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The Value of Rule of Law: 20 Basis Points

posted by Adam Levitin

The rule of law is not even worth 20 basis points.  That's the ultimate message in a recent paper by Charles Calomiris, Eric Higgins, and Joseph Mason evaluating the proposed AG mortgage servicing settlement. Calomiris et al. estimate that the settlement will raise mortgage costs at least 20bps, and they think that's too much.  

Recognize what they're really saying:  that 20-45bps is too high a price to pay for the rule of law. They value the rule of law at less than 20bps. At present conversion rates, that's about 30 shekels of silver. 

The whole Calomiris et al. document is rather strange, as it's hard to do any serious evaluation of the settlement without knowing the terms. We've seen a proposed servicing standards term sheet from the AGs and we've seen a CFPB analysis of disgorgement of wrongful profits and the costs of potential principal reductions, but it's way premature to attempt any sort of real evaluation of a settlement. Unless, of course, the goal is not a serious evaluation of a settlement, but an attempt to forestall a settlement. Which is what this paper is.  

So let's get down to brass tacks. The paper is financed by the financial services industry, including institutions that would be affected by the settlement. That's properly disclosed, but would three academics otherwise take the time to write up a 29-page paper evaluating a proposed 27-page term sheet that is an incomplete part of a settlement? 

Like every good bit of financial services lobbying clothed in academic garb, it's got its perfunctory claim about the necessary increase in the cost of credit as a result of the regulation: 20-45 bps.  I've blogged before about how bogus statistics are the financial services industry's go-to lobbying tool (here and here and here; see here for a Fisking of an earlier bogus statistic), and we can now add another chapter to that sorry story. In retrospect, the card industry really missed the boat by not making up a bs number regarding the CARD Act. 

Calomiris et al.'s 20-45 bps number is little more than a back of the envelope guess.  It's extrapolated from a range of studies including those of non-US credit markets, pre-2008 US mortgage markets, and studies of "strategic default" that use overly broad definitions of strategic default. Lots of obvious problems there. 

What I love about this concocted number, however, is that it leaves Calomiris, Higgins and Mason hoist on their own petards. 20-45bps is basically what consumers currently pay for the protections of judicial foreclosure. So servicers are going to be forced to perform what they contracted to do. Boo-hoo.

The 20-45 bp estimate of the increased cost of mortgages as a result of the settlement is in perfect accord with the difference in mortgage costs between judicial and nonjudicial foreclosure states. Federal Reserve economist Karen Pence has a marvelous study on the difference in mortgage credit availability between judicial and nonjudicial states.  In an extended (but unpublished) version, she translates the difference in credit availability into credit costs. She finds that mortgages in judicial foreclosure states cost 22-30 bps more than in nonjudicial foreclosure states, depending on LTV.  In other words, borrowers in judicial foreclosure states pay another 22-30bps in exchange for the legal protections of judicial foreclosure.

The AG settlement would make servicers comply with existing law in judicial foreclosure states. In other words, it would make servicers give mortgagors what they had bargained for--adherence to judicial foreclosure rules. So what Calomiris et al. are really saying is that if mortgage servicers had to actually follow the law and honor the mortgage contract, then it would cost them just about what the homeowners bargained for in judicial foreclosure states. That's just the internalization of externalities.  Servicers tried to cut corners and cheat on their bargain and if the worst effect is that they are forced to honor their bargain, it's a pretty good regulatory outcome. 

Calomiris et al. also misread the $24B figure in the CFPB powerpoint as representing the dollar figure for principal write-downs. That's not what it is in the CFPB powerpoint. That's the dollar figure for wrongful profits from robosigning, etc. In other words, the $24B is a disgorgement figure. Calomiris et al. base their entire argument on the assumption that the $24B has nothing to do with the harms caused by robosigning and is simply gratuituous principal reduction. By their own conclusion, however, the settlement should address illegal behavior directly, so the $24B fine should be something that they would support, as it is disgorgement of illegal profits. 

There's lots of other whacky claims in the document too.  It continues to view the settlement terms as mandatory; no servicer is compelled to settle--it's a choice for the servicer to make.  The settlement is nothing more than a contract offer.  If servicers don't want to do principal mods, then they don't have to settle.

