by hilzoy
The House seems to have postponed action on mortgage cramdowns until tomorrow, which gives all of us one more day to contact our Representatives and let them know our views. The best post I know of on this topic is from Tanta; this discussion in Business Week is also good. Here's my take:
HR 1106 would allow judges to modify the terms of mortgages in bankruptcy. Presently, judges can do this to all other forms of secured debt, and to mortgages on houses that are not the debtor's primary residence. They could do it to these mortgages as well until 1993 in many parts of the country. This bill would not put mortgages for primary residences on a par with other unsecured debt, though: for instance, it would require that the mortgage be in foreclosure. (I think this is a mistake.)
There are two main arguments against mortgage cramdowns. The first is that, according to banks, it would make future mortgages more expensive. Tanta disagrees, as do Jason Kilbourne at Credit Slips and others:
"Not everyone accepts the Mortgage Bankers Association's math, however. 'The M.B.A.'s number is kind of hokum,' said Adam J. Levitin, who teaches bankruptcy law at Georgetown University. After recently analyzing loan data from 1978 to 1993, he found that interest rates did not rise in areas where cram-downs were common."
The second argument is that it would reward lenders borrowers (oops!) who took out irresponsible loans, which would be bad in its own right, and because it would create moral hazard. It's worth noting exactly what the bill does: it would allow mortgages to be written down if they are already in foreclosure, but only if there was no fraud involved, and if the resulting plan is one that the debtor could reasonably be expected to actually pay. According to this statement (pdf) from the Center for Responsible Lending, and my rather inadequate attempts to read the bankruptcy code, the mortgage could not be written down below the present value of the property, and the amount by which it was written down would be recaptured as unsecured debt. (I don't know bankruptcy law well enough to check these claims; any illumination would be welcome.) Moreover, if the borrower sold the home for more than the new, written-down value during the next five years, s/he would have to share any proceeds with the lender. The combination of (a) a prohibition on writing the mortgage down below the value of the home and (b) the requirement that a plan be one the debtor could reasonably be expected to pay means that people who took out truly outrageous loans will probably not qualify.
Besides that, when someone takes out a mortgage that they should never have been able to take out, that person is not the only one to blame, and not the only party whose moral hazard should concern us. Lenders made loans they should never have made. People bought securities based on these mortgages that they should never have bought. Moreover, these people, unlike your average borrower, are professionals whose job it is to know how to make responsible decisions about things like this. It is true that people ought to pay their debts, but it is also true that when businesses make stupid decisions, they should live with the consequences.
Cramdowns inflict losses on the people who hold the mortgage. But bankruptcy inflicts losses on the person who took it out. Moral hazard is less of a concern when you have to suffer some ghastly fate in order to get the benefit that supposedly creates the hazard. This is why I wouldn't really be worried that paying for chemotherapy would create moral hazard: you have to get cancer in order to get this payment, and both cancer and chemotherapy are sufficiently dreadful that it's hard to imagine anyone thinking: hey, now that my chemo will be paid for, I don't need to worry about getting cancer! Same here: you need to declare bankruptcy in order to get this benefit, and that mitigates my concerns about moral hazard — especially since, as noted above, there seem to be real limits on how much courts can write loans down.
On the other hand, I worry a lot about the moral hazard of letting people who are paid to understand mortgages and loans make irresponsible decisions. As things stand, if I buy a mortgage on a primary residence that I should have known the borrower would never be able to pay, I am still entitled to payment in full, even if the borrower declares bankruptcy. I therefore have less reason to scrutinize that loan than I would have if I were, say, buying corporate debt. Providing people who make, securitize, and buy mortgages with more incentive to scrutinize the credit-worthiness of borrowers seems to me like a good thing.
***
There are two more general factors that make me think this is a really good idea. The first is that everyone in this country has too much debt. We need to find some way of reducing it that does not reward stupidity too much. Mortgage cramdowns, which borrowers can access only by going through bankruptcy, and only if they will be able, under bankruptcy, to afford their house at its present value, seem to me a good way to do that.
