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

posted by Adam Levitin

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!


What about the servicer's power to agree to modifications in the best interest of the entire trust? If the Treasury is majority holder, and it can persuade the servicer to go along with a mod, are you so sure that won't work unless Treasury has 100%? Maybe I'm totally not getting this, but Alan White's comments seem to suggest that this is not an all-or-nothing proposition, at least in the specific context of MBS trusts. See his comment at http://pubcit.typepad.com/clpblog/2008/09/its-the-mortgag.html

Does Zingales proposal for a cram-down of the debt holders of the troubled financial institutions face similar problems? Is there a legislative solution?

Paulson just 5 min. ago answered a similar question in the house. "More or less" he said that the government could assert "leverage" to get the servicers to modify but was very general in his overall answer. Debtors would still be at the mercy of the servicers’ bureaucracy with no one to pick up the bill for the modification. Not to mention no one dictating the terms of the modification (by law or policy). Servicers don’t make anything to my knowledge for modifying the contract unless it is the debtors paying for it. Sometimes they roll it into the loan, most of the time they want the fees up front with no checks and balances on the reasonableness of the fees. You would kill a whole flock with one stone in Bankruptcy. Bankruptcy would be the least expensive and would be the shortest distance from point A to point B. Then the “paper” the government would now own would have a court ordered value (better than any ratings company) who screwed up royally BTW.

The problem for the U.S. Government will be the same one individuals in foreclosure face:

The servicers make far more money on loans that are in the twilight zone between default and foreclosure, than they do on a loan that is "brought current" through loss mitigation.

The servicers' incentives are to "stay in the zone" between a fix and foreclosure, collecting late fees, inspection fees, BPO fees, etc., etc., etc.

This is accomplished by making it exceptionally hard for mortgagors in trouble to find the right person to talk to, and if they do reach a loss mitigation department, putting people on hold, shuffling them back and forth, dropping calls, and generally making every five minute conversation take 5 hours. Most servicers have gotten really good at this.

But I'm sure as soon as our government applies to their public spiritedness, everything will work almost as good as HOPE unbiased studies say it does now.

I have seen this same figure in several news articles:

"The 700 billion dollars represents about 5 per cent of all outstanding mortgages in the country, the officials said."


If the bailout is 'only' going to have the U.S. government owning a maximum of 5% of the outstanding mortgages at any given time, what are the chances that the government will own 2/3s of any given tranche of mortgages?

By my math, the chances are greater than zero only in the same way that the chances of Elvis impersonating monkeys flying out of my butt are greater than zero.

Therefore, for financially distressed citizens to have any meaningful abilility to fight to keep their homes on reasonable terms, bankruptcy reform remains absolutely necessary.

And if Congress doesn't do it as part of the bailout, bankruptcy reform is going to die, and the folks losing their homes to foreclosure are going to absolutely nothing meaningful out of this $700 Billion boondoggle.


This is the hour of decision. We need to allow bankruptcy judges to make minor adjustments to mortgages in Chapter 13 bankruptcy cases. Period.

It keeps additional homes from adding the existing glut on the housing market, and works against the slide in housing values that has triggered the urge to 'just walk away'.

"Voluntary" programs haven't worked. And the government buying up 5% of existing mortgages certainly isn't going to do anything for the 95% of the Americans who still have to deal with the same totally unresponsive lenders they've always had to deal with.

The government can easily force mortgage modifications if it chooses. It would just do so using the mechanisms of legislation, not the mechanisms of being a shareholder.

If the government is willing to flush $700B of taxpayer money down the drain, they are certainly willing to violate "the sanctity of contracts".

So, a new law gets passed; "Any contract to the contrary notwithstanding, the Secretary of the Treasury may order the modification of any mortgage contained in a pool of which the government is a shareholder of more than one-tenth of one percent."


Bankruptcy modification is in fact the only viable option. The alternative suggested by Sammy, while possible in the abstract, is more draconian in its outcome, because it would affect tranches of debt not otherwise held by the U.S. At least I think that's right.

A change to the bankruptcy law has the positive outcome of assuring that changes would be made without the need for negotiation with whomever is tasked with administering (under contract with the Fed Gov't) the assets acquired by the gov't in the bailout. That actor may prove as unwilling (or more unwilling) to negotiate as was the lender, out of fear of jeopardizing the pool of assets acquired (and becoming liable to its principal for defalcation).

The bankruptcy fix puts the "write down" onto a judge whose valuation could be second-guessed. The resulting quick "mark to market" that results would be good for the system long-term, and would help to cut down on the number of foreclosures, which themselves depress property values.

Your article gives the following reasons:
"PSAs, however, cannot easily be modified. This is to preserve pass-thru tax
status for the trust in order to avoid double taxation; to preserve the bankruptcy remoteness of the
trust, so that the trust’s assets cannot be seized by creditors of the mortgage originator,and to
protect the MBS holders from liability for the trust’s actions."

However most of these do not apply to the government which is not a taxpayer; others like bankruptcy remoteness and liability exposure can be eliminated in the current legislation. Indeed the TIA itself could be modified by legislation.

The question is which legislative fix you want. I think your stance as an advocate of mortgage modification has led you to mis-perceive that the alternative is impossible (see the title of your piece - the government "can't" do something, whereas the reality is that all alternatives are just as possible as mortgage modification.

The issue I have with mortgage modification is that it equalizes the best lenders - the ones who kept the mortgages on their books, did not have to mark to market, etc. - with the securitization guys who now have to sell at a discount. That is just bad policy.

