Credit Slips

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.

AP Launches the Economic Stress Index

The Associated Press has launched the Economic Stress Index. Credit Slips readers will find it very useful and interesting. For a dataphile like myself, it's just plain cool. OK, it's not cool at all because it shows the tremendous depth and breadth of middle America's suffering. But, it shows what someone with real data know-how and computer graphic skills can do.

The Economic Stress Index "weighs three economic variables -- unemployment, foreclosures and bankruptcy -- to produce a score on a scale of 0-100 that measures how the recession is affecting a county compared to all others." You can scroll over each county and get a separate measure for each of the components or for the composite Economic Stress Index. The press release indicates the index and data will be updated monthly. Check it out.

Does Anybody Know If Credit or Foreclosure Counseling Helps?

The infusion of millions of dollars to pay "counselors" to forestall foreclosures on behalf of consumers who are delinquent on their mortgage payments seems as American as apple pie and should perhaps help some homeowners. These dollars are split among neighborhood non profits, specialized housing counseling organizations and a considerable amount has flowed to providers that have historically spent most of their time counseling consumers with credit card delinquencies. A group of United Way supported family and children service agencies also receive some of these funds.

Anecdotal reports indicate that the housing counselors are a cut above the historic credit card counselors. The credit card counseling industry agencies were mostly begun by creditors and their funding has always been supported by payments from creditors. The housing counseling organizations began with funds from HUD and the Ford Foundation and the extensive new dollars have come from the Federal government through a central organization called Neighbor Works. The neighborhood organizations obtain their funding all over the lot. The cultures of the various organizations differ a good deal among themselves and between the various types of providers.

Mortgage Modification Vote in Senate

Credit Slips has featured a lot of articles about a legislative proposal to give bankruptcy judges the power to modify home mortgages in chapter 13 (here, here, here, here, and here for a just a few examples). Heck, we were blogging about back this idea back in 2007. In March, the House passed H.R. 1106, the Helping Families Save Their Homes Act of 2009, which would enact this proposal into law. Since then, it has faced an uncertain future in the Senate. Yesterday, CongressDaily reported that Senate Majority Leader Harry Reid will bring the mortgage modification proposal for a floor vote in the Senate. Although this might seem like good news for supporters of the legislation, close observers of the political scene seem to be predicting defeat. Two Democratic Senators (Ben Nelson of Nebraska and Jon Tester of Montana) and Republican Senator Bob Corker of Tennessee are quoted in the CongressDaily article as being against the legislation, with Corker going so far as to say "Cram-down is dead."

If you support the legislation, however, now would be a good time to tell that to your senators -- or, in the case of Minnesota, senator. It's not over until the fat lady lets the horses out of the barn.

Mortgage Symposium at Pepperdine

On Friday, Pepperdine University School of Law is hosting a symposium entitled, "Bringing Down the Curtain on the Current Mortgage Crisis and Preventing a Return Engagement." As the announcement notes, the Pepperdine Law Review is bringing top scholars and Bob Lawless to campus. OK, it doesn't actually say that explicitly, but I've always wanted such an announcement to say something like that. Besides myself, the speakers include Ann Burkhart, Rick Caruso, Deborah Dakin, Wilson Freyermuth, Sam Gerdano, Melissa Jacoby, Alex M. Johnson, Jr., Timothy Mayopoulos, Grant Nelson, Mark Scarberry, and Dale Whitman. Truly trivial question: which four were once colleagues at the University of Missouri School of Law?

The papers will be published in the Pepperdine Law Review. My contribution has been co-authored by my research assistant extraordinaire, Jeff Paulsen. Before he goes off for a two-year clerkship with Judge Jack Schmetterer in the bankruptcy court in Chicago, I wanted to take advantage of his talent work with Jeff on a scholarly piece. We have a working title of "The Missing History of Bankruptcy Mortgage Modification." The short version is that the current rule against modifying mortgages in bankruptcy is not the considered policy choice as it is often portrayed. Rather, like many things, the history is much messier, and path dependence explains a lot of it. When we have a version for SSRN, I'll post a more detailed summary.

How to Start to Get Trillions in Lost Wealth Back

The fact that wealth is rapidly declining deserves public policy attention. Wealth serves critical functions in the U.S. economy that relies heavily on individual initiative. It is primarily an insurance against a range of economic risks. The more such insurance exists for the typical family, the less a family has to worry about their basic necessities and the more they can focus on longer-term economic growth. A family that has the basics covered can take more chances by sending their kids to college and letting them choose a degree that suits their abilities. Also, family members can more easily switch jobs to match their particular skills. And, a family with enough wealth is in a better position to let their creative side take hold and start a business. The entire economy wins from letting people gain more skills and apply those skills most effectively in their job or by starting a business.

Recommending what the government should and should not do about rebuilding family wealth has become as ubiquitous as real estate ads in the mid-2000s and dot-com IPO discussions in the late 1990s. Here are just a few principles that will likely guide the reform debate.

Our House in the Middle of Our Street is no Longer Our House

Here’s a news flash: The housing market is bad. Actually, it is really bad, historically, woefully bad. And, the bad news won’t stop coming. Housing wealth is dropping precipitously, families own ever smaller shares of their own homes, and home owners are falling behind in their mortgages in record numbers.

According to data from the Federal Reserve, housing wealth has taken a nose dive for two years. In December 2006, housing values reached a peak of $18.9 trillion (in 2008 dollars). By December 2008, they had fallen by $3.9 trillion to $15.1 trillion.

