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A Few More Thoughts on Subprime Rescue Plan

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The Wall Street Journal’s page one story, “Rate Plan Has Skeptics, Fans,” offers little new information about the substance of the program (not surprising) but gives mainly positive reviews.

In case readers somehow haven’t figured it out, I believe this program to be a Bad Idea in any form, although some variants could be worse than others. Since we don’t have the details yet, I’ll limit myself to a few obvious objections that are inherent to any plan along these lines.

Just to be clear: I am not against helping borrowers, particularly borrowers that were defrauded by being told they were getting one set of terms and finding out much to their horror that they had signed up for something different. But this program does not address that problem. Similarly, I recognize that it is generally better to restructure loans if the borrower has reasonable ability to repay, rather than foreclose.

First, and I am surprised the business media has not made more hay of out of the fact that this program is a repudiation of contracts. I don’t see how any investor with an operating brain cell would ever buy an asset-backed security from a US issuer again, at least one backed by consumer assets. Many (likely most) of the subprime ARMs are securitized. The servicers’ ability to modify the loans is defined in the servicing agreement with the investors. The servicer is an agent for the investors. Yet they are now going to modify loans in a program explicitly designed to help borrowers. The benefits, if any, to the investors remain to be seen.

Proponents argue that loan mods will help investors. Loan modifications done in the traditional fashion, of evaluating borrower ability to pay and for those with the wherewithall to make it, coming up with a new structure, is a better mousetrap. But this program is a significant departure from that model. For example, keeping borrowers destined to fail going for another year or two will lead to worse outcomes, since the houses will be foreclosed in an even weaker housing market (housing recessions generally last 3-4 years).

I’m no constitutional law expert, but this approach appears to raise serious Federal-state issues. The servicing contracts are governed by state law. The Journal states that:

A bill introduced by Rep. Mike Castle, a Delaware Republican, would temporarily free servicers from any liability for modifying loan terms. “Investors are still going to get a return and it’s in their better interest to have those loans perform rather than fail,” Mr. Castle said.

Any lawyers in the readership? How can the Feds indemnify parties against claims made under state law?

This whole scheme is an act of eminent domain, except the government isn’t formally seizing property rights, but emboldening private parties to do so. Why is no one calling a spade a spade?

The Journal has another priceless bit:

Peter Haveles, a partner at the law firm Arnold & Porter in New York, said the agreements underlying issues of mortgage securities generally give the servicers discretion to modify loans if they consider that to be in the best interest of the holders of the securities. He said the possible litigation isn’t likely to derail the Treasury plan, in part because of the breadth of the coalition negotiating it.

Huh? The only parties representing investors in the discussions are Freddie, Fannie, and the American Securitization Forum, a lobbying group. An advocacy group is hardly an authorized agent, and Frannie and Freddie are not representative.

The second issue is that this plan is unlikely to yield much relief. As initially presented, the program would fix teaser rates for borrowers who were current on their payments but couldn’t afford a reset (we have the perverse incentive that ones who can afford the increase suffer).

But no one knows what proportion of ARM borrowers are current even on their teaser rates. So we have a huge untertaking with uncertain benefits, and no ability to measure results versus objectives. As Dean Baker pointed out, subprimes are showing substantial default prior to reset, so the universe of borrowers that can be helped may be much smaller than envisioned.

But even when this subset has been isolated, consider the process: the servicer has to make a determination as to whether the borrower can continue to service the loan, and assess whether he would be able to meet the payment after reset. Tell me, how is this any different than the work that needs to be done to make a loan mod? The questions to be answered are somewhat different than in a traditional mod, but the work of evaluating the borrower – looking at the stability of his income, his other financial commitments, his credit history, his motivation level – is the same assessment that take place with a mod (Tanta, if you see this, correct me if I am wrong).

