Megan McArdle Uses Straw Men to Argue Against Principal Mods

Megan McArdle Uses Straw Men to Argue Against Principal Mods

Megan McArdle has a post up discussing why she thinks the benefits of principal mods would be “at best small and mixed”. The problem with her lengthy discussion is that it is rife with straw men. Before we get to the nitty gritty, I want address two bits of framing at the top which I found troubling. The first was the title, “Principal Write-Downs Still Popular With Wonks”. The “still” suggests that wonks like it even though some, presumably most, yet to be named others don’t. And singling out “wonks” further implies that (aside from homeowners) they may be its only fans. That is very misleading. Who is in favor of mods? The only people who under normal circumstances ought to have a vote on this matter, namely, the borrowers and the lenders. First mortgage lenders overwhelmingly favor mods to borrowers with who still have a viable income. Why? Do the math: Foreclosures are now running loss severities of 70% or higher. “Loss severity” means “loss as a percent of principal balance”, and it almost always is stated in terms of the original principal balance. So foreclosures result in really big losses. And this is only going to get worse: –More borrowers are challenging foreclosures based on standing – More judges are sympathetic to borrower arguments, so cases go more rounds and incur more costs – Housing values are still falling in most localities; the overhang of foreclosure inventory only makes it worse – Banks are destroying value of REO with failure to secure and maintain properties (a lot of reports on this, with very large falls in value) Investors would take 30-50% writedowns for borrowers with adequate income all day. This is a complete no brainer. The only investors who’d be against it are the ones holding tranches that are effectively interest only, the bottom tranche still getting payments. These are generally a small percent of value of the deal and often bought by speculators. The prototype of this sort of investor is Carrington Mortgage. It was affiliated with New Century and is now servicing many of their loans. They have been making out like thieves by as owners of the residual or low rated tranches by buying the for pennies on the dollar, and then delaying foreclosures and the recognition of principal loss, allowing them to collect much more in interest payments. The reason policy bottom fishers can have undue influence is that mortgage securitizations are what Anna Gelpern and Adam Levitin have called “Frankenstein contracts.” They are effectively “immutable contracts” and the authors make clear why this is a disastrous development. Tom Adams elaborates as to why these rigid contracts aren’t working now: Regarding securitizations being contractually flawed: one reason this is so, under the current environment: securitization relied in part on issuers having skin in the game either through an investment in the residual (while retaining the servicing rights) or through the desire for continued access to the capital markets. Since most of these issuers/lenders have blown up and the residuals have long since been written down to zero, these incentives no longer work to keep servicers honest. In addition, servicing is now light years more expensive than anyone ever thought it could be, so the servicers now have a huge, new incentive to recoup costs or pass the costs along to another party, such as the investors or homeowners. This is exactly the same set of circumstances that got Fairbanks to engage in widespread abuses that got it into trouble with the FTC – since they were a stand alone servicer of distressed loans and were unable to cover the costs of running their business from their fees. This takes us to the second bit of framing in the piece, which again occurs at the top. McArdle quotes Tyler Cowen (a designated wonk, we presume) as making the best case for principal mods. Huh? It’s not much of a “pro” case: it starts with a rant about how principal mods are “WRONG” and “terrible for the long run rule of law” and “EVIL” and “UNFAIR” (in fairness, McArdle says she does not think principal mods are “particularly evil”). Gee, Mrs. Lincoln, and aside from that, how was the play? Now I must confess I do not read McArdle and Cowen often enough to be certain, so readers should correct me if I am wrong, but I strongly suspect their concerns about the rule of law were and are notably absent when the idea of modifying other types of contracts, like union pension agreements, comes up. Or when banks fabricate documents when they have trouble proving standing (one of numerous examples: a bank produced two different purported “wet ink” signature, meaning original, borrower notes, hat tip Lisa Epstein). Now if those who raise the rule of law question were consistent about it, they’d also be up in arms about foreclosure fraud, bogus servicer charges (as we’ve indicated repeatedly, a much bigger culprit than is widely acknowledged), the lack of meaningful punishments for Wall Street executives and key profit center managers (or more generally, that banking has now become institutionalized looting as described by Akerlof and Romer). The societal fish tends to rot from the head, and worrying about a prospective breakdown of morality among little people seems awfully misplaced when we have numerous actual and likely examples among their betters. The fact is that modifying contracts is normal. Period. Before the era of securitization, when banks were lenders, they would routinely modify a mortgage if the borrower still had a predictable income that was not insanely below his former income level (or if he’d had a crisis, like a medical emergency, and they needed