This reflects a historically fast depreciation of housing wealth. Over the past two years, real housing wealth dropped by 20.5%, a record for any two-year period since 1952. In fact, before this crisis occurred, there had never been a two-year period when real housing value fell by more than six percent. 

Great New Reading on Mortgage Modification

It's not all just fun and games with old credit cards at Katie Porter's house!  She and a couple of co-authors have a great new paper on SSRN describing the history of the anti-modification provision for principal residence mortgages, an empirical study of home mortgage burdens in Chapter 13 plans, and some comments on how reasonable forced modifications of those burdens could save not only these folks' homes, but Chapter 13 in general.  This had not occurred to me (I admit), but the 66% failure rate for Chapter 13 plans must be in large part explained by the burden of bloated mortgage obligations. Katie's paper more or less confirms this suspicion empirically. Reducing that burden to a reasonable level would therefore not only help people to stay in their homes, but it could result in a much higher plan-completion rate in Chapter 13 generally. This would be a great double-whammy. The paper deserves a close look by anyone interested in this hot topic. 

In other related news, another CreditSlips blogger has released a particularly high-profile paper on the subject of addressing mortgage foreclosure woes. Elizabeth Warren heads the Congressional Oversight Panel looking into foreclosure mitigation practices, and the panel released its report last Friday. I can only assume the report was authored in large part by Elizabeth--it has the tell-tale signs of her incredibly lucid and incisive writing style, backed up by a wealth of empirical knowledge about how struggling with mortgages and other debts really looks in practice. Check it out!

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.  

Bankruptcy Mortgage Modification Getting More Attention

You know the steam is starting to pick up for the horses to close the barn door before the barn burns done while we're counting our chickens when .... let me try that again.

Bankruptcy mortgage modification is moving beyond the specialty blogs such as this. David Abromowitz over at The Huffington Post has a post up advocating passage of a bankruptcy mortgage modification bill. I'm hoping the fact that the bill is getting broader attention means the train is about to sail.

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.]

A Note on Notes

When you're in court, you have to provide evidence of your case. When you're a creditor, that proof includes the fact the debtor owes the money due and should include the contract (the "note" in legalese) that the debtor signed. Bankruptcy specialists have been following this issue for a while now, and it has made its way into the New York Times today in Gretchen Morgenson's column. I recommend it as a read. And, congrats to Judge Sam Bufford and attorney R. Glen Ayers for their mention in the column. It's not often that a paper prepared for a professional meeting ends up in the New York Times, but they accomplished just that with a paper on the somewhat arcane rules that govern proof in such matters.

H/T to reader Mike Dillon for bringing the article to my attentiion.

Responding to Schwartz on Mortgage Modification

Professor Alan Schwartz of Yale University has an op-ed in today's New York Times arguing against the proposals to give bankruptcy judges the power to modify home mortgages. For our readers who do not know him, Professor Schwartz is a respected academic and bankruptcy expert, but with all due respect, I think he just gets this wrong. He makes three principal points, but none of them are a good reason not to move forward with this much-needed legislation.

First, Schwartz says that the proposal would swamp the bankruptcy courts and the nation's 300 bankruptcy judges. That seems empirically dubious given that my forecast of 1.4 million filings this year is below the number of filings in 2002 - 2004, when the annual filing rate was around 1.6 million filings and we had about the same number of bankruptcy judges. Even if the mortgage modification bill resulted in hundreds of thousands of extra filings in the short term, we still would be below the 2 million bankruptcy cases in 2005 when filings surged ahead of the draconian new bankruptcy law. The bankruptcy system survived those filing levels and should handle any increases that would come from mortgage modification.

Waiting for H.R. 1106 (a.k.a. H.R. 200/S. 61)

The comment thread from the previous post raises an important point that deserves treatment in its own post: what's the deal with the House version of the mortgage lien stripping bill (H.R. 1106), a vote on which has been postponed due to fears from pushback from "Blue Dog" and "new" Democrats.

First, my two cents: I believe (1) limiting application of this relief to property "that is the subject of a notice that a foreclosure may be commenced" is foolishly short-sighted and a significant restriction that has not gotten much press, but (2) relieving these folks of the idiocy of pre-filing credit counseling is to be roundly praised (perhaps we can be rid of this requirement for all filers in the not-too-distant future, as Sweden did in its 2007 reform of consumer bankruptcy law), (3) the balance of interests is impressive and eminently fair, allowing for reasonable modification of interest rates, extension of repayment term, and a reasonable strip-down of the secured claim, but also allowing for recapture of a declining portion of that loss if values rebound and the home is sold for a profit within 5 years. The big question will be valuation, and I fully expect the banks to push back hard on that question in any future case, probably irrationally, as I've complained elsewhere. As usual in bankruptcy discussions, people just don't get that this law doesn't create losses, it forces banks to acknowledge already existing losses, which is an important prerequisite to getting us out of this financial crisis. Banks' arguments that this law will reduce lending are subject to only two appropriate responses, in my view: if banks reduce lending in response to this law, that would indicate either (1) yet more irrational mismanagement by banks, which makes me feel like nationalization of the home mortgage industry is a more attractive option, along the lines of the full nationalization of the student lending industry in President Obama's budget proposal, or (2) a proper reevaluation of the risk of lending to uncreditworthy borrowers--forcing the banks to engage in the sort of responsible risk management that was needed all along. Heads we win, tails we win. The only losers here are irresponsible banks, who deserve to lose given their mismanagement, and they should no longer be allowed to externalize the negative consequences of their mistakes onto debtors, their families and communities, and society at large. Internalizing negative externalities from irrational creditor action is the primary reason why country after country in Europe adopted consumer bankruptcy systems in the 1980s and 1990s, as I'm writing in an article on the Danish system now.

