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Why the McCain Mortgage Refinancing Plan Won't Fly

posted by Adam Levitin

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.

It's basically a repeat of the 1930s Home Owners Loan Corporation (HOLC), which purchased defaulted mortgages at market value (requiring a new appraisal) and then modified them into 30-year fixed rate mortgages.

A HOLC-type solution, however, cannot work today because the vast majority (80%+) of residential
mortgages are securitized. The government cannot purchase mortgages directly out of securitization pools unless it pays face value (100% of the loan amount outstanding), and purchasing mortgage-backed securities doesn't give the government the ability to modify the underlying loans. McCain is not proposing to do that. Instead, what he's proposing (from the very confused description given by his economic adviser Douglas Holtz-Eakin in a media call) looks like the HOPE for Homeowners Act of 2008 that was signed into law in August, and which is unlikely to have much of an impact because it relies on voluntary mortgage industry action. Because the McCain plan doesn't recognize the (admittedly complex) problems created by securitization it is simply unworkable. At best it will help a few homeowners, but Treasury is already authorized to do that.

As it stands, there are a limited number of ways to get around the securitization problem:

1. Government can refinance the mortgages directly, which would involve paying 100% of outstanding amount of the loans. To do this the government would pay off the entire outstanding balance on individual mortgages (plus any prepayment penalty) in exchange for getting a new mortgage on the property. Pros: effective way of helping homeowners. Con: expensive, rewards lenders who made predatory loans, and undeserving homeowners (e.g., flippers)

2. Buy up ALL the RMBS and CDOs and CDO2s and then modify the underlying loans. Same pros and cons as above. Maybe slightly cheaper as the MBS can be purchased at less than face value (excluding a holdout problem).

3. Take the mortgages from the securitization trusts via eminent domain. Government will have to pay fair value for the properties. Same pros as above. Cons: terrible litigation costs (lots and lots of jury trials!) and also likely to have high fair value costs. Also, the forced nationalization of investments isn't exactly what we expect in America.

4. Create incentives for MBS holders to (unanimously) change their trust indentures. This could be done by threatening MBS's favorable tax-status (pass-thru REMIC), as Michael Barr has suggested. Problem with this is that it only take one holdout or party that doesn't open its mail and the whole deal is off. I like market-based solutions, but when the market is malfunctioning like today, I'm reluctant to put my faith in a market-solution.

5. Permit modification of the mortgages in bankruptcy. Pros: no cost to taxpayers; imposes costs on borrowers and lenders; immediate; sorts between deserving and undeserving borrowers. Cons: potential impact on future cost of credit.

6. Pass Gold Clause type legislation that changes MBS holders' rights in a way that will allow modification of the mortgages. There are several ways to do this (allow Treasury to put the trusts into bankruptcy; change the limitations on modification of the trust indenture, etc.). This might not ultimately be Constitutional (Gold clauses cases are still good law, but the Supreme Court was able to fudge those by saying it was about monetary policy). Still, I doubt any judge would issue a pre-trial injunction, so by the time there was a final ruling, the matter would be over and done and the worst case is that the government would have to pay out some (maybe a lot) of money.

Those are really the options for dealing with the Gordian Knot of securitization. If we want to help homeowners, we are going to have to pick a poison. To my mind, 4, 5, and 6 are the only real options, and the effectiveness of 6 depends on what the particular legislation looks like. In the end, this comes down to an issue of political will, and by the time that will is mustered, it might be too late to help a lot of families and to help the economy.

Comments

The minute I heard the McCain plan I was flabbergasted. Bailout I (the $700 billion) was sold in part on the theory that the taxpayers might make money on the purchased assets. Whereas Bailout II shifts all the losses in the housing market to the taxpayers and locks them in! Because, as you point out, the only way the government can buy the mortgages directly is to pay face value, and then refinance the borrowers at values which are at or close to the bottom of the market.

Amending the Bankruptcy Code is so obviously the cleanest, simplest and cheapest way to address this problem without shifting all the losses of the entire industry to the taxpayers. The McCainiacs will surely respond that their plan saves homeowners from the "stigma" of bankruptcy. But why is that not a reasonable choice to ask the homeowner to make? If bankruptcy can provide GENUINE relief, then the homeowner can choose whether the costs of bankruptcy are worth the benefits. Also, there are existing structures and mechanisms already in place whereby bankruptcy judges, Chapter 13 trustees and U.S. Trustees can identify the undeserving or fraudulent actors and deny relief they shouldn't get.

It is amazing to me how eager we are to socialize the mortgage industry but heaven forbid we should do an eensy teensy bit of that to fix health care.

The immediate problem remains to restore enough confidence in the worldwide credit markets so that banks start lending to one another again and stock markets stabilize. The 700B rescue bill was supposed to do this but it has clearly failed. One option is to repeal it and replace it with a guarantee backed by the full faith and credit of the U.S. Treasury (i.e. taxpayers)of the bond payments. It wouldn't necessarily have to be a 100% guarantee. E.g. it could be a 90% garantee for Aaa rated MBS's with the % decreasing on a sliding scale based on the bond's rating. In exchange for the guarantee, the Treasury would obtain recourse against defaulting borrowers. Decisions could then be made on an individual mortgage basis whether to foreclose on a speculator or someone who lied about their income etc., or to renegotiate better terms for the honest but unfortunate homeowner. A guarantee of bond payments is riskier than the 750B bill but is much more likely to immediately restore confidence so as to avoid the worst case scenario.

http://news.yahoo.com/s/politico/20081009/pl_politico/14414

McCain changes homeowner plan

Mike Allen
Thu Oct 9, 12:29 AM ET

Sen. John McCain (R-Ariz.) made an overnight change in the homeowner bailout he proposed at Tuesday’s presidential debate, making it more generous to financial institutions and more costly for taxpayers.

