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The Way Forward: Going in Circles?

posted by Adam Levitin

The latest proposal for dealing with the mortgage crisis comes from The Way Forward by Daniel Alpert, Robert Hockett and Nouriel Roubini (AHR), a policy paper sponsored by the New America Foundation.  AHR present is an incredibly wide-ranging proposal covering all sectors of the economy, not just housing, but I'm going to limit my comments to their mortgage crisis proposal. 

I was really hoping that there's be something innovative in the paper in terms of dealing with the mortgage crisis. There isn't.  Instead, AHR cobble together a variety of existing proposals.  The problem is that many of the existing proposals are grossly impractical (such as turning homeowners into renters en masse) and for the more practical proposals, such as principal reductions, AHR haven't figured out the catalyst for adoption, which is key. 

I don't like yucking on somebody's yum; this is a proposal that tries to grapple seriously with the mortgage problem in the US.  I wish there were more of this going on. (Hey, where's your proposal Levitin?) That said, I don't think this proposal is going anywhere. The one really novel move in AHR is its approach to loss recognition. It's also the scariest part of the proposal as it proposes taking us back into the "regulatory goodwill" accounting days of the S&Ls. 

AHR's basic move on mortgages is to divide homeowners into three buckets--unemployed, negative equity, and marginal borrowers--and then propose solutions tailored to each bucket. On a broad conceptual level, I think this is an appealing approach; different homeowners have different problems and need different solutions. More narrowly, however, I'm not sure that they have the buckets quite right and they don't address the existing foreclosure and REO inventory, which alone is a major problem. 

AHR are keenly aware that a major problem with HAMP and HARP was that they tried to avoid loss recognition by kicking the can down the road in the hope that the economy would resurrect. AHR nevertheless end up doing the same thing--they aren't ready to rip the bandaid off fast.  The goal in housing should be to get the market to clear without rely on foreclosures. AHR's approach doesn't exactly get the market to clear. Instead, it is really aimed at buying time for the market to grow out of its problems--it starts with market clearing moves, like principal reduction, and then softens the move. AHR haven't resolve the tension between loss recognition and the hope that we can grow out of the problem over time. 

For bucket 1, the unemployed, AHR propose bridge loans that will get consumers to where they can start paying again. There are some state bridge loan programs and this is a proposal to make them national.  This proposal comes from some of Bob Hockett's work.  Unfortuantely, I think a bridge loan program would be an administrative nightmare.  A bridge loan is an easy thing to do when you're dealing with a single bank or company or the like.  (Not surprisingly, the authors come from the sovereign and corporate debt world.) But to do that for millions of homeowners is administratively a nonstarter.  It takes the briefest familiarity with HAMP to know that you want to keep administrative work to a minimum to make a program work. Mandating forbearance and giving the banks (including in their role as servicers obligated to make advances) capital injections as needed would be a lot simpler to do, and it would avoids the awkward problem of direct government loans to consumers. 

For bucket 2, homeowners with negative equity, but the ability to pay, AHR propose a trade-off of principal reductions contingent on payment in exchange for quicker foreclosures and with share appreciation. This is exactly what I proposed in my Chapter M proposal, albeit in the context of bankruptcy.  And that raises the critical problem with AHR's negative equity proposal--they don't have any suggestions for how to get such a deal implemented. They don't have a stick (like bankruptcy) and their proposed regulatory accounting shenanigans (more about that later) is hardly a juicy carrot. They mention in the context of second liens the possibility of government exercising emminent domain to seize the second liens from recalcitrant banks--an idea that has been around for a while--but that's not what this proposal is based on. Beyond this fundamental flaw, there are a lot of critical details missing, such as how much principal reduction and how to deal with the problem of securitized loans, where the regulatory accounting legerdemain discussed below doesn't apply. Bottom line is that if you want to deal with negative equity, you need either a stick or a carrot or both. Otherwise the proposal is a nonstarter.  

