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.

Schwartz's tag-along point--that the "flood of new cases would delay the resolution of business bankruptcies, to the detriment of the economy"--is opaque and seems especially tendentious. If we're talking about big corporate bankruptcies, we're talking about a couple hundred cases per year concentrated in a few jurisdictions like Manhattan and Delaware. It does not seem likely mortgage modification would act to the detriment of the judicial docket in these jurisdictions. In any event, the federal courts can and do assign judges to a different jurisdiction when necessary to meet a temporary increase in caseload.

Schwartz's second major argument against mortgage modification is that many debtors will be disappointed because they will not get as much relief as they think. Mortgage modification is essentially a battle over the valuation of the residence. Debtors and their lenders will put on competing evidence at a trial. Schwartz notes lenders will win many of these cases because they have more expertise and more resources. Debtors certainly are at a disadvantage when dealing with powerful and large financial institutions, but that is true inside and outside of bankruptcy court. The disadvantage would seem to be a reason to get consumer debtors into court rather than leaving them to the mercy of the financial institutions outside of court.

Schwartz also says that the proposal would worsen economic uncertainty because banks would not know what their collateral is worth. He is right to say that valuation is tough. I'm not as quick to agree that bankruptcy judges are not experts in valuation. It is a lot of what they do, and their judgments are at least not tainted by financial incentives that inescapable in so many professional appraisals. Schwartz also seems to argue against himself when he says that valuations are a shot in the dart that will be affected by the judge's personal sympathies. He had just said that debtors would lose a lot of these cases because of the financial institution's resources, but now he seems to be saying they would win a lot of the cases because the judges will sympathize with the consumers. (I am assuming the financial institutions would not attract the sympathy of very many, bankruptcy judges included.)

This last argument seems to come down to an argument that we're hearing a lot from the mortgage industry--bad stuff will happen if we give bankruptcy judges this power. Lending will shrink, exactly at a time when we can't let it, and interest rates will go up. It is, of course, easy to point to an unknown future and say it will be bad (just as it is easy for me to assure people it will be OK).  A point I often make is that before the 1993 decision in Nobelman, many courts had decided the bankruptcy law did give bankruptcy judges the power to modify home mortgages. The sky did not fall then, and I don't expect it to happen if that power is restored.

Comments

[Jason Kilborn]

The recent CBO analysis of the mortgage modification bills, a link to which I cannot find, reports that the burden on the judiciary will be negligible (and offsetting receipts from filing fees will actually produce a net gain for the Treasury), as Chapter 13 filings will likely increase in 2009 about 13% anyway. Like most law & economic analyses, this latest commentary seems intent on not allowing facts to get in the way of theory (even if the facts cut in different directions for different parts of the theory).

[AMC]

One other point on the bankruptcy courts being "swamped" issue - in 2005, in the two weeks before BAPCPA took effect, the bankruptcy courts withstood a flood of filings that we will - I hope - never see again.

Back then, there were still a number of non-ECF courts. Now, I think electronic filing is mandatory almost everywhere. This greatly increases the ability of bankruptcy courts to withstand large increases in their case load. Even adding 600,000 Chapter 13 cases a year, which might be possible if a broad bill mortgage modification bill is passed.

The Chapter 13 trustees are likely to have more of a problem dealing with the mortgage modification volume than the bankruptcy courts.

The comment about business cases being delayed makes Schwartz look pretty dumb. How many Chapter 13s does he think are filed in Manhattan or Delaware? That's just nonsensical. I'd expect that from a politician, not a law professor with Schwartz's bankruptcy background.

[Patrick J. Conway]

I believe the proposed legislation, if passed, will finally require mortgage lenders to make meaningful loan modifications directly with debtors. Until the law passes, they have little incentive to make a deal. Once true loan modification through the bankruptcy court becomes a real alternative, the lenders will work to keep people from letting a bankruptcy judge change the mortgage.

[Val Popov]

What if modifications for underwater mortgagors is the wrong answer?