The second is more speculative. Consider this question: why, exactly, are banks so opposed to mortgage cramdowns? By all accounts, taking over properties in foreclosure is not good for them: the properties lose a lot of their value, and banks are not really set up to be in the real estate business. Cramdowns would remove the need for a considerable number of foreclosures while ensuring that banks still get the present value of the house, which is probably the most they could get if they took it over and sold it themselves. So what's the problem?
I had my suspicions, but didn't know enough about accounting procedures to know whether or not they were right. However, Business Week attributes my theory to people who do:
"A major reason financial institutions and investors are so determined to avoid modifying loan terms more aggressively has to do with accounting nuances, say industry lobbyists. If, for example, a bank lowered the balance of a certain mortgage, there would be a strong argument that it would have to reduce the value on its balance sheet of all similar mortgages in the same geographic area to reflect the danger that the region had hit an economic slump. Under this stringent approach, financial industry mortgage-related losses could far surpass even the grim $1.1 trillion estimated by Goldman
Sachs (GS) in January. A desire to postpone this devastating situation helps explain lenders' intransigence, says Rick Sharga, vice-president of marketing at RealtyTrac, an Irvine (Calif.) firm that analyzes foreclosure patterns."
If this is right, then banks are afraid that allowing bankruptcy judges to reset mortgages to the present value of homes would force them to reduce the value of similar mortgages. That is: it might force them to admit losses they have been trying to paper over. And the word "admit" is crucial here: these would not be losses caused by cramdowns; they would be losses that banks have already incurred, and are trying to paper over.
This is a good reason for banks to resist cramdowns. But it's a really good reason for the rest of us to support them. We need banks to admit the full extent of their losses. The banking system will not return to normal as long as people worry about the unexploded bombs that might be lurking on banks' balance sheets. If a bank is basically sound, we can recapitalize it. If not, we should put it out of its misery. The sooner we figure out which is which, once and for all, the better. And if mortgage cramdowns will help, all the more reason to support them.
Sent my request to my rep, though she is a Republican and will probably vote against it.
Even talking to the banks right now, they are basically requiring you to play chicken by falling far enough behind on your payments to allow greater modification options, but no so far behind that you can’t catch up again after the penalties.
Knowledge is power and that is why there was very little reporting done by the Republican-owned media, that it was George Bush who pushed for minority home buying…. not Clinton as they love to distort about and gave Speculators the go ahead to get minorities to buy homes in the hundreds of thousands.
Source: Dateline: 06/18/02
“Calling a home the “foundation for families and a source of stability for communities,” President Bush has proposed three new initiatives designed to enhance existing federal home buyer assistance programs by helping African- and Hispanic-Americans buy homes. According to the White House, fewer than half of all African and Hispanic Americans currently own their homes, compared to nearly three-fourths of white Americans. “We must begin to close this homeownership gap by dismantling the barriers that prevent minorities from owning a piece of the American dream,” said the President in a nationwide radio address. To close the homeownership gap, President Bush proposed legislation funding the following new initiatives:
American Dream Down Payment Fund
This program would provide money to qualified low-income families to assist in making the down payment on a home. “The single greatest hurdle to first time homeownership is a high down payment requirement that can put a home out of reach,” said President Bush. White House analysts estimate that the American Dream Fund will assist some 40,000 low-income families annually in making down payments on homes.
Tax Credits to Create Affordable Housing
This proposed initiative would provide home-builders and developers with nearly $2.4 billion in tax credits for building affordable single-family housing in distressed areas. The tax credits would help make 200,000 new affordable homes available to low-income buyers over the next five years.
