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Paying Loan Servicers to Modify Loans.

That is the proposal of Christopher Mayer, Edward Morrison, and Tomasz Piskorski, contained in this paper, which has received attention from Congress. The proposal addresses one of the major difficulties posed by the current financial/economic crisis: millions of homeowners with negative equity have a strong incentive to walk away from their homes, leading to foreclosure, which predictably reduces the value of the homes by as much as fifty percent. In the old days, the bank and the homeowner would renegotiate the loans because the bank does better if the homeowner pays off a smaller debt based on something above the foreclosure value, and the homeowner does better if he or she pays less than the payments under the original loan agreement (through lower interest payments, or deferral of payments, or whatever). Today, loan servicers act as agents for thousands of mortgage-backed security holders, who have conflicting interests to the extent that their claims have different levels of seniority. Some readers of my earlier post disputed these assumptions, but the Mayer et al. paper cites the latest academic literature that confirms them.

According to Mayer et al., loan servicers have weak incentives to renegotiate the loans. A loan modification costs between $750 and $1000. Foreclosure costs the loan servicer nothing; it is reimbursed for foreclosure-related expenses under the contract. However, the servicer does continue to receive its fee (typically, 0.25 percent of the balance per year) if it can maintain or renegotiate the loan. A numerical example shows that under (presumably) reasonable assumptions, servicers will often foreclose rather than renegotiate even though renegotiation is in the bondholders' interests. Because they are numerous and dispersed, bondholders cannot, as a practical matter, renegotiate with the loan servicer and pay it to renegotiate when it would otherwise prefer not to.

The proposal has two parts. Like other proposals, including bills in Congress, Mayer et al. would give loan servicers a good-faith defense against suits brought by bondholders. The more distinctive part of the proposal is the use of TARP money to compensate loan servicers for the cost of renegotiation. The government would pay loan servicers an amount equal to ten percent of mortgage payments up to $60 per month, plus an additional amount if the borrower prepays. Only certain types of loans would qualify: privately securitized non-jumbo mortgages. The fees on jumbo mortgages are high enough to compensate servicers for the costs and risks of loan modification.

The proposal can be contrasted with the FDIC proposal, under which the government pays servicers $1,000 for a loan modification that survives for at least six months, and shares fifty percent of the loss if default occurs. The main difference between the two proposals is that the FDIC proposes a flat fee with some protection on the downside, while Mayer et al. give the servicer a share of the upside. That helps align the servicer's incentives with the bondholders' interests. If the bondholders gain, the servicer gains. By contrast, under the FDIC plan, the servicer could in principle gain by agreeing to loan modifications that ultimately fail. Mayer et al. also argue that their proposal is superior to bankruptcy strip-down proposals, which would lead to endless litigation rather than a quick end to the housing/financial/economic crisis.

A few concerns about the Mayer et al. proposal (and readers are invited to give their reactions as well):

1. If it has ex ante effects (that is, creditors expect that in any future financial crisis, the government will do the same), then it will help reinflate a credit and housing bubble. Loan servicers, creditors, and homeowners can divide ex ante the future government bounty. By contrast, loan moratoria, Chapter 13 reform, and the like, should reduce the incentive to extend credit (for better or worse). Think of the way agricultural subsidies are capitalized into the cost of farmland: there is a one-time transfer of wealth, and then a permanent surplus of crops which are pure waste.

2. Mayer et al. criticize the bankruptcy reform proposals for being crude, but their approach is crude as well. Why ten percent capped at $60 per month? Why not lower or higher? The proposal rests on pretty aggressive empirical assumptions about such things as the risk aversion of loan servicers and the likelihood that beneficiaries of renegotiated loans will default. And then there is the question of whether the estimated $10 billion in TARP funds have a better use.

3. Servicers will have an incentive to renegotiate loans even in cases where the homeowner should lose the house. In some places, the foreclosure value of the house will not necessarily be much lower than the market value—for example, in healthy neighborhoods where a homeowner defaults not because housing prices have plummeted but because the homeowner suffers a permanent loss in income. Here, the house should be foreclosed and resold. Instead, the servicer will renegotiate the loan down to a level the homeowner can afford, thanks to the subsidy from the taxpayer. The proposal makes a fetish of foreclosure: we don't want to avoid all foreclosures; we want to reduce the incidence of inefficient foreclosure that results in the loss of home value.