Bucket 3 are homeowners who can't afford even a modified loan. AHR suggest letting them rent their properties for 5 years in exchange for a deed in lieu. Changing homeowners into renters is an intuitively appealing idea that has gotten a lot of play in many quarters. But it's wildly impractical. Those proposing it haven't thought through the differences between being a mortgagee and being a landlord.  The duties of being a landlord are very different from those of a mortgagee.  If the furnace gives out the landlord has to replace it.  The mortgagee doesn't.  If there's lead paint in the house and a child lives in it, the landlord might have to undertake remediation.  The mortgagee doesn't. Most mortgagees don't want to be landlords.  Period.  It's just not the business that they're in.  They aren't property management companies.  A bank like BoA would have to deal with properties spread out all over the country.  Large landlords get economies of scale in maintenance and monitoring via multi-family units, rather than geographically dispersed properties.  It's really hard to imagine most mortgagees becoming landlords.  And there would have to be major federal legislation to deal with all of the securitized mortgages in this regard. I don't see banks willing to do this voluntarily. If you want to let people rent their old homes, you need to have professional landlords purchase the properties from the mortgagees as part of the deed in lieu deal. Good luck finding that volume of landlords willing to deal with dispersed single-family properties. 

The interesting move here is on the bank balance sheets.  AHR propose taking a page from the resolution of failed S&Ls in the 1980s, namely accounting tricks. AHR propose rewarding banks that do principal reductions by allowing them to recognize the losses over 7 years as a special type of asset, rather than taking the immediate write-down. As far as I can fathom, what they are proposing is a change in regulatory accounting. I don't think they're proposing an exception to GAAP. If so, it doesn't help a lot to avoid a regulatory write-down, but have to take a GAAP write-down.  

What really freaked me out here was that AHR tout their proposal as a redux of the FSLIC strategy for dealing with insolvent S&Ls:  have solvent S&Ls purchase the insolvent ones and let the solvent ones book the difference between the purchase price and asset value as "regulatory goodwill" which would be depreciated over time.  Anyone notice that FSLIC isn't around any more?  That's because the regulatory goodwill strategy just served to paper over the losses and didn't actually fix anything. It enabled crooked accounting to continue and worse the S&L crisis. I'm kind of shocked that anyone would suggest a repeat of regulatory goodwill, which is generally seen as one of the most misguided bank regulatory moves.  Ever.  

There are lots of other details one could quibble about (or more precisely complain about the absence thereof), but these are the basic moves and problems with them, I think. The different solutions for different homeowners move seems right, but the specifics just don't quite work. For the unemployed, I don't see any solution other than forbearance, and that isn't exactly a fix. It's a lottery ticket. AHR are right to address negative equity--you just aren't serious about dealing with housing unless you do, but they haven't figured out the implementation mechanism, which is the critical part. And mortgagors-to-renters is an idea that looks great on paper and is completely unworkable in practice; I'd really like to see it leave the conversation, as it's a mirage that distracts us from real solutions. But kudos to AHR for at least trying to deal with this central problem in the US economy.  



A deed in lieu with a simultaneous lease option program could be set up to be a solution to a portion of troubled loans. Perhaps not as a national solution banks volunteer for, but a program alternative set up as part of bank settlements.

This is like doing cpr on a week old corpse.We're headed to the "Big Reset Button".

I spoke with Asst. AG Todd Leatherman, who heads the Consumer Protection Division, a week ago. As he was making hideously vague and elusive attempts to answer my questions regarding why the Kentucky AG is doing NOTHING of effect to protect citizens of the state he referred to the 50 AG Panel and their efforts to make and maintain good "public policy" ... That was a sentence I was unwilling to tolerate. Unable actually as I know TOO much of the fraud. I interrupted him saying, in essence, "It has been my understanding that public policy in our state is the rule of law. How do you feel that policy is put forward or maintained by your refusal to charge, prosecute, and, where appropriate, convict?" As you can imagine the conversation went further downhill from there.

