--it requires filing for bankruptcy, and that has serious costs and consequences. More importantly, though, cramdown is typically an out-of-the-money option. It is only in-the-money when (1) property values are falling enough that there's negative equity and (2) likely to remain depressed in the long-term. Long-term declining residential property values have been the historical exception. What this means is going forward there really isn't much for creditors to worry about with cramdown--homeowners can't exercise an out-of-the-money option.

Moreover, because the likelihood of the cramdown option being in the money is Instead, it is an option that is more likely to be valuable when default is imminent, at which point the loan is in the secondary market. So to the extent that the cramdown option does cost creditors, it is the secondary market, and the effects on credit availability and cost to homeowners would be diffused.

(3) Arguments about bankruptcy court capacity and bankruptcy transaction costs are made by people who have no experience with the actual bankruptcy system. A serious misconception about bankruptcy modification is the belief that the bankruptcy judge would decide how to rewrite the mortgage. That's not how bankruptcy works.  The debtor (and debtor's counsel) would propose a repayment plan that includes a mortgage modification. The judge either confirms or denies the plan, depending on whether it meets the necessary statutory requirements. This means that bankruptcy judges can actually handle significant consumer bankruptcy case volume. If you want proof that the bankruptcy courts can handle a huge surge in filings, look at what happened in the fall of 2005, before BAPCPA went effective. The courts survived that flood of filings. Today the bankruptcy courts are better prepared; there are more bankruptcy judges (thank you BAPCPA) than in fall 2005. Nor would there be tremendous time and money lost in valuation disputes. After there are a handful of cases decided in a district, all the attorneys know what the likely outcomes would be in future cases and settle on valuations consensually. Court capacity and excessive transaction cost arguments are made by people who have never stepped foot into bankruptcy court.

(4) There's no other serious option on the table. Permitting bankruptcy modification of mortgages will not by itself solve the finance crisis. It will not stop all foreclosures. But it will help stop some uneconomic foreclosures, which benefits homeowners, investors, communities, and the financial system. And, more importantly, whatever imperfections bankruptcy modification has as a solution, it's the only real option on the table.

There is no other detailed legislative proposal. There are various economist pipedream proposals around, but even the best of them fail, either because they are politically unrealistic or because they are too rooted to a belief that the private market can solve problems with a tweak here and there. I believe that people and institutions respond to incentives, but market-based solutions haven't worked to date. How many times do we have to be burned by "market-based" solutions before we try something else? The unfortunate truth is that no one understands enough about various mortgage market players' incentives to properly align them. We can't follow all the trails of servicing contracts, insurance, reinsurance, credit derivatives, overhead, and litigation risk and know what incentives look like. Even if we did, it would take serious time for the market to correct itself and start doing large-scale loan modification. That's time that families don't have, and I don't think that anyone who is advocating a market-based solution is also pushing a foreclosure moratorium to allow the market to get its act together. Bankruptcy modification is the only game in town, and to pretend otherwise is disingenuous cover for opposing it in the name of "studying all the options."

Shared Appreciation Clawbacks

As bankruptcy modification of mortgages (a/k/a Chapter 13 "cramdown") looks more and more likely to become law, it's worth considering what the final legislation might look like.  Already there have been some compromises in order to get Citibank's support. 

One issue that might be raised is a clawback of principal for creditors if there is future appreciation on a mortgage, the secured amount of which has been reduced in bankruptcy.  The question of shared appreciation emerged last year when bankruptcy modification failed to pass Congress and is one that has bedeviled many mortgage modification plans, including the Hope for Homeowners Act, not just bankruptcy modification.

Leaving aside the thorny question of how a clawback would work, I think it's important to consider whether there should be a clawback.  How one views this issue, I think, depends heavily on framing.  If the comparison is between a modification involving a principal write-down and a loan that performs at its original terms, then permitting an appreciation clawback as part of the modification seems quite fair.   In this framework, it makes sense to try to give the creditor as close to its original bargain as possible; otherwise would be a windfall for the debtor. 