Second, though I hope and expect this bill will pass next week, the "Blue Dog" Democrats appear to have fallen prey to the Jedi mind tricks of the lending industry lobbying juggernaut. This reminds me of a portion of the late 1980s Eddie Murphy Raw monologue, in which Eddie recounts an exchange with Mr. T. Eddie explains that he had been making fun of Mr. T in an earlier monologue and was accosted by Mr. T when Mr. T found out about this: "I heard you been saying @#$% about me," Mr. T accused. Eddie explains in Raw that, fearing reprisal from impressively scary Mr. T, he decided to use his "Jedi mind trick": he responded calmly, "It wasn't me." When Mr. T retorted that he had heard Eddie saying these things about him, Eddie simply repeated, "It wasn't me." Finally, Mr. T conceded, "Well, well . . . I guess it wasn't you. I pity the fool who's been telling me them lies!" The Bankers Association apparently saw Raw and has effectively applied Murphy's Jedi mind trick on the Blue Dog Democrats (no offense is intended to Mr. T through my comparison between him the weak-minded Blue Dogs).

Comments are wide open--what do you think about H.R. 1106?

Mortgage Database

The National Mortgage Data Repository is making its data available to a select group of applicants to conduct mortgage resarch. The Repository is a joint project of the National Consumer Law Center and the University of Connecticut School of Lawand includes data from 750 loans made in 10-15 states between 1994 and 2007. While the database isn't as comprehensive as HMDA or Loan Performance, it has a unique collection of data and the data are free. For each loan, the researchers have gathered the loan application, the truth in lending disclosure, the good faith estimate, the HUD-1 Settlement Statement, and the loan note. These are the core documents in a mortgage origination, making this a great dataset to study the costs of mortgage credit and underwriting decisions.

Research proposals of 2 single-spaced pages are due by March 31, 2009. Submissions are welcome not only from academics but also from advocates, attorneys, and other professionals interested in mortgage issues. (Having teamed up with guest blogger Tara Twomey for our Mortgage Studyof bankruptcy and homeownership, I encourage my scholarly colleagues to consider the many virtues of collaborating on research with attorney/practitioners). Authors whose projects are selected will present their work at a symposium in Spring 2010 at Valparaiso University School of Law. The full call for papers is here: Download Investigating Lender Practices in the Subprime Mortgage Market . Thanks to former guest blogger Pat McCoy for sharing this opportunity with Credit Slips.

Some Good News for Homeowners

JPMorgan Chase and Citigroup have announced a weeks-long moratorium on foreclosures while they await the release of the Obama administration's forthcoming plan to deal with the issue. J.P. Morgan said its moratorium will apply to loans it owns and services, while Citi is including its own loans as well as those on which it has reached agreements with the relevant investors. For both banks, this is an expansion on similar past efforts. It remains to be seen exactly how many troubled home loans this will cover.

What a Surprise, the Ability to Pay Matters on Mortgage Modifications, Too.

Last week the Center for Responsible Lending posted a foreclosure ticker on its web site that counts projected new foreclosure filings as they occur: a new one every 13 seconds in 2009.  That puts it at nearly 276,000 as I write this post.  (You can check out your state’s share on the map.)

Cool as technology is, the figures are as depressing as the slow pace of response to the crisis is puzzling. In a December guest blog,  Tara Twomey lifted the veil on the OCC’s report of disappointing re-default rates on modification.  Professor Alan White’s analysis of remittance reports from loan servicers found that only 35% of modifications reduced the homeowner’s monthly payment, while 20% stayed the same.  The largest share-- 45%--actually increased payments.

Yesterday, Fitch Ratings released a report that says (you heard it here first) "the key to a successful loan modification program is that the modification is sustainable." The modifications with 10-20% increases in principal and interest (P&I) payments had a 49% re-default rate within 6 months, more than double the re-default rate for modifications to a 20% or greater reduction in P&I payment (21%). Imagine that!

The Fitch report notes that payment reduction, at least so far, has a more direct impact on re-default than principal reduction. (They also, though, believe principal reductions that give homeowners equity are also likely to improve sustainability.) Fitch projects a high rate of re-defaults unless servicers start focusing more on – (ahem) – long-term ability to pay.

Seems that we’ve come full circle: Hey, guys, maybe you should think about whether people can make the payments when you originate the loan. Hey, guys, maybe you should think about whether they can make the payments when you try to fix the loan.

Should it really be this hard?

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. 

The Good, the Bad and the Ugly of Mortgage Servicing and Implications for Mortgage Modification

It looks as if the mortgage cramdown--er, modification--legislation will be sitting around for a while, at least until the stimulus package gets through Congress. So it seems worth talking about its reference to making "payments of such modified loan directly to the holder of the claim" instead of through the Chapter 13 trustee. Although this language was still in the manager’s version of the bill (H.R. 200) as of last week, apparently discussions continue in Washington about whether this is the best policy approach.

A big reason for needing trustees in the picture is to keep track of mortgage payments, because servicers make a lot of errors. There are apparently new servicing companies that are trying to avoid the problems that have been rampant in the industry in the past—dare we hope that some good servicers are coming on line? But no doubt there are still many of the bad (careless) and the ugly (those who are deliberately charging unreasonable or illegal fees during bankruptcy). I'd be interested to hear whether anyone is seeing improvement in this industry since the new focus on its shortcomings.