I have come to realize that there is no alternative to our going down. There is no fix. The idea that the guilty will not only "get away with it," but will also be enriched beyond any reasonable measure AND WILL SUFFER NO CONSEQUENCES WHATSOEVER ... Arrgg!! Never again will I trust ANY elected or appointed official.

Our officials are rapidly running out of time, as are those they are protecting. As for the people, we're already in the gutter and have no further to fall.

That is a good post but underestimates the mortgage to rent idea. The regulatory problems that you identify with mortgagees-to-landlords, e.g., lead paint, could be easily cured by legislation that leaves the homeowner turned lessee solely responsible for all that, just as they were before the transfer of title. Auto leases do that kind of cost allocation all the time. It would have to be a federal pre-emption law to be imposed efficiently. And you'd have to have strong eviction rights as auto leases have. But there is no reason to let a rigid concept of what a landlord is and does block an otherwise sound solution.

The real problem with it is pricing the rent. Original proposals suggested some sort of bureaucratically determined market rent which everyone who is familiar with cities that have rent control knows is a disaster. A better idea is to simply set the rent as a discount to the first mortgage interest and then grow it to 100% of first mortgage interest over time (e g 60% year 1, 70% year 2, etc). The government could pay the difference, knowing that it already backs 2/3 of those mortgages anyway and the program would scale out in 5 years. If this were coupled with a wide-scale refi program it would provide a meaningful improvement in the situation.
Second mortgages should just be wiped out in the transfer to the first mortgage holder. The second mortgagees can have the option to buy the property prior to transfer for the first mortgage debt, subject to the lease back. Or the government could pay them $3000 to consent, as I see done in short sales.

Mortgagors should have the ability to buy the property back for the first mortgage principal in the first decade as long as they are in compliance with the lease. After that, they should become like any other buyer and take market price.

It's true that banks aren't set up for this, but they're not set up for Dodd Frank either and that argument did not seem to carry much weight. If you keep the property obligations on the owner-turned-lessee, the bank role does not change that much at all.

The underlying problem is that our title and recording systems have been fatally undermined with respect to residential real estate transactions between 1998 and 2008. First came MERS coupled with a huge number of gaps in a huge number of loans files. Second came LPS et al and widespread forgery in an attempt to cover up the aforementioned gaps.

The banks would like us now to blithely accept their version of the "truth" about who owns what, which is tantamount to arguing that their forgeries are "good" while others' are "bad."

Instead, the only valid, indisputable and real legal indicia remaining as to who owns what is possession. The "paperwork" and public records establishing legal ownership and mortgage interests in properties for residential real estate transactions from 1998 to 2008 have, as a whole, been so corrupted and undermined as to have no legal weight.

So possession is all that we have left of the truth, and the banks created this situation by their own actions, first, by failing to legally perfect the mortgages they issued and packaged so greedily and hastily, and, second, by engaging in widespread criminal forgery.

Hence, across-the-board mortgage relief would simply reflect the legal reality of the situation that we face. This will create moral hazard, but it is the only choice we have. The predatory mortgages and the pyramids of securities and derivatives built thereon have been rendered, by the banks' own actions, empty, meaningless and untethered to chains of title and valid legal claims of ownership. All we have left of that is indisputably true about "who owns what" is who is actually in possession.

There would be nothing unprecedented about across-the-board mortgage relief. Debt amnesties have been common throughout history, and the government has been generous in viewing the liabilities of the banks as mere social arrangements as opposed to binding obligations.

The obvious solution - given the mess that the financial industry has created - is to leave the homeowners out of it, forgive their mortgage debts, and let the financial institutions argue amongst themselves as to who will bear the huge costs of their predatory lending, fraud and forgery.

mt--yes, one could through legislation come up with a deal in which a particular renters have less rights than others. (It won't be easy to set up the legal framework for this in 50 states.)

