A Possible Approach to the Mortgage Mess

On a post yesterday on how well (or more accurately, how badly) various state efforts to rescue homeowners were faring, reader Richard Kline offered a suggestion.

Note that while I still favor the apparently destined-never-to-see-the-light-of-day idea of permitting bankruptcy judges to write down mortgages to the current market value of the collateral (the rest becomes unsecured), Kline’s idea is elegant. One change I’d recommend is to have his markdown from the index vary by either state of MSA.

Hoisted from Kine’s comments:

I don’t mean to frown any excessive frowns on the issue, but there is simply NO solution to the bad mortgage problems that exist as they are presently constituted. The problems are too diverse; there are too many lenders, and worse diffused standing with respect to the actual mortgates; the volume of property is, well, vast. That’s just on the lender side. Borrowers have many and various problems so there is no one-size or even middle-of-the-curve solution to implement. These mortgages need to be, literally, re-negotiated one at a time. But it gets worse: with asset values plunging to well south of the face value of many loans there is no sane way to ‘save the loan’ as written. You want the lender to eat 40% of the loan? It might be easier for them to walk away—or there may be no ‘lender’ to walk away, they’re dead. For troubled mortgage holders, it’s a big blot on their credit, a life-changing event. For lenders, it’s often going to be a blot on an x-ray; a life-ending event.

Don’t expect a fast resolution to this issue; three years from now, we’ll still be unwinding it, in my view. Federal legislation does nothing to solve the problems. ‘The guvmint buys all notes?’ They don’t got that kind of dough.

The government can’t solve the problem—but the government just might be able to change the problem. Here is the outline of a coherent solution process; it won’t happen, and I’m not going to propose offhand the means to get there, but since this all is a mess, and we’ll have some time to kick arouond issues, here is one way to go about it.

Take the market or appraised value of the property as of a set, market top date; oh, March, ’07 for an index. Now take 60% of that: this is the new value of the property. Take the loss, and apportion it between mortgage holder and lender based on their equity shares as of today; this means most, but not all of the writedown goes to the lender. Many mortgage holders will end up with negative equity, but at much lower total dollar value; the property is worth less, but by the same token the amount which will have to spend to pay it off and own it clear is much less, too. That’s a situation which may keep an owner willing to stay in the property and pay off that smaller negative equity; they take some loss, but they can end up with whole credit and a home, not a bad outcome. Refi the loan into a traditional loan structure. If the owner can’t meet that payment, well the loan is dead anyway, we’ve done all we can. The advantage to the lender is that they now have an asset again, rather than a rotting, unoccupied structure against which they owe taxes after foreclosure costs in a horrible property market without viable mortgage lenders and huge inventory overhangs.

No one forces this solution on either party to a locked up, upside down squat, but it’s a package deal, go/no-go, with little or no side dickering over terms: you go to court and say, “We both agree to this change in our pre-existing contract by the terms of the Somebody Help Me Jesus Act of ’09,” judge raps the gavel, ever’body clap hands, and walk out the door with chins up and best foot forward. Once a mortgage holder at a viable payment is signed on, the lender can sell the package or hold it to term, but the mortgage is a tradable instrument again at known value. This is for first liens only. I have no solution to propose for second and third mortgage situations other than the Darwinian solution: stupidity means your equity dies stillborn without reproducing.

Rather than a total loss-loss, cut cards and do a re-deal, but ‘automate’ the process with shared pain.

Don’t like it? Let’s hear your plan.

He also offered an addendum for borrowers in severe negative equity land but able to service the debt, but I figured we’d stick with the base case for now.

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19 comments

  1. a

    “Don’t like it? Let’s hear your plan.”

    Nah I hate it. My plan? Do nothing, until it becomes clear enough that doing something is better than doing nothing.

  2. Richard Kline

    I’m in agreement with Yves that a regional write down number would be better than a national one, yes. But the rate shouldn’t float over time, or parties to down mortgages will fiddle waiting for a number they like. I don’t know whether 40% is a reasonable number as a median or bottom either; the point is that a reasonable index could be fixed.

    This could be passed as a single Act of Congress (I suspect, I’m not a lawyer or a legislator) and structured in a way like bankruptcy, but it has to be a package just in that way. And it’s best if it’s optional; if the lender doesn’t like the terms, than they can foreclose and take their chances. That is the only fair way if we are going to respect the contractual nature of the mortgages. Throwing out contract law has severe consequences, especially in our society: anarchist or not, I’m not too hot for going that way. For that reason, I’m not wild about judges being granted the authority to unilateraly renegotiate contracts for _unwilling_ parties; to me that is the problem of just turning this over to a judge to decide. Plus the incredible amount of time and court costs and burdern on the court system.

    I don’t know, but I suspect from current readings on this issue on the web that many lenders would jump at an option like this if they could get it. They know that their collateral is down and that the face a loss, but there’s just no good way for them to move on. If they could take a clean fast hit losing the limb at the kneecap, and put on a suitable peg, they might just be happy enough to get on with their next best step. Now, they can’t sell the note except at pennies to face; they can’t even necessarily walk away from it. “Better a miserable ending than misery without end,” per Hans-Wilhelm Voeller re IKBank in another post here.

  3. Yves Smith

    Richard,

    The “letting judges modify mortgages in bankruptcy” option has been demonized by opponents.

    First and foremost, this would apply ONLY in bankruptcy, not for every merely defaulting homeowner.