As a policy matter, the argument for payment of mortgage obligations through the Chapter 13 trustee, rather than directly, is that this approach likely makes it easier for debtors to complete their plans and keep their homes without an expensive fight at the end about whether they are up to date on payments. Putting Chapter 13 trustees in charge of disbursements gives debtors the benefit of their superior record-keeping ability and understanding and their leverage with servicers because of their continuing relationships. While lawyers in areas that have not had a practice of conduit payment of regular mortgage amounts through the trustee often oppose that approach on the assumption that trustee fees will make plans infeasible, the evidence seems to be that conduit payments result in the percentage fee going down. Most trustees already top out on the compensation they are allowed by law. Lower percentage fees in conduit trusteeships may mean that most debtors do not have a problem with feasibility, although unsecured creditors may get paid less. There may be some debtors at the margin who won’t be able to afford a plan if they have to pay trustee fees, but courts could make exceptions in such cases on feasibility grounds (feasibility can cut in different directions depending on the case).

What's in a word (or 2?) Cramdown

Last Sunday's New York Times Magazine's feature, On Language, discussed the etymology and signification of the word "cramdown." (Or is it "cram down?" That's a separate debate that professors have with law review editors every year).

William Safire observes that cramdown is coming into popular parlance as bankruptcy becomes an everday topic and the debate continues about the mortgage modification legislation. Credit Slips guestblogger, the Honorable Eugene Wedoff, found a use of the term in a 1948 law review article and a 1944 judicial opinion. The term has a general use as a verb to indicate forcing unwanted treatment on creditors. In today's bankruptcy context, the term refers to at least two specific types of such treatment: 1) reducing a creditor's secured claim to the value of the collateral and 2) confirming a chapter 11 plan over the objection of a class of dissenting creditors. Law students often become confused when their professors use the terms in these two different contexts. I try to use cramdown only to mean the chapter 11 voting override provision and instead speak of "lien stripping" to refer to the writedown of a secured claim under section 506 of the Bankruptcy Code. (Of course, lien stripping is a misnomer, since the the lien remains on the collateral and should not be confused with lien avoidance. What is being "stripped" in part is the value of the claim.)

Safire suggests that the ugly connotations of the word cramdown may be hindering legislative efforts to pass mortgage modification. Senator Durbin's spokesman said that the appropriate term to describe his proposed legislation is "judicial modification." While not as colorful as cramdown, it has the virtue of reminding people that a write down in principal is NOT the only feature, and may not even be the most beneficial or widely used feature, of the legislation. Depending on property values where you live, when you bought your house, the type of loan, and future interest rates, debtors may find reductions in interest rate or reamortizations of their loans to be more helpful in reducing their monthly payments and avoiding foreclosure. Using cramdown as shorthand to describe the bill gives short shrift to its potential benefits when all the term may invoke for many people is the specific ability to reduce a mortgage to the value of a house.

Mortgage Cramdown--Layering On Complexity

Chapter 13 is already too complicated, and cramdown legislation will make it more so and lead to a new round of litigation and expense that will stand in the way of keeping people in their homes. By all means, Congress should enact mortgage cramdown, but it should take up bankruptcy simplification immediately after that if it really wants people to hold on to their homes in chapter 13.

Katie Porter has already noted the problem of high noncompletion rates in chapter 13 as a reason for suspecting that mortgage cramdown will not “save” many homes. See Cramdown Controversy #2--Will I "Succeed?" The problem is that the impact of the pending cramdown legislation could be small given the messy state of bankruptcy law since the 2005 changes.

The 2005 law has substantially increased the expense of bankruptcy, deterring and delaying its use among the worst off. The chapter 13 filing fee has gone up to $274.  “No look” attorneys’ fees of at least $3,000 are the norm in chapter 13 (see http://www.gao.gov/new.items/d08697.pdf at 25-26), and this is a bargain price considering what lawyers are expected to do under the new law.

Mortgage cramdown will add the difficulty of a valuation hearing, with experts engaging in a swearing contest about the value of a home for which, in many cases, there currently is no market. Cars have various “book” values that can be used to set default measures of value in bankruptcy, but there is no similar simple approach to valuing homes to save on litigation costs.

The bills add a lot of complexity of various sorts. S. 61 and H.R. 200 both would layer on a ridiculous, unnecessary third "good faith" test in chapter 13. The debtor already must file in good faith and propose a plan in good faith, yet the bill’s drafters felt compelled to add an additional requirement that the modification be in good faith. This would stoke litigation over whether it is bad faith to pay the value of the home if the debtor could "afford" more ("afford" always being a malleable concept), with an open question about what other expenses should be taken into account when deciding what the debtor has available to pay for an underwater home.

It would be much better for Congress to explicitly state what it wants—for example, whether just paying the home’s value is fine, with excess disposable income (if any) going to other secured debts (such as cars) and then unsecured debts.  Furthermore, it would be a good idea for Congress to state that if home and car payments use up all the available income over regular expenses, it is not “bad faith” to pay zero to unsecured creditors.  Congress should be heading off the inevitable arguments that just paying for collateral in chapter 13 is not good faith.  If chapter 13 is going to be a mechanism to save homes from foreclosure, many debtors will have nothing left to pay old unsecured debts.  Unfortunately, some judges and trustees have used a good faith test to push for rule-of-thumb amounts of unsecured debt repayment in chapter 13 whether or not that is feasible, contributing to a high noncompletion rate (historically, about two-thirds of chapter 13 cases).