4. Servicers will have an incentive to renegotiate loans even in cases where the homeowner would be able to avoid default without a loan renegotiation. Consider people with low or even negative equity who nonetheless want to stay where they are and possess the wherewithal to make loan payments. The loan servicer would be willing offer the homeowner better terms in return for a loan renegotiation that would enable the loan servicer to claim TARP funds. Perhaps, this behavior would be considered bad faith, creating a risk of litigation by MBS holders. But the loan servicer might be able to avoid the litigation by adjusting the loan only minimally—it would still be entitled to the TARP funds and the MBS holders might think that the cost of litigation exceeds the gain from any remedy.

Real American (mail):
Damn! I knew I should have purchased a house I couldn't afford when I had the chance.
2.4.2009 6:31pm
Francis (mail):
I agree with the diagnosis; I disagree with the cure. As the son of a banking lawyer, I saw the S&L crisis through him. He said then, and says now, that the quickest cure is the one which incurs the most pain upfront and gets it over with. Trying to keep renegotiating loans that are hopelessly underwater is a fool's game. (see, also, Tanta's old posts at Calculated Risk.) Bad banks and bad loans simply have to go bust.

So, if the fair market value of the house is less than the borrower can reasonably afford, then write the loan down to the affordability level in the context of a bankruptcy. (The inconvenience, impact to credit rating, and risk of losing the house should prevent most people from filing bankruptcy in order to game the system.) If it's greater, then foreclose and lease the house back to the former owner at 90% of fair market rent. I'd much rather put a temporary ban on evictions than try to get servicers to do something that they're structurally unprepared to do, and which may have the effect of artificially supporting housing values.

Another way to clear the housing market is to penalize banks (presumably through the tax code) that keep REO inventory on their books more than, say, 12 months. If prices get low enough, people who are renting will once again be able to afford to buy.
2.4.2009 6:49pm
Gabriel McCall (mail):
1. If it has ex ante effects (that is, creditors expect that in any future financial crisis, the government will do the same), then it will help reinflate a credit and housing bubble.

This is one of the biggest problems with government economic interventions of any sort: they encourage future malinvestment.

Any safety net can and will be used as a hammock.

With regard to 3 and 4: Of course there are perverse incentives. The only way I can think to avoid them might be to compensate the loan servicer on the overall performance of an entire portfolio, not any individual transaction.
2.4.2009 6:53pm
ohwilleke:
Loan servicers exist to a great extent because an organization without underwriting authority can operate on autopilot and will "deskilled" employees who cost less to employ, relative to regular banks and loan orginiation companies.

I doubt that loan servicers have the information or the expertise to carry out this function effectively. The big consideration for the servicer is the need to basically create an entire new line of business from scatch, with different employees and different data systems, rather than the marginal costs of individual deals or of lost or gained servicing revenues.

A better approach would be to expand the authority of bond trustees (which almost have bonds have to avoid precisely the collective action problems described) to renegotiate loans in the best interest of the bondholders, notwithstanding a lack of express powers to do so, or express prohibitions on doing so, at least for real property mortgages in states (or some other convenient geographical unit for which data are readily available for almost all jurisdictions) where there has been a signficiant decline in property values.

Such an approach would be consistent with a long line of case law and statutes that disfavor or invalidate restrictions on the alienation of property, and would have better incentives. Loan servicers would be used by bond trustees to communicate with eligible mortgage holders in much the same way that street name stock ownership nominees and brokers without fiduciary authority transmit proxy statements to their customers, the equitable owners of the property.

