Paying Loan Servicers to Modify Loans: Mayer, Morrison, and Piskorski reply

to my comments (in italics) on their proposal:

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).

First, we think you are criticizing TARP, not necessarily our proposal. TARP could generate ex ante effects of this sort, if you believe (which we do not) that the government is likely to spend this kind of money again. Also, we don't need to rely on TARP. Our original draft relied on an industry tax, but this would likely cause further damage to the industry when it is already receiving government help. We settled on TARP funds because we want a plan that can be implemented quickly and want to limit the waste of these funds on other proposals such as Hope for Homeowners and the FDIC plan proposed by Sheila Bair.

Second, loan moratoria would only prolong the current crisis; the last thing we want to do right now is restrict the supply of credit.

Third, if you want to restrict lending, we don't need Chapter 13 reform. Given recent experience, future lenders will be naturally more cautious in offering credit, with or without changes to bankruptcy law.

Fourth, our proposal corrects a well-defined market failure (badly-written servicing contracts) and, by its very nature, is a temporary intervention. Changes to the bankruptcy code would have permanent, unintended consequences.

Put differently, while the ex ante effects of our proposal are highly speculative, the welfare losses from bankruptcy cramdown are real and documented.

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 $9 billion in TARP funds have a better use.

We computed our Incentive Fee to mimic the fee earned by existing servicers who are successfully modifying mortgages. Also, please take a look at our cost-benefit analysis in Appendices 2 and 4 of our proposal. The empirical assumptions may seem aggressive to you, but they are fairly conservative and (importantly) were checked by many market participants.

Our litigation safe harbor should address your risk-aversion concerns.

Finally, your last point (about better uses of TARP) is a critique of TARP, not our proposal. If the $9 billion is going to be spent, how would you spend it?

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.

Your hypothetical doesn't track our proposal. Under it, a servicer is incentivized to modify a loan only if modification generates a greater recovery to investors than foreclosure. Your hypothetical is just the opposite: it is a case where modification generates a lower recovery to investors than foreclosure. Your servicer is acting contrary to investor interest and opening itself to lawsuits. This servicer would not be protected by our litigation safe harbor.

Perhaps you are thinking that there will be no lawsuit, because investors and servicers will split the booty. If that kind of coordination were possible, we wouldn't have inefficient foreclosures in the first place. Put differently, your critique is valid only in a world without coordination failures and transaction costs.

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.

This critique misunderstands our proposal. Our Incentive Fee does not depend on whether a loan is modified or not. A servicer receives an Incentive Fee for _every_ loan being serviced. The Fee continues to be paid until either (1) our program expires or (2) the loan goes to foreclosure. So a servicer will never be tempted to modify a loan when there is no risk of default. That would be a self-inflicted wound: the servicer would be reducing monthly payments by the borrower and, as a result, lowering its own Incentive Fee. Moreover, modification isn't free. No servicer will invest up to $1,000 to modify a loan that needs no modification.

Our proposal should be contrasted with the FDIC plan, put forth by Sheila Bair. That plan offers $1,000 to servicers for every loan that is modified in a specified way. The FDIC plan, not ours, makes a "fetish of foreclosure," because it encourages too many modifications.

Note also that our plan avoids micromanaging the modification process. We leave the choice—foreclose, modify a little, modify a lot, or don't modify at all—in the hands of the servicer, who is incentivized to keep loans ongoing and modify only when modification is better than foreclosure for investors.

In a world where something is going to be done by Congress, we are trying to find an alternative that does the most good at the lowest cost. Doing nothing is not an option, at least from the perspective of Congress, and from our perspective too.

BobVDV2 (mail):
Title VII of the stimulus bill (the Nelson-Collins compromise version found here) provides that Treasury shall develop a plan "within 15 days of enactment" for loan modification, and directs $50 billion of TARP funds to carry out that plan. Someone should send copies of this blog conversation to the Treasury official who will hold the $50 billion checkbook.
2.9.2009 10:50am
One issue that often gets overlooked is the fact many of the suspect mortgages are covered by private mortgage insurance (PMI). The way these policies are written, if the homeowner defaults, the PMI company must pay out to the servicer the full amount that the homeowner owed on the loan. However, if the loan is voluntarily modified (or crammed down under applicable law), there is no default, and no insurance recovery for the amount modified or crammed down.

The end result is that the servicers can actually recoup more money from a default than they can from a modfication, thus disincentivizing modifications. Of course, if the insurance company can't pay either, then the point becomes moot.
2.9.2009 10:52am
BobVDV2 (mail):
Title VIII of the same bill also provides for fees of up to $2000 per servicer. Would this enact the Mayer, Morrison, and Piskorski plan?
2.9.2009 10:53am
Jon Roland (mail) (www):
The intelligent response to the meltdown, which is really a collapse of a standard of living bubble, is to try to find ways to bring down the standard of living to the point where it would have been without the bubble, but without the overshoot to a much lower level that would be truly disastrous. What our leaders are actually doing, however, is seeking ways to prop up that standard of living at a level that we can now see is unsustainable. None of them want to admit that the United States is going to have to revert to a standard of living closer to that of Mexico or India.