I agree with Katie Porter that the provision in the bills for direct payments by debtors to claim holders is a mistake.  It is unclear whether this would always be required, or whether this language just gives courts discretion to allow direct payment.  In most cases, Chapter 13 trustees are needed to make sure that payments actually get credited appropriately to debtors’ accounts.  If the problem is feasibility of plans due to paying trustee fees on mortgage amounts, Congress could provide for a lower trustee fee on those payments. Without the trustees involved in record-keeping, debtors will face huge cost and difficulty at case closing to try to show that they really are current on their mortgages.  Most trustees now make it a default practice that mortgage payments be made through them, and this has saved on trouble for debtors, trustees and judges.    

Another aspect of the bills that is troublesome is that the debtor must have already received a notice of foreclosure in order to cramdown.  This prevents debtors from taking charge of a hopeless situation and getting it resolved; they would have to wait for the lender to send a foreclosure notice before they could make use of chapter 13 to modify their mortgages.

The elimination of credit counseling for debtors who have received a notice of foreclosure is a step in the right direction, but if Congress paid attention to GAO reports, it would repeal the credit counseling requirement entirely. http://www.gao.gov/new.items/d07778t.pdf   It represents a cost in money ($50 per debtor) and inconvenience way in excess of very minimal benefit.

Mortgage cramdown would also add to the complexity of other issues currently making their way through the appellate system, particularly issues concerning means testing and treatment of car loans.  (For more discussion of these issues, see my recent paper, A Guide to Interpretation of the 2005 Bankruptcy Law at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1307250.)

Means testing allows above-median-income debtors in either chapter 7 or chapter 13 to include their secured debt obligations as part of their expenses, yet with cramdown on a home possible, the debtor might not have to pay the full secured debt in chapter 13.  This will lead to a new round of litigation over additional layers of means testing, whether under the “good faith” or “totality of the circumstances” tests in chapter 7 or the “projected disposable income” or various “good faith” tests in chapter 13 when the debtor might be able to cramdown.

And then there will be the ironies of allowing cramdown on underwater home mortgages while perhaps not allowing cramdown on seriously underwater car loans, particularly the most risky subprime ones.  If the car lender rolled in a big wad of debt from the last car (known as “negative equity”), making the debt severely undersecured from the outset, it doesn’t make a lot of sense to treat that debt as fully secured under the “hanging paragraph” while cramming down a similarly undersecured home loan.  I am among those who think it is ridiculous—both as a matter of law (see http://www.nacba.org/s/45_50fc1f2acc4e329/files/PeasleeSupportBrief.pdf) and policy—to treat paying off your last car as part of the purchase money for your next one. As a policy matter, this is very risky credit, and it does not deserve preferred status (disallowing cramdown).

All this is to suggest that we desperately need a fresh start for bankruptcy reform, and layering mortgage cramdown on the 2005 mess will just make this more apparent.  The complexity of the law stands in the way of its use at an affordable price and makes it hard to mobilize the bankruptcy system for this crisis.

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. 

Cramdown Controversy #2--Will I "Succeed?"

Our active readers at Credit Slips already started debating the second controversy about the pending cramdown legislation: is the failure rate of chapter 13 too high to make mortgage modification in bankruptcy a very useful tool? To briefly reprise that discussion and add my own gloss, there are longstanding lamentations that chapter 13 is a poor system because a minority of debtors completes the repayment plan and receives a discharge. The academic studies suggest the number is about 33%; I believe the National Association of Chapter Thirteen Trustees thinks it is about 40% (one wonders why the US Trustee Program doesn't carefully track this and publish it?)

So lots of chapter 13s fail. But what conclusion should we draw from that fact? This is a broad question and one that I'm exploring in a new empirical research project. I do not believe that chapter 13s "fail" just because they do not reach discharge. For now, let me narrow that concern to whether cramdown legislation is sound policy.  A  couple of observations:

1. The failure rate for chapter 13 may be, at least to some unknown degree, a result of housing affordability problems. Tara Twomey, John Eggum, and I have a forthcoming paper showing that over 70% of chapter 13 homeowners in our 2006 sample spent more than 1/3 of their incomes on mortgage payments, the HUD benchmark for unaffordable housing. If cramdown lets debtors reduce their mortgage payments, it may permit more debtors to confirm plans and give debtors needed flexibility in adjusting their budgets to the normal ups and downs of life. Put another way, the low chapter 13 completion rate may be an effect of the inability under current law to modify mortgages, which is all the more reason to permit such modification.
2.  Lots of people are going to have upheavals in their lives just because that is life. As one of our Credit Slips commentators said: "Chapter 13 cases fail primarily because '_____  happens' in the 3-5 year term of the plan. Debtors live and die; they change jobs; they lose jobs; they move; they buy and sell homes; they get married; they get divorced; they have kids; they lose kids; they get sick; etc. -- all of which impact their financial circumstances." These circumstances would occur and be problematic regardless of how we structured the mortgage relief--that is, they would hamper non-bk court modifications too.
3. One benefit of modifying mortgages in bankruptcy is the potential to actually monitor what happens. IF the Administrative Office of the US Courts and the US Trustee Program release the needed data, scholars and advocates can track these cases. How many debtors are seeking modifications? What kinds of terms are courts granting? How are these debtors faring? Such data has been scarce of non-existent for the voluntary modification programs. What data do exist, such as those that Alan White examines, seem to me to indicate that a very high fraction of modifications are doomed to failure.

Cramdown Controversy #1--Who Do I Pay?

The pending legislation to permit courts to modify home mortgages is stirring up some controversies--even among its advocates. The key issues are operational and very important, I think, to the success of this legislation. Here's the first brewing controversy: How will consumers make the payments on these modified mortgages (directly to the mortgage servicers or through the chapter 13 trustee?) 