The paper also insists that servicers are fiduciaries of investors.  Servicers should be fiduciaries, but I don't know of any servicer that considers itself a fiduciary or of any caselaw that say so.  Servicers think that they are bound by the contractual language in the PSA and nothing else. What's more, whether they are fiduciaries or merely subject to contract, it's all pretty irrelevant given that there's virtually no oversight of servicers. There's no way to verify that servicers are only foreclosing when a mod would be NPV negative or that their NPV calculations are at all reasonable. Indeed, I have heard of servicers that use one NPV calculation for short sales and another for mods. Let's be honest about what valuation is--an educated guess, compounded by another guess. Change the input assumptions in NPV models and you'll get very different outcomes.  But Calomiris et al. are very content to rely on the belief that servicers are true and faithful agents. This is very strange given Joseph Mason's other work on servicing, which is quite cognizant of all of the problems in the servicing world. Thus Mason has previously written about "standard and well-acknowledged conflicts of interest between servicers and investors". 

Let's get real about mortgage servicers. The world of mortgage servicing is the world of Private Snafu. Four years into the crisis, and many servicers still don't have basic operational kinks worked out. Many of the large servicing shops still use fax (yes, fax!) as their primary form of communication with borrowers.  If you have 40,000 pages of fax coming in a day, of course things are going to go wrong. Even if servicers wanted to be faithful agents, it's ridiculous to think that they're getting stuff right.

Calomiris et al. try to argue based on HAMP that mods don't work. All that the HAMP experience can possibly show is that half-assed mods don't work. Of course HAMP mods don't work--they're basically roll-overs into remodeled subprime loans: low FICO, high LTV, increasing interest rates, balloon payment. We don't know whether serious principal reduction mods work because we haven't seen them in action. But there's every reason to believe that they will because if you put borrowers back to positive or near positive equity and give them affordable payments, then it's just a sustainably underwritten mortgage. 

The only solution I see offered by Calomiris et al. is to let foreclosures take their course. It will take several years for the housing market to clear if that's all we do. I'm going to post separately on this, but anyone who thinks that we can clear this market via foreclosure is nuts. Foreclosure is an inefficient, incredibly slow method of market clearing that produces lots of negative externalities. The settlement might actually speed up foreclosures which have ground to a halt in several states. 

Finally, back to that 20-45bp number. The calculation of this figure is really pretty silly and not a serious academic exercise. It's a guess. It's also a very unfair figure to pin on the settlement. If the residential private-label MBS market is to get restarted, mortgage servicing will have to be radically reformed. There's no doubt that going forward servicing will cost more. Servicers massively underpriced relative to the costs of performing their contracts. This has nothing to do with the AG settlement proposal. The real question is whether the AG settlement proposal will add costs to mortgage servicing above and beyond the costs that will be imposed by the market. It's far from clear whether there are any given how skittish private-label MBS investors are (and rightfully so). 

I would have thought that rule of law was priceless; that without it markets could not function, homo homini lupus and all that. But apparently, rule of law is not even worth a lousy 20bps. 

[Update:  Konczal and Felix disemboweled this paper before I had a chance. Their analyses are well worth the read.] 

Comments

Adam, I blame relaxation of FAS 157 mark-to-market rules for removing a powerful incentive for banks to engage in principal reductions to meet borrowers part way and try and salvage some value in distressed portfolios, but of course it's really the servicers calling the shots. Another problem was successful dissemination of bullshit data that informed the financial industry's position that loan mods don't work because of high redefault rates.

You covered the Boston Fed's problematic discussion paper "Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization" two years ago. Check out Mike Dillon's comment astutely observing the paper's renegotiation data was from LPS. What a difference a couple of years makes, huh?

http://www.creditslips.org/creditslips/2009/07/is-redefault-risk-preventing-mortgage-loan-mods-.html

On a different forum I said back in July 2009:

"This study provides cover for banks persisting in folly. The 'self-cure' issue can be addressed by limiting the pool of applicants based on household income and equity in the home. The redefault rate is based on restructured loans of any kind, not those with reductions in principal as is really needed:

[W]e broaden our definition of renegotiation to include any modification, regardless of whether
it lowers the borrower’s payment.(Report, page 13)

Hello? So you define 'renegotiation' to include changes that are of no real short-term benefit to borrowers . . . Strange how the data then support a finding that borrowers 'redefault.' Please."
-----------
So first-mortgage cramdowns were defeated, crap info from the Boston Fed was disseminated in all the major financial news outlets and strong anti-modification sentiment gained traction via confirmation bias and bad analysis. Oh yeah, and CNBC-style propagandizing against deadbeat borrowers strategically defaulting and livin' large on the savings.