These bond trustees, in turn, would likely contract with struggling loan origination firms, or with banks, to do the actual loan modification work, which is very similar to the loan origination work that they already do.
2.4.2009 6:53pm
FK:
Real American's posting above ["Damn! I knew I should have purchased a house I couldn't afford when I had the chance"] makes an extremely valid point. What about the responsible individuals who didn't purchase an un-affordable home, or didn't refinance their mortgages to take out a hunk of cash when they might have? The same "financial/economic" crisis has decimated their income and investments, and making mortgage payments is no less difficult. Does anyone believe there will be any relief for those who were prudent, or will this be a case of rewarding only irresponsible behavior?
2.4.2009 7:56pm
wooga:
As a responsible purchaser, I can afford my loan. As a terrible predictor, I bought my home right before the peak. Now, I owe twice what my home is worth. The mortgage holder refuse to negotiate, because they know I will keep paying (I have a good score and perfect payment history). There are also the conflict of interest issues these guys explain in the paper (which are news to me).

In this scenario, it makes financial sense for me to just walk away from the loan - all my mortgage is purchase money, and I'm in a non-recourse state. So it's not just a matter of bailing out bad loans - despite everyone's single minded focus on the irresponsible purchasers.

Until something is done which discourages voluntary foreclosures on "good" loans, property values will keep getting crushed. I'm glad somebody is finally addressing this problem.
2.4.2009 8:52pm
Dick King:
I would like to proffer an idea I've been incubating.

Normally I would say that the reduction of housing prices is not a problem, because what hurts the seller helps the buyer. However....

Part of the problem with the preponderance of houses "upside down" is that people who experience a locally bad labor market can't move to improve their situation, because they don't have enough cash to sell their house. There are alternatives such as walkaways, but that may make buying a replacement house after the move a challange. I don't know how prevalent this problem is -- I don't know how many people are unable to improve their economic situation because an otherwise suitable job that they are otherwise willing to relocate for is out of reach because they are upside down and can't bring money to the closing. However, this blockage is arguably causing loss to the economy. I have a proposal whose costs will be proportional to the benefits, and small compared to those benefits.

How about an amendment to the stimulus plan as follows...

If you meet the following conditions:

1: you have a job offer far enough away to require a move, and

2: your principal residence house is "upside down", and

3: you have an offer to buy that house which would require you to bring money to the closing

then the government will lend you the money you must bring to the closing, with repayment as a 10 year fixed rate fully amortized note, non-dischargible in bankruptcy [like government guaranteed student loans]? This could be done slickly enough and predictably enough that title companies can accept paperwork at the closing. The interest on this loan has the same tax treatment as principal residence mortgage interest.

I realize that the evidence that this problem exists is only anecdotal, but it has the feel of a problem that can suddenly come to exist on an industrial scale, so it would be nice to have the mechanism in place before we need it, and if the problem doesn't actually exist my proposal costs nothing.

The cost to the taxpayer would be that proportion of the loans that doesn't ever get repaid [if the interest rate is comparable to T-bill rates] which I would expect to be relatively modest given that you actually need a connection to the labor force to participate and the senior nature of the debt. How many government insured student loans never get repaid?

-dk
2.4.2009 8:58pm
GD:
Maybe the government should prop up food prices to the same extent it is artificially inflating shelter prices. Oh wait, we do prop up food prices. At least we pay lip service to homelessness and hunger.
2.4.2009 9:01pm
eyesay:
This problem would not exist if each mortgage were owned by exactly one lender. I can understand why banks want to sell some of the mortgages they originate, e.g. for the purposes of geographical diversification. I cannot understand why any one mortgage should be split into parts. Without the practice of splitting loans into parts, the problem goes away. Even if the loan is serviced by a different entity than its owner, the owner and servicer can easily set up whatever arrangements they want on how to renegotiate mortgages with borrowers.

As a matter of public policy, I think we should strongly discourage, if not prohibit, the splitting of mortgages.
2.4.2009 10:08pm
Grover Gardner (mail):
"What about the responsible individuals who didn't purchase an un-affordable home, or didn't refinance their mortgages to take out a hunk of cash when they might have?"

As a "responsible" homeowner, I'm watching the value of my house plummet and my neighbors (nice folks who were just a little in over their heads) disappear. Honestly, do you think I would give a hoot if my neighbors got a break on their mortgage payments if it kept my neighborhood intact and preserved the value of my own property?
2.4.2009 11:19pm
devil's advocate (mail):
Mayer's plan focuses on the disincentives to servicers and not the disincentives to mortgage owners. It ignores the rights of mortgage owners by proposing to outright abrogate contract provisions that Mayer finds inconvenient to his vision.