The whole raison d’etre of this program was to avoid doing allegedly too time consuming loan mods. Yet this program appears to commit the servicers to peform the bulk of the labor, meaning assessing borrower ability to perform. Yes, only a subset of borrowers is being targeted, but you didn’t need meetings at Treasury and possible repudiation of contracts to come up with parameters for triage.

But here we have the worst of both worlds. The program appears to require servicers to do pretty much the same analysis that they’d do for a mod, yet forces them into a Procrustean bed of a single mod option. I can see simplifying the mod alternatives so as to streamline the process, but why a single choice? This is moronic, and increases perceptions of arbitrariness and unfairness.

It seems that the objective of this exercise is for the Bush Administration and any Congressmen who care to join the bandwagon to get some headlines and assert that they are helping to keep people from losing their homes.

What is likely to have more impact are far less glamorous measures, ones that might also ruffle the feathers of the mortgage lending industry. Per above, target fraudulent lenders and devise programs for assisting borrowers who suffered; modify bankruptcy laws (as in Chapter 11, judges should be able to adjust mortgages downward if the market value of the house has fallen and possibly even give them latitude to modify other terms). If lack of capacity of qualified staff to execute loan mods is the impediment, would it be possible to devise a crash course to train them in two-three weeks? There are a lot of un and under-employed mortgage bankers and real estate brokers who already know the vocabulary and understand the basic concepts.

It seems that this Hope Now Alliance is just that, an exercise in wishful thinking, rather than a disciplined and programmatic effort to define bottlenecks and problems and tackle them surgically.

Update 12/1, 4:00 PM: There’s a very good post by Elizabeth Warren at Credit Slips on the supbrime plan, “A Non-Bankruptcy Bankruptcy Solution?” Here are a couple of interesting observations:

2. Are the losses confined to the bad guys? The good news about this plan is that it shifts the losses directly onto the investors who took the bad mortgages. The bad news is that there is no clear legal basis for doing this kind of wholesale revision of the value of the collateral and forced revision of the mortgage terms. The lawsuits will fly thick and fast, enriching the lawyers and tangling up the homeowners.

3. Are the benefits confined to the good guys? The first reports indicate a sorting based on ability to repay the mortgage. This puts the mortgage lender squarely at odds with every other lender. This plan may send a message: If you dump the credit cards and quit paying the car loan, you can keep a great deal on a home mortgage.

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20 comments

  1. Jojo

    My question is, were I an investor, what guarantee do I have that helping some unknown number of people stay in their homes would mean that they will continue to be able to pay the mortgage? If they can’t, then the foreclosure will happen anyway, just later in time, and I might then wind up having to sell the property in a general economic downturn for less that if the house was foreclosed now.

    Too many people are ASSUMING that this band-aid will fix all the problems we face and will prevent the economy from going south.

  2. The Hube

    I really think this whole thing is just a way for the banking industry to avoid a significant rewriting of the bankruptcy laws, including a repeal of the draconian provisions of the last rewrite.
    One thing is certain – nobody is doing it for the borrowers.

  3. GeorgeNYC

    The “eminent domain” angle is certainly a real concern. The government is effectively taking the value of your contract over a certain interest rate. Plus it is interfering with your already set out contractual rights. Even of the servicers have the “discretion” to do this, forcing them to do it is really a different thing. I have the “discretion” to sell my land to the government at any price, but the point of “eminent domain” s that the government can force me to do so for the “public good.”

    I could not find old blog about MBS but I thought I recalled that there were many different tranches and that some tranches benefited when loans went bust and other lost because some received principal payments and others received only the interest?

    In any event, my guess would be that the plan is once someone steps out and complains about this being government “taking” of private contract rights, that they will be immediately branded an un-American traitor and barraged with bad publicity.

  4. Tanta

    (Tanta, if you see this, correct me if I am wrong)

    You’re not wrong. That is what you do on any mod. The only difference between this proposal and a normal workout is that the latter has an extra step: you then estimate what it would cost you to foreclose, versus what it will cost you to mod, and proceed with the one that loses you the least money. When in doubt (not sure which option is less expensive to the investor), give the borrower the benefit.