The pending legislation contains language that would require the payments on mortgages modified in bankruptcy to be made "directly to the holder of the claim." In more than 2/3 of jurisdictions, chapter 13 trustees serve as conduits for at least many mortgage claims, meaning that the debtor pays the trustee the mortgage payment, along with their payment on their unsecured claims, and the trustee transmits the payment to the mortgage company. The legislation, apparently at the urging of some consumer advocates, would bar this practice. I think this is a bad approach for several reasons: Why change existing practices that are working well and add confusion? Some courts have local rules that require debtors to pay all claims through the trustee; the legislation would override such rules, which are growing in popularity becuase of problems with letting debtors make mortgage payments. Many debtors like the convenience of making only one payment--to the trustee--and letting the trustee disburse. It helps keep them on track financially and may improve completion of chapter 13 plans. Further, given the numerous and well-documented problems with mortgage servicers' ability to correctly apply payments in chapter 13 cases, why put the burden of sorting all those problems out on the debtor or debtor's counsel? If the trustee is the conduit for the payment, then the trustee can take steps to ensure the payments are applied properly and the debtor is being charged correctly. I suspect this stems from some concern that consumers shouldn't have to bear the added costs of paying a trustee. Many trustees, however, take only 5% commission instead of the usual 10% for the disbursement on mortgages, and if Congress is concerned about this, they could amend section 586 to provide for a lower trustee fee for mortgages. Also, consumers who pay the trustee are getting services; the trustee is the one who must wait on hold with the mortgage servicer, try to reconcile the accounting, deal with RESPA and escrow issues, etc. I think it is fair to pay trustees for that work. I think debtors should have the option of making payments on a modified mortgage either directly to the mortgage company or through the trustee, as is currently the practice.

Cramdown Commentary

Bob scooped me on an initial post about the deal between Citigroup and Senate Democrats on pending legislation to permit bankruptcy judges to modify mortgages in bankruptcy. But I have details. And commentary. And questions.

First, the letters from Citibank to the House and Senate outlining the changes that they request be made to the legislation are available in the middle of this WSJ article. They requested three changes to S.66 or H.R. 200 (both denominated the Helping Families Save Their Homes in Bankruptcy Act of 2009). First, that the legislation be limited to loans in existence when the legislation is enacted. This gives the bill a sunset, of sorts, but it could be a long one, given some people have 30 or 40 years left on their loans. Second, only when a violation would give rise to a right of recission under the Truth in Lending Act can the claim be disallowed. Given the relative difficulty and cost of litigating such claims, this is not, in my opinion, a large concession. Consumers retain their rights under the Truth in Lending Act to bring a claim under its provisions and recovery (puny) statutory damages. Third, a reduction in a loan's principal balance is only available if the homeowner certifies they contacted the lender to modify the loan before bankruptcy. Note that the "reduction in principal" is only ONE of the options available to bankruptcy courts. Apparently, the court could freeze or adjust interest rates or extend the term of a loan even if a borrower had not contacted the lender. The only problem I see here is if lenders begin litigating whether the borrower has indeed contacted the lender. Borrowers who did so by phone won't have great records of having done so. I would advise borrowers who call to also send a written letter and keep a copy asking for a modification.

Apparently, the news of the Citi's support for the legislation traveled fast and yesterday at chapter 13 confirmation hearings around the country, debtors asked to have their hearings continued to see if the legislation passed. I also wonder what are the options for homeowners who filed chapter 13 a few years or months ago and were not able to modify their home mortgages. Can they ask the court to modify their plan if the legislation passes?

Chapter 13 Cramdown Bill

The Wall Street Journal is reporting that Citigroup is negotiating over the terms of a bill to give bankruptcy judges the power to adjust home mortgages in chapter 13. The article further reports that the National Association of Home Builders has dropped its opposition to the bill, although Citigroup says it still has not made a decision on what its final position will be. Credit industry opposition is the primary obstacle to passage of this legislation. If this opposition evaporates, the bill almost certainly will become law given its support among congressional leaders and the incoming Obama Administration. For background on how the law would work, see here.

UPDATE: Just as soon as I posted this, the news broke that a deal had been reached. This is a welcome development. Of course, the devil is in the details. If anyone has a link to the text of the legislation that would result from the deal, please post in the comments.

Loan Modification Quality Matters

Yesterday new foreclosure and loss mitigation data was released by HOPE NOW in its "Loss Mitigation National Data July 07 to November 08" and by the OCC/OTS in their "Mortgage Metrics Report."  Combined the reports show a steadily increasing number of loan modifications and a slight decrease in foreclosures.  That's the good news.  The bad news is a large number of loans that have been modified are redefaulting.  The OCC/OTS report shows 37% of loans were 60 or more days delinquent after six months.  Here's an example to put this in real numbers.  The HOPE NOW report shows nearly 870,000 loan modification in 2008.  Using the 37% redefault rate means that  just over 317,000 borrowers will enter the foreclosure pipeline again within 6 months.  

The reasons that borrowers are falling back into default is the source of much debate.  Industry representatives claim that every modification is affordable when it is made and borrowers redefault because their circumstances change.  Consumer advocates argue that servicers are not creating long-term, affordable loan modifications.

Whose side does the data support?

Poor Servicing Paves the Path for Predators

Thanks to Credit Slips for having me back. I wanted to start the week talking about how poor mortgage servicing is paving the path for a new breed of predators and how little is being done to address the situation.

Homeowners facing foreclosure have always been vulnerable to scammers, con-artists, and thieves. As soon as an impending foreclosure becomes public information, homeowners are bombarded with post cards, telephone calls and even door-to-door solicitations from would be saviors.