The idea that servicers must be incentivized is not illogical, but there is immense moral hazard Mayer is ignoring as the servicers have vastly gamed the system already leading me to believe that Eric's concerns that they would game modification incentives are not speculations, but likely outcomes. The servicers orginated these mortgages in the first place and made money selling them. Then they filled their coffers with TARP funds because they are too big to fail -- after all, the servicers are the major banks who got the lions share of the first 350 billion. And now they are praying on dupes like Mayer to get them legal immunity from repurchase guarantees they made in selling thes mortgages promising to buy back any mortgages they modifed. On top of this, where they have been accused of improper practices in origination -- they have settled class action lawsuits by giving away mortgage holders rights rather than their own.

It just seems to me a fundamental disconnect for economists to ignore the parties who brought wealth to the table in the first place in favor of micromanaging these workouts for the purported health of the macro economy while vastly rewarding the parties who least deserve it. Yes, some of those who bought securities were seeking high returns and bought risky investments, and they should not be artificially insulated from the loss, but none of the government money has gone to them, it has all gone to the servicers.

This anti-investor attitude is born out here by eyesays comments opposing loan securitizations. The money lacking from the market right now is the money that was flowing from private investors. If these so-called solutions spook people with money from investing in mortgages, then all the mortgage money will have to come from the government because the banks don't have any!

The fact that models miscalculated risks in the mortgage market is not a reason to oppose securitization. Indeed the idea of parceling the groups of loans in accordance with risk tolerance is a highly sound economic proposition. That the risk taken was too extensive and that the returns in no way aligned with the extent of risk was disguised by government behavior and irrational exuberance. So, as a number have opined here, they should take their medicine, the bubble should burst.

Insofar as bursting the bubble, I have been a proponent of cramdown -- with upside protection for any mortgage holders sustaining a writedown from bankruptcy (I have recommended incorporating aspects of the Zingales proposal Eric posted here)as a longstanding bankruptcy practice that has been the only legislated alternative to foreclosure.

Far from being crude, the bankruptcy process is designed to figure out which loans should be foreclosed and which shouldn't. While it does offer a template for loan modification, that template requires filling in the particulars of the individual circumstance. In traditional cramdown, if the debtor cannot repay a loan crammed down to present market value, i.e. the price the debtor would have to pay to replace the collateral (see ACC v. Rash, 520 US 953) at an interest rate that compensates for taking that present value as a stream of payments (see Till v. SVS, 541 US 465) then there should be no reorganization, there should be a liquidation.

The main downside with cramdown is that certain MBS issues have a poison pill that could send another trillion in paper down the drain. So there may be prudential considerations that could outweigh this otherwise pragmatic approach. But the alternative is not to vacate inconvenient portions of MBS contracts. It is to accept that there is a potential downside to trying too hard to prevent foreclosures.

Brian
2.4.2009 11:24pm
Bruce:
As the authors note, many servicers don't actually have the authority to modify loans, whether they want to or not. That's what makes their second proposal huge:


2) Remove legal constraints that inhibit modification. The federal government should enact legislation that modifies existing securitization contracts. The legislation should eliminate explicit restraints on modification and create a safe harbor from litigation that protects reasonable, good faith modification that raises returns to investors.
2.4.2009 11:41pm
TruePath (mail) (www):
A few comments.

First, I would reiterate the point that foreclosures create negative externalities. Foreclosed properties often stand empty, attract crime and lower the quality of life for those in the surrounding neighborhood. They do this while at the same time letting a nice house that would benefit many people to occupy go unoccupied and fall into disrepair. Thus the same considerations of public benefit that justify government funded parks or condemnations and condemnations justifies interventions to eliminate foreclosures resulting from inefficient market conditions.