    The whole thing is too stupid for words. As you know I am a big proponent of working out loan portfolios when it makes sense to all parties to do that, and I believe it makes sense to investors a lot more often than some people think.

    Giving servicers legal “safe harbor” from liability when they acted in what they believe is the best interest of the trust as a whole seems like a good idea to me (although I leave it up to the Real Lawyers to determine whether federal law can do that). Giving them a mandate to act against the trust’s interests when that conflicts with the “Hope Now” agenda? Can anyone possibly be that stupid? Well, apparently, yes . . .

    On the subject of tranches: there can certainly be conflicts within a trust. Senior tranches that aren’t likely to take write-downs of principal might prefer FC, as that gets them prepaid and the losses go the junior tranches. The junior tranches would benefit from the mod.

    Servicers likely benefit from mods, because it keeps a loan on the books and thus keeps the servicing fees coming. OTOH, in most cases servicers just eat the costs of processing the mods (those can’t be billed to the trust unless the PSA explicitly says so, and if it did, we wouldn’t be having this argument about whether PSAs allow mods).

    So the incentives are mixed. That’s why you use “the trust as a whole” as your measure when you ask which is less costly, mod or FC. (You pretend, basically, that it’s like a simple single-class pass-through. That isn’t too hard to do: most GSE MBS are single-class PTs. So servicers have some experience dealing with them. Another way of saying this is that you measure the cost to the trust–the entity that owns the pool of loans on behalf of the capital investors–not the cost to any owner of any specific cash-flow.)

    But this idea is being pushed by the same people who brought us MLEC, which could easily be described as legalizing illegal accounting for expediency. Isn’t MLEC just a way to mark to myth while pretending that it’s a market?

    Tanta

  5. Independent Accountant

    “‘There’s a part of this that’s just morally repugnant. The probelm is that the policy makers are talking to servicers about giving away other people’s money,’ said Mark Adelson, a principal of Adelson & Jacobs Consulting LLC”, WSJ, 1 December. So? The Fed’s plan is inflation: and giving away the VALUE of people’s money. We had debt moratoria in the 1930s. The abrogation of contracts is easy. Does anyone know of the “gold clause” cases of the 1930s? I think any legal challenges to the plan can be surrmounted.

  6. Anonymous

    My worst fear is that this subprime bailout is more about bailing out a banking/financial system that has collapsed because of mis-management of synthetic credit derivatives — versus bailing out a few hundred thousand homeowners that are having trouble couging up hundreds of dollars per month!

    This subprime bailout is looking more and more like a pea-and-shell game which is using the media to hype theoretical losses of homeowners in a very large attempt to take the focus off the Trillions that seem to be lost in a global derivative game filled with compounding bad bets.

    If this was just homeowner related, I think we would be looking at a few billion tops and this would not be an emergency, pull-out-all-the-stops effort to buy time. I think people should look deeper and balance what the banks have lost versus what homeowners might incur.

  7. Anonymous

    Interest rates are set to reset next year on $362 billion worth of adjustable-rate subprime mortgages, according to Banc of America Securities. An additional $85 billion in such mortgages is resetting during the current quarter. The estimates include loans packaged into securities and held in bank portfolios

    Also Thursday, the Commerce Department said the median sales price of a new home fell 13 percent in October from a year earlier to $217,800. It was the biggest annual decline since September 1970 in the median price, the point at which half of homes sell for more and half for less.