When property values were appreciating rapidly, foreclosure rescue scams primarily focused on obtaining title to the home and robbing homeowners of their equity. Today with property prices depreciating and many homes already “underwater,” equity is no longer the game. Instead, rescuers have become high-volume, “loan modification specialists.” A recent editorial in the New York Times (here) and an article from BusinessWeek (here) describe this business that is now booming across the country. The gist of the business model is that for a fee, which can reach several thousand dollars, these specialists will attempt to obtain a loan modification for the borrower.

But why are homeowners giving their precious dollars to loan modification specialists when they should be able to obtain the same results for no charge?

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.  

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. 

Creditors: Fear Not?

Just as public ire at the mortgage industry reaches a pinnacle, courts have offered the mortgage companies refuge from their mistreatment of consumers in some recent rulings. While these decisions may be aberrations, they have powerful lessons for consumer debtors and their attorneys that bear some discussion.

A bankruptcy court ruled last week that the United States Trustee (UST) lacked the authority to bring a complaint against Countrywide for abusive mortgage servicing practices. (Hat tip to Amir Efrati at the Wall Street Journal for bringing the ruling to my attention.)The In re Sanchez court concludes that the UST failed to state a claim for sanctions because the UST is not authorized to pursue sanctions. I disagree.

It's Still the Economy

You can't be serious! Federal Reserve chairman Ben Bernanke says what anybody with a passing interest in economics already knows -- that it will take time for the economy to turn the corner -- and the market tanks. The market seemed punch drunk on the massive stabilization packages -- $2.5 trillion and counting -- that the industrialized world was showering on failing financial institutions. A mere 36 hours later, though, Wall Street realized that it cannot regain its strength without a healthy Main Street. It was a weakening labor market, following a bursting housing bubble, that contributed to the massive foreclosure wave and to the crisis. No amount of tinkering with the stabilization package will detract from the fact that people and businesses need more income, not loans, to pay their bills and to invest in their future. It should be clear by now to everybody, even extremely myopic financial markets, that the next policy step lies in helping U.S. businesses and families back on their feet through a well designed second economic stimulus.

Regulation Cannot Depend on Irrational Markets

At this point, it is all too clear that financial markets can get things wrong. This is not an isolated phenomenon. No, getting it wrong tends to be the name of the game for financial markets. Understanding that financial markets regularly underestimate or overestimate the risks of investing is crucial to the proper design of financial market regulations.

Wealth Destruction by the Numbers

Financial markets went into free fall in late September and early October. The third quarter of 2008 continued the wealth destruction that took place in the previous nine months. This wealth decline is large, broad, and quick.

The primary reason for wealth building is retirement. Many families nearing retirement, though, relied primarily on their homes for their retirement income. According to the Federal Reserve, only 62.9% of families between the ages of 55 and 64, had a retirement account, such as a 401(k) or IRA, in 2004. The typical holding in such accounts was $83,000 in 2004 dollars. In comparison, 79.1% of such families owned their own house with a total typical value of $200,000. In other words, policymakers need to take a comprehensive view at restoring family wealth in an effort to strengthen retirement income security. Much of the policy attention has been on protecting housing wealth. Policy responses, though, need to match the problem, specifically by fostering a pension renaissance and by vastly improving existing retirement savings plans in addition to protecting housing wealth.

How Long is the Way Out of the Hole?

The stock market just ended its worst week in history. This has sharply eroded families' financial security. Under rather optimistic expectations it would take about six years before families can hope to achieve the same level of financial security as they had at the end of 2007, before the latest round in the financial market crisis took shape.

LA Times: Illegal Immigrants Have Lower Mortgage Delinquency Rates

The LA Times ran an article earlier this week reporting that undocumented immigrants to the United States had generally lower rates of mortgage delinquencies than other types of borrowers. It is an informative read and should be of interest to Credit Slips readers. The article is here. Hat tip to Credit Slips guest blogger, David Yen, for alerting me to the story.

Who Needs Bankruptcy Reform?

When Eric Nguyen, a 3L at Harvard Law School, conducted his research on the disproportionate efforts of families with children to save their homes through bankruptcy, he seemed to be embarking early on a promising scholarly career. But events have made his research intensely relevant to national debates. In an op-ed in today's New York Times he reprises his central findings.  Eric endorses an amendment to the bankruptcy laws that would permit a bankruptcy judge to restructure home mortgages. 

Senator Dodd and Congressman Miller advanced this proposal early last spring, but the lobbyists from the American Mortgage Association fought them off.  Even as the bailout took shape, the banking lobbyists were still calling the shots to block bankruptcy amendments. Not surprisingly, mortgage holders prefer a government bailout over taking the write downs on their bad mortgages.  The McCain proposal offers just that: a payoff on bad mortgages at their full face value. The taxpayers--rather than the investors--would take all the losses. 

Eric's op-ed is timely--but time is running out.

More on the McCain Plan

Now it appears that the McCain plan is to pay 100% of the outstanding balance on distressed mortgages (and, presumably prepayment penalties if applicable). What isn't clear is whether the government refinancing will be for fair market value or at the old outstanding balance. If the later, it really won't help folks with negative equity.

If the McCain plan is going to buy mortgages at 100 cents on the dollar and then replace them with, say, 80 cents on the dollar mortgages, there's good news and bad.

Underwater Homeowners

1 out of every 6 US homeowners is underwater. There's probably no better indicator than being underwater of a mortgagor who is likely to end up in foreclosure. That's very worrisome. And it means that foreclosure prevention plans that don't address the problem of underwater homeowners aren't going to help a lot.