Let us consider what this means, for example, for private housing. The price, and cost to build, a typical 1500 sq. ft. 3 bedroom 1 bath house in 1950 was about $6000 in 1950 dollars. Adjusted for inflation, with additional sq. feet and a second bathroom, that would have been about $150,000 in 2007, but it would likely have sold for three times that amount. The old rule of thumb from the early postwar era was that one should not spend more than a quarter of one's earnings on housing, including mortgage service, insurance, taxes, and utilities. With "normal" interest rates at about 5%, that would peg housing prices at a fraction of their 2007 levels. It was also a rule of thumb that it should always be possible to buy a house on credit and rent it at a profit at current market rates. That hasn't been possible for some time now.

So what we need to do in just the housing (and construction) market (never mind transportation and other fields), is to write down prices and debts to their inflation-adjusted 1950 levels. (And most of our 3000+ sq. ft. houses are going to need to be converted to house two or more families.) Future houses will need to be built smaller, with smaller rooms, and smaller or nonexistent yards.

The problem is how to write down prices and debt, as well as replacement costs, in this way, wkith the least damage. It would be the greatest deflation in history, but the alternative, if we keep trying to sustain an unsustainable level of consumption, will be the greatest inflation in history. Both will take down most of our private and many of our public institutions.

Education will revert to online training. Medical care will revert to self-care and family care. Banks and money will revert to barter. People will build their own houses as they can scrounge the materials. Perhaps one person in a neighborhood will own a car he will use to taxi his neighbors, and he will have to do his own repairs. Civil litigation will become too expensive for anyone, and corrupt courts will throw people into prisons in which the prisoners rely on their families to bring them food.

I just got back from a visit to Mexico. If you want to get a sense of the future, spend some time there.
2.9.2009 11:00am
Avatar (mail):
Roland, er... what are you smoking? There are plenty of markets in the US where you can get a five-bedroom house for the $150k you cite. We don't all live in California!

The additional costs of housing aren't because they're that much bigger; it's not THAT much more expensive to build in an extra bedroom if you're building a house to start with, and there's significant additional utility there. Nor are you necessarily having to buy additional property; very few people buy a house that sits on their entire property, after all.

Why, I ask, is it essential that we reach significantly greater population densities? As it is, we've got plenty of land to work with.

Nor does the rest of your comment follow from the beginning. Not really any comment on that; I guess some people enjoy spinning disaster scenarios.
2.9.2009 1:47pm
paul lukasiak (mail):
I have a hard time justifying any money going to do what mortgage servicers should be doing on their own dime -- modifying mortgages in a way that maximizes the value of the mortgages in question.
If it costs $1000 to do the paperwork necessary to modify a mortgage, and that prevents foreclosure that would cost the mortgage holders $2000, I don't see why we should pay for the modification (especially when fees and points were already assessed when the mortgage was initiated the first time; if they screwed up then, why shouldn't they pay for their own mistakes?)
IMHO, there should be additional disincentives to not modifying mortgages aimed at the mortgage servicing industry. I suspect that they collect fees regardless of what happens to the mortgage -- and get a nice big fee for "managing" defaults and foreclosures. If there is any financial incentive for mortgage servicers to not modify these loans, those incentives should be eliminated immediately.
2.9.2009 3:01pm
Dan Weber (www):
I have a hard time justifying any money going to do what mortgage servicers should be doing on their own dime -- modifying mortgages in a way that maximizes the value of the mortgages in question.

Modification benefits some of the bondholders, but penalizes others. With all those tranches it gets complicated. Forcing foreclosure might even be written into the contracts to make those decisions easy.

Even if there isn't, I don't think there is some guiding principle that says which stakeholders need to be placed over others. I've seen all sorts of chicanery happen a million times in small VC funded firms -- the company gets sold off at an amount that precisely matches the amount needed to make whole some preferred class of shareholder, and the deeper tranches get squat. Oh, and the BoD was majority composed of people working for those preferred shareholders. Just a coincidence.

The VC community doesn't think this behavior is obviously illegal (or else no one has ever called them on it). I don't expect the loan servicers are so noble as to lower their own revenues to fulfill some regulatory goal that cannot even be shown to exist.
2.9.2009 6:07pm
A quick and dirty (and certainly unconstitutional at the fed level) solution would be to declare all mortgages that exceed 150% of the assessed value of a home as "unconscionable" and unenforceable. "Mortgage" would be defined as the lump some of all mortgages on the home.

That should force banks to write down loans immediately to reasonable amounts. You could either obliterate the second mortgages, or require some sort of proportional write down of all mortgages on the property.

If people owe close to the value of their home in their mortgages, they have an incentive to try to keep the home. In contrast, the severely upside down people lack such an incentive, which means they will continue to foreclose regardless of any rate changes.

It is unfortunate that Mayer, Morrison, and Piskorski dismiss this issue out of hand in response to Posner's point #4 ("No servicer will invest up to $1,000 to modify a loan that needs no modification.") There are many, many loans which technically don't "need" modification since the borrower has the wherewithal to continue making payments. But that doesn't mean the borrower will actually continue to make payments (ie, nonrecourse states like California). Aside from the kindness of the upside down borrower, what in the world is preventing them from just walking away, creating an unstoppable downward price spiral? That will be much worse than the recent bubble deflating.
2.9.2009 6:53pm

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