At that point, though, why is our former homeowner going to stay in the house as a second class renter rather than going across the street to be a renter with full rights? Liquidity issues aside, the former homeowner will only stay put if the cost of a true rental + the transaction costs of moving are higher than the costs of a second-class rental. In order to make this work, then the rent on the second-class rental actually has to be a below-market rent. That is, the bank could rent the house out to a real renter for more or (presumably) sell the house to someone who could be a real renter. I'm just not sure if the economics work.

From the bank's perspective, it might just be more profitable to sell the house. Plus I'm not sure what the regulatory accounting treatment would be--I think this would be a 100% risk weighting for capital requirements, rather than the 50% for a 1st lien mortgage.

As far as the Dodd-Frank comparison, the banks don't have a choice about Dodd-Frank. They do with mortgage-to-rent. That matters. And if we're going to make it mandatory, why not just mandate principle reductions?

Offering a deed in lieu and simultaneously signing a lease with option to purchase at FMV could be provided as an option, amongst other options, as an alternative to foreclosure.

Rent could be established using mod like parameters, say 30% of income. Competitive rent seekers may move shortly after the transaction, but this would still be more orderly than what is happening.

Banks may not willingly play along, but an argument can be made that it would be in their (and the economies) best interest over all.

There are other helpful attributes than what I outlined in a related post a couple weeks ago found here: http://getoutofdebt.org/31299/nfcc-challenges-debt-relief-industry-to-think-bold-my-thoughts

Work force mobility would normalize some.
Housing inventory supply levels in hard hit areas of the country would come down sooner.
Set a percentage of rents aside in a fund to deal with larger repairs. County offices with the vested interest in their communities could oversee this aspect of ownership.

A deed w/lease option could be part of wider bank settlements, or help to keep a semblance of order if resolution authority is exercised, or in a wind down of Fannie/Freddie etc.

What if servicing abuse with GSE loans reaches to the level of losing servicing rights? The beginning infrastructure to fill the servicing void is somewhat hinted at in the above link.

Banks with seconds are screwed in the liquidation anyway. Those banks with large exposure to seconds participated in the fiasco. Why should they not participate in the solution? Oh, capital requirements… Maybe those who took risks proven to be unwise should experience the consequences of their actions. If the consequence is the failure to maintain viability, all the more reason to have developed the infrastructure for a deed with lease option and proof of concept.

Principle reduction and cram down in bankruptcy works too.

It is a Gordian Knot. "Circles" is the answer to your article. Dog chasing his tail, trying to make sense out of nonsense.

Do we want the government to compete with Wal-Mart? Why was the mortgage business chosen for this venture?

"And you'd have to have strong eviction rights as auto leases have."
Self-help eviction? Talk about a disaster.

Professor, thanks for your thoughts on my idea.

First, I think you underestimate people's attachment to their homes and neighborhoods and the "face" that goes with being able to stay in them. I don't think people are as economically rational as you posit, or many more would already have taken the steps you outline. As proof, I note that people have been buying for decades when it has been cheaper to rent.

I did not mean to make it a choice for first mortgage banks, but rather a law requiring them to rent back, with government payments making them whole for any difference between rent and first mortgage and legislation holding them harmless from collateral exposure as landlords. That avoids the issues raised by principal reductions which, as I understand the proposals, are meant to leave the banks at a loss which raises all kinds of takings issues.

On a back of the envelope basis, using the discounts I suggested above and assuming (a) properties with $1T of first mortgages were so treated, (b) their mortgages were refi'd at 4%; (c) such properties were 20% underwater on average and linearly climbed to 100% over 7 years, (d) a 5% annual delinquency even with the discounts, and (e) $1B per year in administrative costs, such a program would cost approx $80B over 7 years, which is approx 1.15% per year per first mortgage principal addressed.

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