Secondly, the goal here is not to somehow reward certain people. Rather it is to emulate the behavior of an efficient market, i.e., somehow counterbalance the large transaction costs and regulatory hurdles that prevent those holding the mortgage security to agree on compromise terms with the person who took out the mortgage. Surely no one thinks the investors who purchased the mortgage backed security should be forced to take a greater loss so the people who took out mortgages they couldn't afford don't get away with it! If you want nothing stops the company managing the mortgage from trashing their credit rating for renegotiating.

Thirdly, currently bankruptcy judges cannot dictate new mortgage terms on a primary residences. Thus bankruptcy does nothing to alleviate the transaction costs involved in getting enough holders of the mortgage security to approve any modification. I'm unconvinced it would be desierable to give judges this power.

The variation between judges in the terms they dictate would serve to increase the difficulty in correctly pricing these mortgage backed securities and it would waste court resources while pulling in all their other financial arrangements into the mix. Moreover, the same transaction costs that prevent the security holders from voluntarily reaching a compromise would likely deprive them of effective representation and the emotional significance of the family home might tempt some judges to hand out windfalls to some debtors. Finally, if permanent, such a change would increase the risk to lenders and increase mortgage rates.

------

Ultimately, I think the government can do far better than the plans I've heard.

1) The government needs to ensure once and for all that institutions holding mortgage securities have no regulatory incentive to avoid maximizing their profit on those securities even if this requires writing down the face value of that security. In other words make sure banks won't run into capitalization hurdles if they recognize the true value of these securities.

I kinda thought TARP was supposed to do this but I'm not sure.

2) The government should create a set of standard modifications to the terms of mortgage backed securities that take effect unless (enough) holders of those securities file written objections. In other words make the people trying to obstruct beneficial deals pay the transaction costs.

3) The government would then induce mortgage services to accept financial instruments that give them both upside and downside interests in the mortgages they service. They would balance the joint risk this would induce by offering them government backed derivatives protecting them against general economic improvements/losses. Indeed, ideally they could actually weight the servicers interests so they take into account the societal costs of foreclosures.
2.5.2009 12:28am
David M. Nieporent (www):
First, I would reiterate the point that foreclosures create negative externalities. Foreclosed properties often stand empty, attract crime and lower the quality of life for those in the surrounding neighborhood. They do this while at the same time letting a nice house that would benefit many people to occupy go unoccupied and fall into disrepair. Thus the same considerations of public benefit that justify government funded parks or condemnations and condemnations justifies interventions to eliminate foreclosures resulting from inefficient market conditions.
On behalf of responsible homeowners in my neighborhood, I hereby offer to, for a small fee, perform necessary upkeep and maintenance on any foreclosed homes near my house. It's a win-win: I get some money, the bank's property does not fall into disrepair before it can sell it, and the schmucks who bought something they couldn't afford don't get a windfall at my expense.
2.5.2009 12:41am
CaDan (mail):
Servicers can't even do the job they were hired to do properly. I have seen numerous foreclosures with incorrect mortgages and notes attached as exhibits.
2.5.2009 12:50am
Rich from Queens:
Only the bankruptcy court has the competancy and power to fairly adjudicate and adjust mortgages, and negotiate modifications, on the scale required. There have been several recent legislative proposals to enable bankruptcy court jurisdiction for mortgage relief. As I've previously posted, I believe an "in rem" bankruptcy procedure as to the mortgage or mortgaged property would allow the homeowner to be treated like a creditor as to its equity, like a "debtor in possession" as to occupancy, and possibly like a source of an "account receivable" on his note as to any part of any deficiency that is not forgiven (in "recourse" states). Mortgages which have been securitized in a particular investment vehicle could be consolidated, and treated akin to a "class action" in such an "in rem" bankruptcy, without the investment vehicle itself being in bankruptcy. Anything short of a court adjudication lends itself to disparities, inequities and inefficient dispositions. We have an existing forum, let's use it.
2.5.2009 9:05am
paul lukasiak (mail):
basically, it sounds to me like the problem is that loan servicers are supposed to act in the interest of bondholders, but don't renegotiate mortgages because there is no upside for them.
_
and the proposed solution is to use tax dollars to provide them with an upside.
_
personally, I'd rather see mortgage servicers provided with greater disincentives for not renegotiating mortgages when necessary in the interests of bondholders. Why should tax dollars go to pay mortgage servicers for doing the job that they are supposed to do?
2.5.2009 10:38am
Oren:
Paul, that's a very reasonably logical way to restructure future servicer-bondholder agreements. Unfortunately, if the current contracts do not provide sufficient incentive, there is little else to do besides externally-provided upsides.
2.5.2009 11:09am
Grover Gardner (mail):
"On behalf of responsible homeowners in my neighborhood, I hereby offer to, for a small fee, perform necessary upkeep and maintenance on any foreclosed homes near my house. It's a win-win: I get some money, the bank's property does not fall into disrepair before it can sell it, and the schmucks who bought something they couldn't afford don't get a windfall at my expense."