The significant issue of mod re-default has not received enouth consideration. A recent Fitch report shows that modified loans with big principal and payment reductions (reductions in excess of 20%) still re-defaulted at 20% - 30% rate after only 6 months! These are terrible numbers, which suggest that over the life more than half of such mods may go down. Judicial mods are very likely to have worse performance since bankrutpcy significantly impairs the borrowers' access to future credit.

What if modifying a mortgage (even with principal reductions and all) is the same thing as asking borrowers to catch a falling knife? Would anyone in their right mind borrower money to buy Citi stock? Second, lenders are exposed to abuse. Loan mods have become the new piggy bank. Stop making payments for a few months and pay off your car loan or any other expense, no problem – we will just roll it into your mortgage at 5% interest rate with no cap on LTV!!!

Modifying underwater borrowers may not be the best solution. Borrowers are still stuck with the risk that property values will continue to decline, in effect forcing them to throw good money after bad. On the other hand, lenders are wide open to abuse.

I believe we should really start a debate on alternative solutions. One option could be a deed-in-liue with a leaseback. The lease can include a 5 year option that allows the borrower to buy the property back at today’s market price at any point as long as they don’t miss lease payments. The borrower is no longer stuck with the downside risk that the property will continue to depreciate; however, all the appreciation potential remains.

Instead of supporting prices for toxic mortgages and mortgage backed, the Government should provide financing for such leases or buy the properties out right. The two advantages are that it is much easier to determine the market price of a house than the market price of a toxic mortgage security, and securitization restrictions on modifications no longer apply, since the transaction is reported to the trust as a short sale.

[AMC]

Um, Val - did you read the Fitch report?

This issue was blogged about on CreditSlips, here:

http://www.creditslips.org/creditslips/2009/02/what-a-surprise-the-ability-to-pay-matters-on-mortgage-modifications-too.html

From Kathleen Keest's take on the Fitch Report:

"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!"

[Patches]

I respect your view Val but common! The game totally changes in Bankruptcy. If you have a 20% reduction in P&I payment outside of Bankruptcy you have other debt weighing you down... ie. vehicle, medical, credit card, Payday "devils" etc.. In the context of a 13 debtors STOP the interest and penalties on unsecured debt from growing. Plus, in most states the debtors will have to only pay a percentage of the total unsecured debt.

[John_Mayer]

It is estimated that it could benefit 3 to 4 million homeowners from the new modification procedures. So how do you qualify for the Mortgage Modification? Check the website http://mortgagemodificationprogram.blogspot.com
to see if you qualify. I was in trouble I am glad I did check it before I talk to my mortgage company and it worked - John Mayer, California

[Val Popov]

Yes, I have read the Fitch report carefully, and I strongly recommend it to everyone who is tuned into the housing crisis. According to the report, the best performing mods were those that had P&I reduced by more than 20%. Still, even those supposedly "good performing mods" experienced 21% re-default rate in 6 Months!!! For comparison, the 2007 Subprime ABX index had 60+ delinquencies in the low to mid single digits at age 6 months.

All I am trying to say is that mod re-defaults is a very serious issue. Everyone seems to be jumping on the modification bandwagon, including Industry, Congress, the Administration and the consumer groups; however, no one has offered an analysis of why 21% of mortgagors stopped making payments after receiving more than 20% reduction in their monthly payment. If you project the failure rate over the life of the mod, the number will be scary - possibly, more than half of such mods will fail.

The problem with the Fitch report is that it does not explore the reasons for the re-default, nor do we have a sense of how representative their sample is. I am simply trying to raise the single biggest issue missing from the public discourse - modifications are failing despite principal and payment reductions, and we don't know why.

Fitch will be coming with a second report that will explore loss mitigation strategies - hopefully, that will shed some more light on the issue.

[Jason Kilborn]

As to Val's point, let's not forget that, based on historical figures, Chapter 13 plans fail at a 66% rate, and I haven't heard anything that would augur a significant change in that sad statistic. I would suspect that the same people who redefault after a MEANINGFUL mod (i.e., P&I reduction) will be unable to complete a plan; therefore, debtor gets no relief, no harm no foul (at least as to the lender). Bankruptcy seems to me to be PRECISELY the right place to work out these workouts and separate sustainable mortgages from unsustainable ones.