Home Buyer Education
To assist home buyers deal with the complexity and difficulty of the purchasing process, this program would provide funds to agencies working to better educated first-time home buyers. Consumers would be advised of their rights and responsibilities as home buyers, and trained to recognize and avoid abusive and unscrupulous lending practices. “Financial education and housing counseling can help protect home buyers against abuses, greatly improve the loan terms they are offered, and help families get through tough times with their homes intact,” said President Bush “Owning a home lies at the heart of the American dream,” Bush said. “My approach to broadening home ownership focuses on empowering people to help themselves and to help one another.”
http://usgovinfo.about.com/library/weekly/aa061902a.htm
And because there were no Regulations to protect said homebuyers who had a balloon interest at the end, well we see what has happened, and they still want to blame the homebuyers instead of the scam perpetrated by lenders who first lowered interest rates to put people into homes then raised their interest rates so they could no longer afford their homes. Someone should go to jail for this!
A lot of smart people agree with you.
Along with everyone else I have been trying to make sense of what’s happening for the last six months. Every time I think I have a grip, another layer comes off the onion and I have to keep going. (It’s really like peeling an onion… the more you do it the more you get tears in your eyes.)
I put up a post that may be helpful regarding “cramdowns.” Apparently there is a group caught in the middle called “servicers” who typically do little more than shuffle paper. But securitization of debts has made their task unbelievably complex. I heard somewhere that part of the stimulus bill designated funds to compensate loan servicers for un-threading thousands of needles.
Elizabeth Warren’s interview with Terry Gross in December was the most instructive half hour I have found helping clarify part of the mess.
Maybe what we need is a return to lending only to people with established employment and good credit histories. If that kind of rule has an unintended but disproportionate impact on a particular group or class–I don’t know if this is the case, I am simply surmising–then we would have to agree as a country to live with that unintended consequence.
What I don’t understand about this cramdown business is why the amount of the cramdown isn’t simply treated as a second lien against the home, and bearing interest at market rates for second liens, that is payable if and when the home is sold and only if there are sufficient proceeds from the sale to pay the second lien, regardless of when the home sells. In that fashion, the banks can perhaps keep the balance sheets looking a bit healthier and the buyer doesn’t benefit from his/her bankruptcy.
If this is right, then banks are afraid that allowing bankruptcy judges to reset mortgages to the present value of homes would force them to reduce the value of similar mortgages. That is: it might force them to admit losses they have been trying to paper over. And the word “admit” is crucial here: these would not be losses caused by cramdowns; they would be losses that banks have already incurred, and are trying to paper over.
It is amazing how pervasive this sort of thing is. We have had problems in the past with accounting for option awards, with mark-to-market rules, with “off-balance-sheet entities,” and now this. Accounting rules that allow the concealment of losses and expenses are dysfunctional.
Can someone make these people produce accurate financials?
“then we would have to agree as a country to live with that unintended consequence”
It’s like the conservative version of kumbaya!
What I don’t understand about this cramdown business is why the amount of the cramdown isn’t simply treated as a second lien against the home…
My understanding is that the problem lies with the terms and conditions of the original mortgage. ARM’s are, as the name says, “adjustable.” Depending on various types, those original mortgages are financial ticking bombs that no second lien can cover. What is being called by that disgusting term “cramdown” represents replacing the first mortgage with another one with terms likely to be met.
Mortgages are evaluated by banks and accounting methods in several ways. The “yield to maturity” valuation presumes the terms will be met in every detail, which means top dollar value.
Under the best of conditions mortgages might be evaluated at 90% of their “yield to maturity” valuation due to early payoffs and a statistical likelihood of defaults, even in the best of times. Financial people use terms like “mark to 90” or “mark to 80” meaning less than the full valuation yield if the loan ran to maturity with no interference.
When times get tight terms like “mark to market” get used, meaning although the full value on paper might look good, the reality of the marketplace makes that a long shot. And in today’s market, no one knows what is a realistic assessment because so many places are up for sale that a buyer can often get property for forty cents on the dollar.