  8. newsman

    The irony here is thick on the ground.
    People are concerned about other people negotiating on behalf of investors who are not really consulted. That has happened to borrowers for years! The state AGs “negotiated” some very dubious terms for the borrowers they supposedly represented in the Ameriquest and Housing Finance predatory lending cases. To get the pittance in compensation that these settlements offered, the borrower/victims had to surrender their right to sue. The real beneficiary of these “landmark settlements” was the lender in both cases. imho.
    IN that environment, AGs who were questioned about all this said their negotiating position was weak because after all, mortgages are contracts and it would be awfully tough to unwind them.
    Now, when the LENDERS are in trouble, unwinding a mortgage contract seems to be perfectly feasible.
    One investigator working for our state had a priceless aphorism: When a borrower cheats a lender, that borrower might go to jail. When a lender cheats a borrower, he might have to give some of the money back.
    The one thing that is ALWAYS missing in these deals is real accountability for misbehavior on the part of the lenders. Nobody ever goes to jail–not the fast talking hucksters in the storefront s or boiler rooms, not the managers who crack the whip over them, and not the executives who pay the managers their bonuses while they cash in their own stock options.
    Worst-case scenario for them: they have to agree to a settlement with the AGS (without, of course, admitting wrongdoing) in which they pay out some millions of the stockholders’ money in reparations.

  9. Anonymous

    I’d guess the reporters messed up in describing the plan. Congressional staffers know about constitutional law. I’d guess they’d try something like having the federal government modify loans however is necessary. My vague and unreliable recollection is that loans are not protected by the “takings” clause of the constitution because it only protects property and contracts are not viewed as property. And obviously, the “contracts” clause doesn’t apply to the federal government, just state governments.

    If the federal government modifies the loans, and sets up some sort of program for the states to administer as agents of the federal government, that might work fine.

    Plus, as was pointed out, the lenders might not sue anyway because realistically this plan is better than what Congress might do otherwise. If things get real bad, Congress could easily modify chapter 13 of the bankruptcy code (workouts for individual borrowers over several years), so that judges could reduce loans on primary residences to the FMV of the residence and otherwise modify the loan. Congress might also roll back all the anti-debtor reforms the lending industry pushed through in 2005.

  10. Independent Accountant

    Newsman:
    Bravo. I’ve been saying things like you for years. Have you followed the debt discharge reaffirmation fiasco following bankruptcy? Will any lender doing this have executives go to prison? Please. As Anatole of France said, “The laws of France are the same for the rich and the poor. Both are prevented from sleeping under the bridges of Paris”. There is no law in this country for the oligarchy. The US is more like Russia than it would like to admit.
    I agree, what’s going on is the Big Banks are bringing out the crying towel for a few unfortunates. The “Plan” goes into effect. 95% of the benefits go to the banks, 5% to the peasants.

  11. Anonymous

    What about Truth In Lending Disclosures and the effects and impacts on banks that are being bailed out? The banks are going to profit from extending the time value of money (future value), to pay off Trillions in bad debt!

    Think about:

    The banks’ plan recognizes that, absent a proactive move, many subprime ARMs could reset next year to 12 percent or more from current rates of 7 percent to 9 percent.

    By offering a broad approach to extend the so-called teaser rates for a certain period — officials and the industry are debating periods of two to five years — it would allow homeowners to keep making payments while the housing industry regains its footing.

    Monthly payment: 30 Years
    Interest rate: 7.000%
    Loan amount: $ 100,000.00
    $ 665.30 a month

    Monthly payment: 40 Years
    Interest rate: 7.000%
    Loan amount: $ 100,000.00
    $ 621.43 a month

  12. Yves Smith

    These are all good comments, and thanks to Tanta for weighing in over here.

    There is an update to the post with a pointer to a post at Credit Slips (those folks are lawyers, BTW) which adds a couple of other wrinkles.

    GeorgeNYC,

    My dim recollection of one class warfare issue (as they call it) is in foreclosure, if the overcollateralization has already been used up, the principal repayment will go to the top-rated tranche (theoretically, if the top rated tranche has been repaid, then it goes to the next tranche, but we are unlikely to see that happen).

    If your ABS has already been marked down in your books (a virtual certainty due to market conditions; it will be marked down even more if there has been a downgrade) you are likely to be happy to take your lumps and go home.