to figure out how to accommodate a new level of expenses). And they were even modifying them in the era of securitization. At the 2008 Milken conference, Lew Ranieri, the father of mortgage backed securities, was stunned to learn that servicers were not doing mods and using the contracts as excuses. He said they always did mods in his day. When a loan goes bad, the first thing a creditor looks into is a debt restructuring. Half a loan is always better than none. It’s funny that a non-wonk like Wilbur Ross, who is the antithesis of a charity or a borrower advocate, is a fan of deep principal mods. And we are told that banking turnaround expert and investors Chris Flowers in IndyMac has developed an effective template for principal mods. Now let us get to the straw men. The first is the argument that the mods in the past haven’t done well. Again, what mods is she looking at? HAMP is not a valid sample, for a whole bunch of reasons: borrowers told they’d were getting a mod, then hit with all sort of late and payment make-up fees; repeated loss of documentation by the bank, which was often instead described as the borrower not meeting program standards; borrowers incorrectly told to default to qualify; bad incentives in program design (the formula favored borrowers who were deeply underwater, yet offered only five year payment reduction mods). You can only look to examples of deep principal mods to reach conclusions about the success of deep principal mods. And the admittedly limited number of current practitioners, plus the historical record, suggest that actually the results ain’t so bad. The second straw man is the idea that mods will reduce the availability of mortgages. In case she hasn’t noticed, the non-government-guaranteed mortgage market is just about dead. And one big reason in many areas of the country is the overhang of foreclosures, both ones in process but not completed, and anticipated foreclosures. Foreclosures continued to drive prices down, hurting both delinquent and current borrowers. No lender wants to risk catching the safe of falling real estate values. In addition, all sorts of other credit products are routinely written down, from car loans to commercial real estates to credit cards. Another straw man is her assumed 20% reduction assumption, which she estimates will have too small an impact on household budgets to make a difference. As I indicated earlier, a figure double that level will still leave investors considerably better off than foreclosures. Moreover, the mod levels discussed are usually of first mortgages. A second lien on a deeply underwater house should be written off (they would be wiped out in a foreclosure). But instead, because the second lien holder often blocks a mod on the first. So a regime that forced seconds to recognize economic losses would also result in greater payment reductions for some borrowers than just the level of the mod of the first. She finally assumes a Chapter 13 bankruptcy regime as the only way to push this sort of program through. Why? Adam Levitin was involved in presenting an idea to the officialdom called Chapter M, which would provide for principal write-downs as part of a streamlined, mortgage-only bankruptcy process. The key points: Create a special prepackaged, streamlined mortgage bankruptcy chapter that does not affect non-mortgage debt. All foreclosure actions are automatically removed from state court to federal bankruptcy court. The foreclosure is adjudicated in federal bankruptcy court under standardized, streamlined procedures. Homeowner and lender both required to make evidentiary showings: homeowner must document ability to pay; lender must document title to note and mortgage, but with validity of securitization transfers conclusively presumed. Limited rights of appeal. If homeowner is willing and able to pay, then homeowner keeps the house. Fresh appraisal done by court-appointed appraiser. Lender chooses between an FHA short-refi with principal reduced to [90]% of LTV or a standardized loan modification with principal reduced to 100% LTV and loan restructured to 30-year fixed-rate, full amortization, market interest rate adjusted to ensure maximum [31]% DTI ratio), with 50% risk-weighting for modified loans. Court validates lenders’ title to mortgage. Junior liens exceeding LTV cut-offs are eliminated If the homeowner redefaults, an expedited, standardized federal foreclosure procedure is used ([45] days to sale), with limited defenses and clear title imparted by sale by bankruptcy trustee. If homeowner does not qualify, lender gets same fast-tracked federal foreclosure and quiet title coming out of the foreclosure sale. If lender cannot show title, homeowner gets quiet title to property. In all situations, the homeowner’s non-mortgage debts “ride-thru” the Chapter M bankruptcy, unaffected, but the homeowner could also file for a traditional Chapter 7 or 13 bankruptcy to address those debts. The last reason her Chapter 13 issues are a straw man is that the existence of a regime that could impose principal writedowns will force servicers to the negotiating table. You see analogous behavior on credit cards. If a borrower gets an attorney or accountant involved in the conversation with the bank (so that a professional is effectively vouching for the borrower representations regarding his income and assets), the bank gets the message that the customer can and just might file for Chapter 7 or 13; and the bank won’t get much, plus it will be faced with court costs and delays. The thread of bankruptcy makes the bank much more willing to negotiate. In the HAMP program, the Treasury tried to promote mods by offering carrots to the banks; the result was horseshit. It seems clear that a few sticks are now required.