[AMC]

OK, think about the time period where this data is coming from - it isn't from loan mods being done today, with today's more liberal standards. Where do you think the loans that got the 20% reduction came from? The ones where the debtors were in the "best" situation a defaulting, loan mod seeking debtor could be in, or the worst?

I would suggest that, in looking at the loan modification applications, mortgage companies were inclined to give the biggest breaks to the debtors who 1) had houses the mortgage company really didn't want back; 2) needed to have that 20% level of reduction to have any shot at staying in the house.

From the link-within-the-link:

"The best publicly available data that we have comes from Prof. Alan White. His most recent analysis shows that "[o]nly 35% of modifications in the November 2008 report reduced monthly payments below the initial payment, while 20% left the payment the same and 45% increased the monthly payment.""

So, in November of '08 (again, probably still too recent to be included in the Fitch analysis, only 35% of the loan mods reduced the monthly payments at all. Of that 35% that provided ANY reduction the monthly payment, there is a subset of those lucky few that provided a reduction of 20% or more in the monthly payment.

Who do you think those people were? They were in the much harsher loan mitigation environment of half a year or more ago. And they got the very best deals.

Now, there is nothing to indicate that these same folks who got the extra heavy 20% reduction on their monthly mortgage payment got any relief on their other debts. The kind of relief typically afforded in a Chapter 13 bankruptcy, where car loans can often be crammed down, or at least an interest rate reduction can be obtained. Not to mention unsecured debt relief and a stay that protects them from lawsuits and garnishments - two factors that may contribute to the lucky 20%s who defaulted.

As was pointed out by another poster - the bankruptcy modification of the mortgage loan doesn't "stick" unless the debtors complete their 3 to 5 year Chapter 13 plan. Of course, there will be winnowing of the wheat from the chaff. But is that worse than the alternative?

It isn't like the banks are going to be getting paid in full (or anywhere near it) on these loans if they go through foreclosure.

If there isn't a change in the direction and downward velocity of the housing market, the banks/RMBS holders are going to get - through a different mechanism: pure economic distress - what the mortgage companies claim to fear will happen because of debtors taking advantage of bankruptcy relief: more losses for the banks as debtors stop paying the mortgages on their underwater homes.

The flood of houses onto the market, and even worse, into little trusts that make the bank owning the property virtually unfindable, are causing a frightening deterioration in many neighborhoods. It's not just housing prices, but a whole host of related problems, from vermin, to uncut grass and weeds, to gangs, to lost property tax revenues.

Chapter 13 bankruptcy loan modification is the most targeted response. It brings to bear bankruptcy judges and chapter 13 trustees with long experience in dealing with all the issues presented by this crisis. And there is simply not enough government money available to even make a real start at fixing the problem.

I don't have a crystal ball. Maybe those who argue we should have done absolutely nothing - no help for financial institutions, no help for the foreclosure crisis, no help for anyone - are right. Maybe the government not spending any money on these problems and letting everything collapse of its own weight was the better way to go. But, we'll never know that, because that wasn't what was done.

Now we're half way into it. Mortgage modification allows people who want to fight to keep their homes, to fight. It also is an incentive for both parties to the loan to reach an agreement on payments that are sustainable.

Have you looked at the website that has the "implode-o-meter"? It shows well over 300 middleman lenders that operated during the subprime heyday and are now defunct:

http://ml-implode.com/index.html#lists

For each of those lenders, there was a stable of mortgage brokers, funneling mortgages into the MBSs as fast as they could shoot out the paperwork using automated underwriting software. Not to mention the efficient securitization machines of those entities that no longer exist: investment banks.

Where are the resources to duplicate that level of effort, in reverse? And fixing the problem is MUCH harder - each loan, collateral value, and financial situation has to be analyzed "by hand" at this point. It isn't like when the mortgage loan was taken out in 2006 - "Oh, you've got a 640 credit score, I've got a loan you can get without any income documentation."

I think the bankruptcy courts and the chapter 13 trustees might have a shot of doing it for a substantial number of people. Frankly, I haven't seen an ability to do anything close to what needs to be done by what's left of the mortgage industry.