    But if the loan gets a mod, the interest payments will be applied as set forth in the original terms, which in most cases means more tranches than just the top tranche get some income (any MBS experts encouraged to provide better/clearer detail).

    Newsman,

    Hadn’t realized that concern about investors stood in the way of decent settlements in the Household Finance and Ameriquest fraud cases. What an ugly bit of business.

    Anon of 3:36 PM,

    Remember that this plan is a bastard child. The government isn’t sponsoring it, heavens no, it’s a private sector initiative. Paulson is merely hosting meetings and knocking heads together. Of course, we have matter of the proposed legislation to keep servicers from being sued, but hey, this is still a private sector effort. And as Tanta pointed out, the servicers have a conflict, they do better to see the lenders alive rather than dead.

    Note the people who would sue are investors rather than lenders, And it isn’t at all clear that they’d do worse with a judge. A judge’s intent will be to get the borrower to pay as much of the old debt as is realistically possible. With this arrangement, a lot of borrowers could conceivably do better than that.

    The 2005 bankruptcy law was a sop to the credit card issuers, and that industry is now pretty concentrated. In fact, the Credit Slips post points out this plan will encourage borrowers to pay the mortgage and not pay their credit card.

    Anon of 4:23 PM,

    One of my beefs has been that no one has, for this proposal or the California plan, says what happens to the principal. All that has been said is that payments are frozen for a certain period. Is the shortfall added to the principal balance or not?

    The other problem is to what degree housing recovers. Housing has been seriously overvalued relative to incomes and rents. The Economist in 2005 said US real estate was 20% overvalued, and it continued to appreciate after that.

    We’ve had just about nada income growth except at the very top end, and that is unlikely to change with a weakening economy. So why should housing return to its old level anytime soon? I see this as a repricing, not a housing recession.

  13. Anonymous

    If an adjustment on the loan has an effect on the market value of it, is this not a huge conflict of interest? It is coming out that municipalities are now holders of these bond,think Florida or Washington, so it would almost be cutting their own throats. Help out the borrowers and screw the investors, but if the investors turn out to be pension funds, cities, state pools, who is to say that these actions really are in the best interests of the nation?

  14. Been there

    I’m with newsman. Banks, who aggregated the subprime garbage with good stuff, bagged it and while holding their noses with their heads turned away, handed it off to investors and took cash in return, are the real bad guys in this situation. My concern is that this “rescue attempt” may indirectly protect these real perpetrators because when it fails and the same loans eventually go south anyway, it will be because of the “flawed” rescue plan, and not because of banks’ participation in the manufacture of the waste product that was passed off as pristine. The rating agenices are also guilty.

  15. David Pearson

    It seems the whole plan rests on the legislation that absolves servicers of liability. I am not a lawyer, but I understand this: in any contract, the incentive for the parties to perform is self-interest. Where interests conflict, however, the threat of litigation steps in.

    Servicers have an incentive to mod all loans rather than foreclose. The longer the loans stay on their books, and the more they can avoid the high costs of the foreclosure process, the more money they make.

    Eliminate the litigation threat and the servicers would be free to pursue their interest at the expense of investors. Most notably, a delay in foreclosure exposes AAA investors to declining recoveries as home prices fall.

    Without the legislation passing, it seems no amount of “representation” of investors in negotiations will prevent the lawsuits from flying.

  16. Anonymous

    add this to your thoughts:

    Nevada state Treasurer Kate Marshall and some of her counterparts nationwide are calling on Congress to fix what they say is an unfair and unexpected hit to families trying to avoid foreclosure.

    Marshall said existing federal law penalizes homeowners who are able to restructure their mortgage and avoid losing their home by treating the amount they save through the new mortgage terms as “realized income.”

    “At the very moment that a family is trying to escape the potential loss of their home, they will receive a letter from IRS telling them they owe income taxes on the loan modification,” she said in a letter to each member of Nevada’s congressional delegation.