McCain's staff says it was always meant that way.

When McCain sprung his surprise idea at the start of the debate in Nashville, his campaign posted details online of his American Homeownership Resurgence Plan, which would direct the government to buy up bad home mortgages, allowing strapped people to keep their property.

The document posted and e-mailed by the McCain campaign on Tuesday night says at the end of its first full paragraph: “Lenders in these cases must recognize the loss that they’ve already suffered.”

So the government would buy the mortgages at a discounted rate, reflecting the declining value of the mortgage paper.

But when McCain reissued the document on Wednesday, that sentence was missing, to the dismay of many conservatives.

That would mean the U.S. would pay face value for the troubled documents, which was the main reason Sen. Barack Obama (D-Ill.) gave for opposing the plan.

A McCain campaign official explained the change: “That language was mistakenly included in the initial draft and it’s been corrected. It doesn’t reflect the intentions of the initiative, which necessitated the correction and the removal of the sentence. A simple mistake.”

Another benefit of your number 4 option is that any unsecured debts will cease to tax the debtors’ monthly take-home income by eliminating monthly payments to them. The debtors would have a better chance at affording the home after it is re-written. After the 60 months the debtors will not have any unsecured debts and may be current or have paid off vehicles, IRS taxes, Property Taxes, leaving more money for ..... spending, saving, investing.... you name it. Instead of stacking the cards against the debtor making it more likely they will lose their home, the combo may stack the cards in their favor. Who benefits? Everyone even the Treasury Department, stock market, even those pesky MBOs will have a more accurate value. CDSs may be the only losers, I guess because of the default, but if the default is cured?????

You have two #4's -- which one is included in your rec of 3, 4, 5?

"4. Permit modification of the mortgages in bankruptcy. Pros: no cost to taxpayers; imposes costs on borrowers and lenders; immediate; sorts between deserving and undeserving borrowers. Cons: potential impact on future cost of credit."

A. There doesn't have to be any impact on the future cost of credit - the reform of the bankruptcy laws to allow modification of mortgages in Chapter 13 can have any limiting provision Congress wants to put in, including a limitation that mortgage modification is only for mortgages taken out before the effective date of the legislation. Or the date could be further back - to the date when the "silly season" for mortgage lending ended, whatever date that might be determined to be.

B. The amount of the modification of the principal amount of the first mortgage can be limited by the legislation. Say, no more than the great of a 10% reduction in principal or the current fair market value of the home. Or, no more than 20% of the purchase price of the home. The percentages can be whatever Congress wants them to be, and multiple limitations could be used - just as the best interest test, the disposable income/CMI test, and the good faith tests are all used for Plan confirmation.

C. The amount of interest rate reduction, or the fixing of the interest rate for adjustable rate mortgages could be limited based on standard interest rate indexes - like the current LIBOR rates, or the prime rate, or some average of those rates over some prior period of time. Using the case law of Till, bankruptcy courts (or more accurately, bankruptcy lawyers, since courts don't usually have to get involved in setting interest rates) are used to adjusting the interest rates for motor vehicles. Doing the same thing with mortgages shouldn't be substantially different.

D. Those lenders who DIDN'T break faith with the American people, could be excepted from any loan modification provision. If Congress wanted such a limigation, the new bankruptcy law could deny loan modification to those mortgages where the original lenders held on to the paper. This credit crises wasn't caused by local banks that loaned to homeowners in their area - they were caused by financial companies pumping out bad mortgages to fill tranches for CDOs/MBSs. So, arguably, the Ma-and-Pa lenders may still be entitled to their special interest exception to the way bankruptcy treats other loans.

E. The legislation could put in a provision similar to Section 707(b)(3) - if the relief would, for any other reason, be an abuse of the relief Congress intended to provide, no loan modification. Say, for example, if a 'house flipper' wound up living in a failed flip, it might be argued that they should not receive mortgage modification relief.

Actually, special/default servicers buy scratch and dent loans all the time at a considerable discount, usually to dress up a pool and have someone else handle the impending foreclosures. The balance owed doesn't change, but the original acquisition cost is far below face value.

The don't do that to lose money. Whether or not a bureaucracy could do the same should give us all pause.

But is it safe to refinance at this time - how does the world crisis affect that? I read at http://www.mortgage-refinancing.be that now we have the best interest rates..

If the McCain plan prevents losses by irresponsible lenders, that does seem like a new low in this policy debate. But I also don't like bailing out irresponsible borrowers, which is part of both McCain's plan and that of Paulson-Dodd-Frank.

I think as John McCain has recognized that homeowners need some help and is proposing to do something for them,is too vague to define his plan of action clearly.That is the reason his plan is likely to sink.

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