Why the McCain Mortgage Refinancing Plan Won't Fly

Last night John McCain presented a "new" plan to deal with the financial crisis. Unlike the bailout rescue bill, it is a bottom-up plan, not a top-down plan, meaning that it focuses on helping homeowners, not financial institutions.

It's commendable that now in October 2008, over a year into this foreclosure crisis, John McCain has recognized that homeowners need some help and is proposing to do something for them. The trouble is that his proposal won't help.

A Countrywide Settlement

Bank of America has agreed to settle a deceptive mortgage practices lawsuit on behalf of its relatively new subsidiary, Countrywide Financial, the notoriously aggressive mortgage lender.  The attorneys general of Illinois and California negotiated the settlement on behalf of their states and at least nine others. The settlement will cost BOA approximately $3.5 billion in California and $190 million in Illinois. The settlement funds will go towards reducing payments for Countrywide borrowers with subprime and/or adjustable-rate mortgages, waiving prepayment and late fees, paying damages to customers who have already lost their homes, and subsidizing the relocation of those who are now in foreclosure.

A BOA spokesperson said that the bank plans to introduce the program in December. Hopefully more details about who will qualify will be available soon.

Foreclosure Tragedy

An excruciatingly sad story about the human costs of the home-mortgage crisis:  http://www.cnn.com/2008/US/10/03/eviction.suicide.attempt/index.html. A 90-year-old woman, Addie Polk, shot herself inside her foreclosed, Akron, Ohio home. It appears that she will live, although she is still in the hospital. Representative Dennis Kucinich, a member of her state's congressional delegation, told her story on the House floor during today's bailout debate, saying, "This bill does nothing for the Addie Polks of the world." He voted against the bailout, which finally passed in the House this afternoon.

Homeowners in Bankruptcy

Katie Porter makes some excellent observations about the Carroll and Li study of homeowners in bankruptcy. There's another crucial point to add: the study's conclusions only tell us, at best, about bankruptcy today. It shouldn't be much of a surprise that bankruptcy doesn't have a huge impact on homeownership retention precisely because it is impossible to modify single-family principal residence mortgages in bankruptcy. The study is looking at a bankruptcy system with both hands tied behind its back. Given that bankruptcy already results in a 15% higher level of homeownership retention than foreclosure, one would expect a much greater impact if debtors could adjust their mortgages to make them affordable.

Consider--Credit Suisse has found that voluntary loan modifications that reduce monthly payments have an 83% success rate in the current market. Involuntary modifications could be even more significant than voluntary modifications. If bankruptcy modification were allowed and we saw a similar success rate in homeownership retention, that would be a big accomplishment indeed.

Thus, I think a fairer interpretation of the study's findings are that currently bankruptcy helps a bit with homeownership retention, even though it is working with the very modest tool set of the stay and a chance to de-accelerate and cure, and that with a broader tool set to modify mortgages, bankruptcy could make a big difference in homeownership retention.

What Happens to Homeowners in Bankruptcy?

Amending bankruptcy law to permit judges to modify home loans for chapter 13 debtors does not seem to be gaining traction in Congress, despite the fiasco with the bailout vote and pressure to incorporate more "Main Street" provisions. For many reasons, I remain convinced that any bailout should attempt to limit losses at the family-level, rather than addressing only the end consequences for major financial institutions. That said, does filing bankruptcy improve a family's chances of saving its home?

A new paper, The Homeownership Experience of Households in Bankruptcy, by economists Sarah Carroll and Wenli Li provides a tenative answer to this question. Before summarizing the findings, let me emphasize a few key points. The paper's sample comes from Delaware. Yup, that's it. That limits my confidence, and to their credit, the authors' confidence, about extrapolating these findings to the whole nation. Another difficulty is that the housing market has changed so rapidly that despite the authors' quick production of this study, the mortgages of today's families may look very different from those of families that filed bankruptcy in 2002. Keeping those qualifications in mind, what do Carroll & Li report on how many homeowners that file bankruptcy avoid foreclosure.

How State Government Can Help Financially Distressed Homeowners

Now that Congress has failed to act to stem the foreclosure crisis, it is up to states to try to protect their residents and economies. A few possibilities remain for state action, some of which states have either toyed with or started to do.

Congress to Homeowners: Drop Dead

A draft of the bailout plan is out. And it contains nothing substantive for financially distressed homeowners.

The plan directs the Treasury Department to engage in reasonable modifications for residential mortgage loans it controls and to encourage servicers to do so for loans it doesn't control. As I've explained in numerous posts (here and here, e.g.), Treasury is unlikely to end up controlling many distressed residential mortgage loans directly. And Treasury has been encouraging servicers to do loan modifications since last fall, but with very limited success. There is no reason to think that the bailout suddenly changes anything. In short, Congress enacted some show provisions about consumer relief, but nothing of substance. This is the same move Congress pulled when it enacted the HOPE for Homeowners Act in July. All sizzle, no steak.

Why The Government Cannot Modify Mortgages If It Purchases $700BN of MBS

I've written a short explanation of the why even if the Treasury buys $700BN of MBS it will be unable to modify the underlying mortgages. The explanation, which is more detailed than any of my previous postings on the subject, is available here.

At core it is a Trust Indenture Act problem, where the bonds cannot be modified absent a specified majority vote and consent of bondholders whose payment rights are affected. And here is no possibility of doing an exchange offer to get around it; there is simply no mechanism for an MBS trust to do an exchange offer. (For the classic discussion of Trust Indenture problems, see Mark Roe's article, The Voting Prohibition in Bond Workouts.) The solution of Trust Indenture Act problems with corporate bonds is...you guessed it, bankruptcy modification!