    “The lender’s steps are thwarted, the financial burden on our families and communities increases and much of the money saved may now go to the IRS,” the letter states.

    That amount, especially in Las Vegas, where many of the homes in foreclosure sold for $400,000 or more, could be substantial.

    “So if you are able to restructure your mortgage and you’re actually able to see some light at the end of the tunnel, you get whacked by the IRS,” she said Friday.

    Marshall’s letter, like those from treasurers nationwide, calls on Congress to pass the Mortgage Cancellation Relief Act of 2007, which would exempt that money from taxation.

    Marshall said the need is especially critical in Nevada, which has the nation’s highest rate of pre-foreclosure filings for the last 10 straight months. She said Nevada has one pre-foreclosure filing for every 185 households, a per capita rate of 4 percent.

    Marshall said she learned about the effort from the Ohio treasurer’s office and immediately agreed to help the effort.

    “An added tax bill at a time when what we’re trying to do is keep people in their home is adding insult to injury. If it’s your primary residence, we need to help you stay in your home,” she said.

    Sen. Harry Reid, D-Nev., is one of the sponsors of the legislation.

  17. Bernard

    A bill introduced by Rep. Mike Castle, a Delaware Republican, would temporarily free servicers from any liability for modifying loan terms. “Investors are still going to get a return and it’s in their better interest to have those loans perform rather than fail,” Mr. Castle said.

    (end)

    Let’s get this straight.

    The government is going to abrogate your property rights because the government knows what is in the best interests for your property better than YOU do.

    You as owner of the property would make decisions that would harm your own interests, so the government is going to step in and protect you from yourself.

    WHAT? Is this the United States of America? I can’t believe my ears.

  18. Tom a taxpayer

    If Treasury Secretary Paulson wants to convince the public that his gross interference (Super SIV Entity, freeze loan rates, etc.) with the markets is to help homeowners and for other noble causes, but not to bail out his banker buddies and Wall Street fat cats, he can do it.

    Simply make it a condition of any New Deals (rate freeze, Entity) he is brokering that the CEOs, principal officers, and board of directors of the banks, Wall Street brokerages, lenders, etc who caused this crisis be fired. Not only fired, but fired with no golden parachute.

    This group of pirates who raped and pillaged the home mortgage industry and the credit markets must be removed from having anything to do with Mr. Paulson’s New Deal.

    Mr. Paulson, the public calls your bluff. Show that you can punish the guilty while saving the innocent. The two are not incompatible. In fact, cleaning out the guilty is part of restoring public confidence in the banking system.

  19. Anonymous

    Castle’s proposal doesn’t abrogate citizens’ property rights. Spineless judges decided that contract rights are not property, so contract rights aren’t protected against congressional override by the takings clause of the constitution. Contract rights are only protected against override by State legislation under the contracts clause of the constitution.

    Investors/Lenders play this game too though. In 2005, after lending consumers a ton of money, they pushed through legislation undercutting individuals rights in bankruptcy. That time retroactive legislation helped the investors/lenders.

  20. Yves Smith

    Anon of 11:11 PM,

    True, but also remember that who prevails in litigation often has less to do with the merits of the case, and a lot to do with how much pain you can inflict on the other side, either just by the act of suing or via the discovery/deposition process (particularly if you can depose important clients and business connections). Remember, 95% of the lawsuits are eventually settled.

    So if Castle’s law doesn’t pass, investors can at least harass servicers (I’m sure they could get a claim past summary judgment). And I don’t think servicing margins are all that great for them to be able to afford a ton of litigation. So the threat of litigation could be an effective check on servicers as far as this program is concerned.

    If any readers are opposed to the Paulson plan, I suggest you call your Senator and Congressman about the Castle legislation. Some of you may be practiced at this, but one angle that might capture their attention is to say as an investor, you’d never be willing to buy any mortgage or asset backed securities again, and abridging investor protections will destroy faith in the US securities markets.

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