But if the comparison is between a modification involving a principal write-down and foreclosure, then an appreciation clawback in the modification would result in a windfall for the creditor.   When a creditor forecloses on a house, the creditor doesn't benefit from any future appreciation in the property's value after the foreclosure sale.  The whole idea behind loan modifications, in bankruptcy or voluntary, is that they are value enhancing.  If a loan will perform at 75% of original value when modified, that's a lot better than a 50% recovery in foreclosure.  If a creditor is already benefitting from a loan modification relative to foreclosure, why should the creditor then also receive a share of the property's future appreciation?  Wouldn't that be a windfall to the creditor? 

Another way to see this is whether the modification is a temporary or contingent one or whether it is a life of the loan modification.  The danger with a temporary mod is that it just kicks the can down the road.  Requiring an appreciation clawback raises the question of modification sustainability.  Any which way, this is an issue that is likely to pop up again. 

New Orleans DA's Chapter 9?

A couple of years ago, it looked like New Orleans itself would have to file for Chapter 9.  Now it might just be the DA's office, which is mulling a rare Chapter 9 filing.  To file for Chapter 9, an entity must be a "municipality," which is defiend as a "political subdivision or public agency or instrumentality of a State."   I guess the local DA's office qualifies.  Interesting game of chicken with the tort plaintiff who was wrongfully convicted of murder.  

More on the Auto Bailouts

The term sheets are up here and here. Two initial observations:

(1) These are supposed to be secured loans, but they are almost assuredly junior liens--Chrysler already has a second lien facility, so that would make Treasury third.  These liens might be underwater from the start, and a lot of the collateral probably isn't very valuable to anyone but GM or Chrysler.  These companies are a lot like railroads in that a lot of their value is as going-concerns.  Piecemeal, there isn't much there.  This means that the primary value of being a secured creditor is having hostage value--the liquidation value isn't going to be very much.  But if either GM or Chrysler can't meet the restructuring terms, they will be going into the Chapter to liquidate (whether they say so or not).  And if that's the case, then it doesn't do the government much good to be secured.  

(2) The government has tried to protect itself by providing that if there's a bankruptcy, the loan will rollover into a DIP facility at the government's exclusive option.  I don't think that works.  First, this is likely an executory contract, so it is automatically rejected under 11 USC 365(c)(2).  Second, even if it isn't an executory contract, there will still have to be a 364 hearing.  I can't see the government getting into a priming fight (or winning--there's no ability to offer the senior lienholders adequate protection).  And because everything is encumbered, the government will have to settle for junior liens, which puts it right back where it was--an underwater junior.  Moreover, if the government wants to do this as a rollup refi of the prepetition loan or a cross-collateralization, I'd wager that it will find itself in some pretty sharp litigation.  There's no circuit level ruling (as far as I'm aware) that signs off on a rollup refinancing, and cross-collateralization is viewed very skeptically.  There's huge hostage value to any creditor that can make a credible threat of pursuing such litigation.  In any case, if GM or Chrysler goes into the Chapter as a freefall, the government would probably do well to wash its hands of the matter.  

Auto Bailout

TARP funds are now going to be used to bail out the auto industry.  Whether or not this is ultimately a good or responsible idea is something that I will reserve comment on for now.  The loans' term sheet isn't out yet, but it's outlines are being reported:  $13.5bn now, callable on March 30 (conveniently on the Obama administration's watch) if the automakers haven't reduced their debt by 2/3s (including via deb/equity swap--shareholders will get diluted) and worked out a competitive labor deal.

The idea animating these bridge loans is that the exploding deadline will force the automakers and their major creditor constituencies--labor, secured creditors, suppliers, dealers, and bondholders--to work out a restructuring.  That's a nifty move, but it is a gamble, and as I explain below, it is a very risky one for taxpayers. The Times reports that the loan will have priority over other creditors, which should protect taxpayers/  Only problem is that I don't know how that would be possible under existing law.     

Auto Bailout Proposals

Over at Conglomerate, David Zaring has an interesting discussion of some of the auto bailout plans.  What follow are some assorted thoughts on the auto bailout:

1.  The Bailout Debate Is Irrelevant Absent a Viable Business Plan

To my mind, the debate over how to help the automakers is a secondary issue.  The automakers' key problem is that they don't have a viable business plan for a restructured company that the key constituencies are behind.  Until and unless they have such a plan, debates over using bankruptcy or not or government bailout funding are really irrelevant.  