The further you dig the worse it gets, and conditions change from one neighborhood, town or state to another, so there is no reliable yardstick. It is for this reason that bankruptcy judges have been given the power to “cram” terms down the throats of unwilling lenders AND borrowers in what seems to be still an Augean task.
And don’t forget that after new terms are set those who “service” the loans must then trace the sliced and packaged threads back up the trail of “securitized” instruments and furnish a multitude of unhappy “investors” news that a few more grains of sand in their buckets just spilled out.
The second argument is that it would reward
lendersborrowers [my edit-TLT] who took out irresponsible loans, which would be bad in its own right, and because it would create moral hazard.hilzoy, this is a very good post but there are some typos in it. The most significant one IMHO is in the 4th paragraph, where you wrote lenders but I think you meant borrowers.
Maybe what we need is a return to lending only to people with established employment and good credit histories.
That is a good step but not sufficient to fix the problem, because it only takes care of 2 out of the 3 C’s (Capacity, Creditworthiness, Collateral). Tanta put up a pair of posts explaining the Three C’s and how they relate to the prime, subprime and Alt-A loan pools here and here. These should be required reading in any discussion involving the practicalities of loan performance and associated moral hazards.
In order to keep default rates low we need all 3 legs of the 3 C’s stool to be solid, not just 1 or 2 of them.
Cramdowns aren’t just about getting the individual borrowers into a position where they have a plausible chance to continue servicing their loans. Cramdowns also have the additional benefit of restructuring these loans so they are in line with the actual market value of the collateral. If we don’t do that there will continue to be performance problems with these loans (that should have been crammed down but weren’t) and with the asset valuations based on them, because they will continue to overstate the value of the collateral which is backing them up. Part of the point of cramdowns is recognizing financial reality and getting good data back into the financial system rather than sticking our collective fingers in our ears and saying “La-la-la-I-Can’t-Hear-You” hoping the problem will just go away.
The key problem is identified in the last 2 paragraphs of hilzoy’s top level post – cramming down mortgages will put downward pressure on market comps, which will effect the MtM value of any pool of loans against homes in the same neighborhood, so the financial interests of multiple lenders are at stake in the restructuring of every single loan.
This is a “everybody is in the same lifeboat” problem, and thus all of the banks need to be brought on board to support this process. We can’t just deal with them in a piecemeal fashion or there will be chaos in trying to sort out whose asset backed paper is marked down in what fashion based on which data and when.
Or maybe we could take that as a sign that we need to do something about the underlying conditions that create the disparity. If some social groups- say, ethic or religious minorities- have an especially hard time maintaining regular employment, that’s a serious problem that needs to be addressed.
mckinneytexas: Maybe what we need is a return to lending only to people with established employment and good credit histories. If that kind of rule has an unintended but disproportionate impact on a particular group or class–I don’t know if this is the case, I am simply surmising–then we would have to agree as a country to live with that unintended consequence.
Roger Moore: Or maybe we could take that as a sign that we need to do something about the underlying conditions that create the disparity. If some social groups- say, ethic or religious minorities- have an especially hard time maintaining regular employment, that’s a serious problem that needs to be addressed.
Or both. These things are separate and not mutually exclusive.
ditto what hairshirthedonist said above.
Semi-OnTopic, more fecal material approaches the rotating blades:
Small/Medium banks are in revolt over a proposed FDIC plan to raise fees, or risk running short of insurance funds:
Our banking system is turning into the fiscal equivalent of The Raft of the Medusa
If this is right, then banks are afraid that allowing bankruptcy judges to reset mortgages to the present value of homes would force them to reduce the value of similar mortgages. That is: it might force them to admit losses they have been trying to paper over. And the word “admit” is crucial here: these would not be losses caused by cramdowns; they would be losses that banks have already incurred, and are trying to paper over.
It’s looney that the business world will treat the numbers on a balance sheet as more real than what the numbers are supposed to inform us about — the health of the business. One sees/hears this a lot, and it’s looney.