Fast forward to today and we see clearly that the financial industry has been effectively outmaneuvering the consumer advocates every step of the way. Not surprisingly, the pressure points just aren't there to use as leverage, to the point that we have Sheila Bair making the alarming/absurd statement on 60 Minutes that homeowner foreclosure defense is getting out of hand, supposedly keeping the housing market from clearing via timely foreclosures, that some kind of remedy is forthcoming in which homeowners are just going to have to accept the banks' assertions of ownership. There's your rule of law, Adam.

I enjoyed your post very much. I am unfamiliar with two of the authors but have a lot of respect for Mason in this space and believe he is as knowledgable and open-minded as anyone covering it.

Taking everything you say as true, to evaluate the quality of the work, it would be useful to know: have the people working on the settlement itself done anything more in this vein? Maybe this paper is a guess, I'll take your view at face value, but are the regulators generating anything more precise? If not, why not and is it fair to castigate outsiders if not.

On a side note, about 10 - 15 years ago, when the RTC was functioning, they did an experiment - they sold some paper on an as-is, where-is basis and on some they gave reps and warranties that they stood behind. They determined that buyers would pay on average a 100bp premium for the latter vs the former. Not directly on point but somewhat in line with the quantifications discussed in your post.

I still think rule of law is priceless and 20 basis points are nothing.

I have read that almost every foreclosure is illegal since contracts made with counterfeit money (fake money created by a bank in prohibition to Art 1 Para 10 Cl. 1 of our US Constiitution) are Ultra Vires contracts.
I ask this question here cause you are not allowed to mention the word Constitution to a Judge.

Hold up, $24Billion in profit from robosigning?

If this fraud were prosecuted under the RICO statutes, then the mortgage servicers would be looking at $72B in damages, just for robosigning alone, never-mind the rest of the chicanery.

To all we admire the work you do. However, they still are not addressing this issue Correctly. Or else they would of shut down these mills already...I know we're talking a lot of attorneys but they've forced fraud on so many! Judges are in on this to and enforcing the FRAUD!

Recusal laws need to be changed! Immunity needs to go! People have BLIND TRUST in these officials just as they have BLIND TRUSTS that funds would have had to go into for enforcing the THEFTS! Why isn't this addressed anywhere? Open up the accounts!

Knowingly putting fraud into the court is a crime and should be addressed as such! I may not be a licensed attorney but I'm also no one's fall guy and NO AMERICAN should have to be for their OUTRAGEOUS DECEPTION AND THEFT!

For anyone who thinks this just goes back to when so called ROBOSIGNING was discovered GET A CLUE! This theft goes back a minimum of 10 years if not 100...Trust me I've tracked it since Abe Lincoln and his banker associates/friends were murdered as well...If anyone doesn't think most of this was all manufactured you'd be wrong!

They order Recusals of Judges, Remove Court Documents, Refuse to TELL THE TRUTH! WELL I have NO PROBLEM DOING SUCH!

No ONE should be made to put their life on their line defending such actions for the millions they've caused damage to. Funny I know more than the average bear. But in my JURISDICTION THEIR CORRUPT TO THE CORE UP AND DOWN!

http://www.youtube.com/watch?v=8VDTAIqOouM

http://www.foreclosurehamlet.org/profiles/blogs/department-of-corruption-black

http://www.foreclosurehamlet.org/profiles/blogs/how-much-money-does-chase-amp

Excellent post. An explanation of what a basis point is might be helpful.

Adam -- this is a fantastic post. Your analysis is dead on. I'm going to direct readers at PropertyProf over here so they can read it.

A basis point is .0001 of the base amount being considered. Or, 1% of 1%.

It was developed to eliminate confusion when talking about changes in things already expressed as percentages. E.g., if interest rates are at 4%, what does it mean to say they moved 10% - does that mean 4.4% or 14%? By using basis points, one can say, they went up, respectively, 40 bps (to 4.4%) or 1000 bps (to 14%) and the content is clearer.

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