[Doug]

I'm stunned that an academic of Schwartz' standing could publish such specious tripe. Please, let's get a grip. First, even if the caseload were to pressure the capacity of bankruptcy courts, the remedy is quite simple: hire more judges and/or figure out arrangements with the well established arbitrator/private sector experts for hire.

Second, last I heard, the human element was an inherent aspect of the rule of law. It's a given. For a professor of law to cite the human element as a reason to prohibit a much needed shift in bankruptcy law is seriously nonsensical. Henceforth, let's object to any and all modifications of any and all aspects of the judicial branch by saying that, because judges are human beings, we cannot risk such changes. Then, let's do one better and simply abolish the judicial branch for the same reason. It's nonsense.

Last, Prof. Schwartz exhibits a special form of blindness when he opines on the economic consequences. Perhaps Prof. Schwartz has not been reading the news lately -- but, frankly, at the heart of the economic meltdown lies humongous uncertainty that, in turn, arises from entirely market based and inadequate mechanisms for valuing dodgy assets. Put differently, Prof Schwartz gets this entirely upside down. By making the reforms to bankruptcy, we will increase economic certainty, not the reverse.

[chew2]

An interview with Paul Van Valkenburg of Mortgage Industry Advisory Corp. regarding the Mortgage “Cramdown” Legislation and what does it implies. (Bloomberg News)

Seems to say cram down will assign principal reductions to lowest tranches first, but he was hard to understand. This is supposedly the "stick" to force modifications. Seems to think will help in price discovery of collateral. Query whether have to go thru bankruptcy to get the benefits, or whether voluntary mods will also work.

http://www.ritholtz.com/blog/2009/03/cramdown-implications/

[AMC]

"Query whether have to go thru bankruptcy to get the benefits, or whether voluntary mods will also work."

Um, that's a can of worms to open up.

Once the housing problem was finally admitted to exist, we were told that voluntary loan modifications were fixing the problem. In 2007. And the fact that the Mortgage Bankers Association was not accurately describing the situation on the ground - vis-a-vis voluntary loan modifications - was apparent in at least early 2008:

http://www.responsiblelending.org/issues/mortgage/research/updated-analysis-of-paulson-plan.html

Voluntary Foreclosure Fixes Fall Short

After denying for months that a foreclosure crisis even exists, the Mortgage Bankers Association (MBA) now claims lenders are making "vast efforts" to prevent foreclosure. Unfortunately, the numbers show little progress. During the third quarter of 2007, mortgage lenders started about 213,000 foreclosures on subprime loans, but offered meaningful fixes ("loan modifications") on only 28,000.

These disheartening results come on the heels of an initiative by the Treasury Department to encourage—but not require—lenders to "streamline" loan modifications by automatically freezing interest rates on eligible loans before the monthly payments increase by 30% or more. Not surprisingly, this volunteer approach isn't producing significant changes. We at CRL have released an analysis showing that under the Treasury plan, only 3% of homeowners with adjustable-rate subprime mortgages are likely to receive a streamlined loan modification from their lender.

Of course, this early 2008 article does not reflect what we know today - most of those "loan modifications" did nothing to reduce the monthly payments. In fact, in many instances, the monthly payment obligation was increased:

http://www.creditslips.org/creditslips/2009/02/what-a-surprise-the-ability-to-pay-matters-on-mortgage-modifications-too.html

"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."

So, do we rely on the people who got us into this mess, denied it existed, and then lied about what they were doing to fix it?

Not surprisingly, more and more people seem to be responding in the negative to that question.

[Poppa Bear]

What if the borrower has a second mortgage and would like to apply for a Home Affordable Mortgage Modification?

Under the Home Affordable Mortgage Modification program, junior lien holders will be required to subordinate to the modified loan. However, through the Home Affordable Modification an incentive payment of up to $1,000 is available to pay off junior lien holders. Servicers are eligible to receive an additional $500 incentive payment for efforts made to extinguish second liens on loans modified under this program. The following article has some good information on the Mortgage Modification program....
http://www.bearmarketinvestments.com/mortgage-modification#mortgage-modification