Your offer comes a little too late in my case. Thanks to foreclosures, the values on my block are already in steep decline. Volunteering to mow the lawns isn't going to change that. Our neighbors weren't schmucks, they were encouraged to take an ARM when it wasn't in their best interest. They were a two-income household and were doing fine until the higher rates kicked in. The "windfall" you think is such a hardship for you would have been a net benefit in our case. The value of my house would be higher and our daughter would have her friends back. We'd sill have people who dog-sat and kept an eye on our house when we wanted to travel.

You'd begrudge them a chance to refinance and keep their house as a matter of principal because you think it would "cost" you something. That's kind of stupid, IMO.
2.5.2009 11:14am
BGates:
Our neighbors weren't schmucks, they...were doing fine until the higher rates kicked in
When they signed the contract in 2005, did it say "your rates will go up if we elect a guy with an Arabic name president the same year the Patriots go 16-0 and then blow the Super Bowl," or did it say "rates up in 2008"? Because if it's the first one, yeah, bad luck there.
2.5.2009 11:21am
Grover Gardner (mail):

When they signed the contract in 2005, did it say "your rates will go up if we elect a guy with an Arabic name president the same year the Patriots go 16-0 and then blow the Super Bowl," or did it say "rates up in 2008"?


Home values here in Southern Oregon were steadily rising and refinancing an ARM two years down the road seemed like a no-brainer. In fact, when we bought here in February 2007, they were still going up, because people were bailing from No. CA and buying up here. Our appraisal came in higher than what we paid.

I don't really care if you think they made a smart choice in choosing an ARM. I'd rather have them back, even if it means they get a break on their interest rate. Really, what do I care? An empty house selling for two-thirds of what it used to isn't doing us a damn bit of good, that's for sure.
2.5.2009 4:15pm
Dick King:

Our neighbors weren't schmucks, they were encouraged to take an ARM when it wasn't in their best interest. They were a two-income household and were doing fine until the higher rates kicked in.


If the problem is negative externalities, and they were just short a little bit, did any neighbors offer to pay the increase in the mortgage in return for some eventual equity?

-dk
2.5.2009 5:29pm
Grover Gardner (mail):
"If the problem is negative externalities, and they were just short a little bit, did any neighbors offer to pay the increase in the mortgage in return for some eventual equity?"

That's a fair question. I think the answer in this case is that people tend to keep these things secret out of embarrassment, and we didn't know they were about to loose the house until things were very far gone. And with a bump up of $600-700 a month in the payments, help was not something people in my neighborhood could have managed to sustain in the long run. At some point, they would have had to find a solution to bring the payments back down to a level they could afford.

If I'd had enough money, I could have offered to loan them enough to pay down the mortgage to the extent that they could refinance. But with the steep decline in values, we'd be talking $20-30,000 or more, which is not something I have lying around. Possibly if I'd had a spare $700 a month I might have considered investing in a way that would guarantee repayment or equity in the property. But I don't.

So of course, that leaves me open to criticisms of wanting to pass the problem off to someone else, like the mortgage company. And that's probably a fair jibe. I'm not saying that what happened to them was wrong or even unfair. But if they'd been able to cut a deal to refinance, or sought government assistance, I wouldn't have been *indignant* that they had gotten a break. I think the problem is too widespread and systemic to be considered just singular bad luck or poor judgement.
2.5.2009 11:23pm
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2.13.2009 7:53pm

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