Fund Manager Fraud Insurance

The Bernard Madoff scandal in which perhaps $50 billion of investor funds were lost due to fraud has left me perplexed.  In addition to market risk, against which investors can hedge, we also see that investors (even, or perhaps especially investors in exclusive investment funds) can face catastrophic fraud risk.  Why haven't some of the insurance companies responded with fund manager fraud insurance?  Insurance, after all, is the proper response to rare, unpredictable, and catastrophic events.  

If you're going to put millions into a single fund, you're trusting the fund manager not only to make good investment decisions, but also not to steal your money.  These are different types of risks.  The first is easier to monitor than the second, and generally less catastrophic.  The second seems more suitable for insurance than the first, yet we have all kinds of specialized credit derivative products that function like insurance, but we don't (at least to my knowledge) have insurance for the later (maybe Lloyd's does?). 

Perhaps investors eager for higher yield don't want to lose a few bp on insurance, and perhaps the insurance companies can't work out the actuarial risk of something as unpredictable as fraud. Still, I would think that at least institutional investors, like pension plans and charitable trusts, would have, as part of a prudent investment duty, to purchase insurance against fund manager fraud.  This seems like a market niche that really should be filled.   

Massachusetts SJC to Subprime Lenders: Clean Up Your Own Mess

A major legal development in the foreclosure crisis occurred today in Massachusetts.  The Massachusetts Supreme Judicial Court, regarded as one of the finest state courts in the country, upheld a preliminary injunction against Fremont Investment and Loan for foreclosing on any "structurally unfair loan" without court approval.  

Tribune Bankruptcy: A Coup for Mark Cuban?

As has been widely reported, the Tribune Company has filed for Chapter 11 bankruptcy in the Delware.  Among the Tribune's major assets are its ownership of the Chicago Shlubs Cubs, a ne'er-do-well "ball" club, but still an extermely valuable Major League Baseball franchise.  (Full disclosure:  I'm a Sox fan.  And please don't ask what color....) 

[Note that this is not the first baseball bankruptcy.  We've had minor league club bankruptcies before, such as that of the Allentown Ambassadors.]

Tribune has already been trying to sell the Cubs.  In fact, bids have already been submitted.  Now, because the Cubs are a MLB franchise, MLB has a veto over any sale.  This likely means that Mark Cuban, the maverick owner of the Dallas Mavericks, who has coveted the Cubs for years, is unlikely to be able to complete a purchase, even if his is the high bid; he's not someone the MLB owners want in their club (in Ivyspeak, he's "not clubable").  And that was before the SEC brought a civil suit against him. 

But bankruptcy might change this picture and let Cuban buy the Cubs.  (Good, we Southsiders say, they deserve each other!).

Continue below the break for two ways Cuban might land the Cubs. 

We'll Miss You Tanta

The world of financial blogging lost a great contributor last week.  Doris Dungey, who blogged under the pseudonym "Tanta" passed away from cancer at a far-too-young age.  The NY Times obituary is here.  

I'll miss the erudition (and the mystery) of "Tanta," whose fabulous posts were featured on Calculated Risk (and who occasionally added to the comments on the Slips).  There have been few keener and better informed commentators on the mortgage crisis.  My understanding of the crisis was much enriched by her posts and e-mails (always behind the pseudonym!).  We'll miss you Tanta. 

The Role of Recourse in Foreclosures

Martin Feldstein has been pushing a mortgage bailout proposal that has been getting some undeserved attention (see here and here, e.g.).  Feldstein gets  (here, and here) how central negative equity is to the economic crisis.  Homeowners with negative equity have a reduced incentive to stay in their home if the mortgage is burdensome.  Negative equity fuels foreclosures, which in turn force down housing prices, setting off a downward spiral. Feldstein is right to focus on negative equity as a key issue for housing market stabilization. The problem is in his solution--it is based on a few erroneous factual premises, all of which could have been discovered with very limited Google searches. 

A Business Model that Encourages Irresponsible Lending

Friday's Detroit Free Press and today's San Diego Union-Tribune feature an op-ed I authored about the Treasury Department getting into the credit card business.  I argue that interchange and billing tricks and traps are integral parts of a business model that encourages reckless lending and irresponsible borrowing, which is why Treasury is having to step in in the first place.  If we're going to bailout the card industry, we should make sure that the business model changes so we don't end up here again.