Couldn't Congress modify any of these trust laws if it chose to do so? Its not that it can't; its that it won't.

Congress should require as a condition for the extraordinary bank bailout another extraordinary measure, required modification of existing mortgage terms; among other possible provisions, (1) a convertable option for debtors owing on ARMs; (2) elimination of unfair subprime conditions; (3) limitation of mortgage amounts to the lesser of ability to pay and house value.

These would greatly reduce the default risk, without the expenditure of a single taxpayer dollar.

I'm not watching C-SPAN in anticipation of these measures being included, though. Listening to Congress asserting it cares about homeowners, and that others are primarily to blame for their problems, is like listening to a still-practicing drunk assert his sobriety. I know better.

Ben- its not that Congress can, sure they can; its when. They pass this now, but when do they get around to enacting those other provisions? The clock is ticking..... for some the clock is ticking faster than others. How can you stop the clock? Act of Congress or an "Automatic Stay". Which is faster?

Its very simple. Congress just declares a "temporary" moratorium on foreclosures, and then keeps extending it. I think this is highly likely to happen next year if Obama gets elected.

It can be done. In order to do it, congress needs to use its constitutional authority to repeal the Federal Reserve Charter. Congress can then put the entire system, including the American part of the $1 Quadrillion derivatives bubble into receivership (bankruptcy). Simultaneously, Congress can create a new currency to keep the economy running. It can then unwind, modify, or dispose of contractual agreements as in a bankruptcy court. This should be done in consultation with the G8 and other nations- many who will likely follow suit.


What are we Mexico? Our new one dollar bill will be the 10 dollar bill. White people from Europe will be (as they have been) coming here for cheap goods. I will then have to start sending my kids downtown to sell gum to tourists.

If these mortgages cannot be modified, then taxpayer dollars should not be buying the securities. Just let them fall. My guess is that the international buyers who were tricked into buying this junk packaged by Wall Street is demanding a full or respectable return, else they will boycott US banks and markets. Go after the Wall Street bankers and hedge fund managers who are behind this scam and start doing criminal investigations on not just the culprits on Wall Street but the Congressional legislators and members of the executive and judicial branches and governement regulatory agencies who sold out their own country for a buck to give these crooks whatever their lobbyists asked for. If the US government can't clean up this mess, then it's time to take it to the streets.

With $700,000,000,000 to spend, why spend it on MBSs or CMOs that don't confer much power to fix the terms?

Why not bypass the financial institutions, use legislative power to be able cut new mortgages with the homeowners and just pay off the existing mortgages with cash, so the prior mortgage disappears.

A quick calculation suggests that 2.8 million homes at $250k each could be refinanced this way. That should cut into the problem a little. They could even sell them on the open market as MBSs and CMOs when home prices stabilize.

Could you please cross-post the following comment from Prof. Alan White. It concerns an intriguing alternative to the bailout. See http://pubcit.typepad.com/clpblog/2008/09/another-idea.html .

Thank you.


Alan White's got his finger on the problem--how can we crack through the securitization trust structure to gain control of the underlying mortgage assets (and then modify the terms of the loans). Here's the problem: these trusts were not designed to permit the sale of teh underlying assets. Instead, they are set up to hold income-producing assets and distribute predictable cashflows to investors.

Neither securitization trustees nor servicers are authorized to sell the underlying loans except if certain conditions are met.

"[T]he Trustee shall not (a) sell or permit the sale of all or any portion of the Mortgage Loans or of any investment of deposits in an Account unless such sale is as a result of a repurchase of the Mortgage Loans pursuant to this Agreement [for loans with defective or missing documentation] or the Trustee has received a REMIC Opinion prepared at the expense of the Trust Fund..."

And also:

"None of the Depositor, the Securities Administrator, the Master Servicer or the Trustee shall sell, dispose of or substitute for any of the Mortgage Loans (except in connection with (i) the foreclosure of a Mortgage Loan, including but not limited to, the acquisition or sale of a Mortgaged Property acquired by deed in lieu of foreclosure, (ii) the bankruptcy of REMIC I, (iii) the termination of REMIC I pursuant to Article X of this Agreement, (iv) a substitution pursuant to Article II of this Agreement or (v) a purchase of Mortgage Loans pursuant to Article II of this Agreement), nor acquire any assets for any Trust REMIC (other than REO Property acquired in respect of a defaulted Mortgage Loan), nor sell or dispose of any investments in the Collection Account or the Distribution Account for gain, nor accept any contributions to any Trust REMIC after the Closing Date (other than a Qualified Substitute Mortgage Loan delivered in accordance with Section 2.03), unless it has received an Opinion of Counsel, addressed to the Trustee and the Securities Administrator (at the expense of the party seeking to cause such sale, disposition, substitution, acquisition or contribution but in no event at the expense of the Trustee) that such sale, disposition, substitution, acquisition or contribution will not (a) affect adversely the status of any Trust REMIC as a REMIC or (b) cause any Trust REMIC to be subject to a tax on “prohibited transactions” or “contributions” pursuant to the REMIC Provisions."

Selling the underlying mortgages could create tax problems for the trust--if it loses its pass-thru REMIC status, the value of the MBS are really kaput. I'm not a REMIC expert (I'm not sure who is--I've been trying to find one to talk to), but if a REMIC sells its assets and then just distributes a pool of cash, I think it loses REMIC status. Perhaps the solution is to change REMIC rules, but the danger with any of the attempts to change the law to make the underlying mortgages accessible is it could create other, unforeseen, adverse economic effects.

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