    Second, this practice is well established. It’s done in commercial bankruptcies all the time. Strangely enough, no one has a problem with it there.

    The judge does NOT have an unrestricted ability to lower mortgage balances. He marks them down to the value of the collateral. The idea is that the loan is secured by collateral (duh); if the unsecured creditors are all taking a hit, it is perverse for the secured creditor to extract MORE than the asset is worth to their detriment.

    To make the math easy: Broke Joe has only $20K in assets ex his house. He has a mortgage of $140K, unsecured debt of $60K. But the house is now worth only $100K.

    The judge would write down the mortgage to the collateral value, $100K. The other $40K gets added to the unsecured debt. Now you have $100K of unsecured debt versus $20K of assets. So the unsecured creditors get 20 cent on the dollar, and the bank gets $8K on the now unsecured portion of the mortgage loan.

    The judge then works out how much Joe can pay on that $100K mortgage.

  4. Yves Smith

    Whoops, I missed the Chapter 13 aspect under the new bankruptcy law (and if I got something wrong, please speak up).

    If you don’t qualify for Chapter 7, Chapter 13 imposes draconian repayment terms on unsecured debt. Thus in the scenario above, the remaining $32K of the now unsecured portion of the mortgage would ALSO be subject to a repayment plan.

    This is why I have trouble with the “tie up the courts” objection thrown out by the industry to the proposed BK law changes. The 2005 changes ALREADY increased the burden on judges. Adding mortgages to the mix would create more work, but not all that much more.

    Now there may have been some loosening of the unsecured payment schedules under the proposed changes to the BK law, but I certainly don’t recall seeing any. And with those tough repayment terms, I don’t see why the banks would object to the new law. In fact, one reason that borrowers may be walking from their mortgages is that it is easier to escape from secured debt than unsecured debt.

  5. Steve

    Yves’ proposal is more reasonable, when compared to a debt jubilee. But there is the little problem of what Joe can afford to pay at the reset rate, even if the value of the house is written down. For example, Joe can just make a 5% teaser payment on $100K, but couldn’t make a 9% full rate payment on $75K ($5K vs. $6.75K). So the mortgage contract rate also has to be jiggered by the judge. Now the lender would probably prefer to sell the collateral for $75K and try to earn more than the 5% for 20-40 years under a cram-down. While a cram-down for mortgage debt is possibly worthwhile in normal economic times, I don’t see how it can be made workable given the teaser-rate terms that are causing much of the current problem.

  6. Yves Smith

    Steve,

    According to UBS, thanks to Bernanke having driven short rates so low, there won’t be much reset shock this year (I’d like to see the full analysis on this one, needless to say). The increases reportedly will be only 5% on average for resets this year. In fact, a lot of lenders are trying to get their resets to go into fixed mortgages so they will earn more.

    However, resets last year were at higher rates, and it takes 15 months on average from first default to foreclosure, so those loans are the ones hitting the wall this year. Your point well taken with them.

  7. Steve

    Yves,

    I believe most ARMs price off Libor, and it appears that imaginary Libor is suddenly converging upward towards real London interbank borrowing costs under the gentle ministrations of hammer blows from the BBA. So we’ll see where the base rate goes. The full spread on subprime can be pretty wide–600bp+ on scratch and dent specials. In any case, negative am loans are a special breed of horror for work outs, and the impact of those alt-a and prime beauties is just starting to be felt. I’d like to think there is a solution, but then I’m not sure the problem has really been defined (for example, is it an economic or political goal to keep people in their homes? Are mortgages in the future going to be funded by private capital or exclusively by government? etc.) I agree with a’s comments below on this issue–do nothing until it is clear that doing something is really better.

  8. Anonymous

    Sorry to intrude but am I missing something basic about this proposal and the situation?

    Isn’t the fundamental issue that the banks simply don’t have the capital to take the write downs — whether court ordered or market based?

    What happens to all of the RMBS when this stuff gets rewritten? Do the investors — who may be pension funds, etc… take it involuntarily on the chin?

    What happens to the insurance policies (CDO, CDS, etc…) when you have an equivalent of a default? Not that anyone cares but what do the MBIA, ABK, PMI, etc… shareholders say?

    What happens to the hedge funds that go belly up with their 10-40X leverage on this stuff? Their counter-parties?

    Assuming my understanding of the situation is correct, I don’t see how Mr. Kline’s solution does anything to help the fundamental issues at all.

  9. Anonymous

    The Smith as well as the Kline strategy should be brought to the attention of Elisabeth Warren.
    BMH

  10. Richard Kline

    Yves, many of the folks headed for foreclosure on firsts are going to give up the house but not necessarily declare BK, so they don’t get to a judge at all. Yes, if someone is in BK trying to keep the home which they can’t afford at it’s illusory market top price, they get to see a judge, who may or may not be given the authority to shave the lender and keep the lendee in the home. But this does seem to me like a very time consuming and ugly process. For example, the judge is going to actually have to see what the lendee can pay and render a judgment on that—which may be a real can of worms. What if the mortgage holder claims fraud or misrepresentation by a now defunct mortgage broker? I mean, few of these hearings are going to be clean and brief.

    What I would hope to see is something like a ‘mortgage-bankruptcy’ where the real issue is apportioning the loss from the collateral value decline in the process of doing a packaged refi. If folks have to dicker over terms, they’ll dick around and argue (tempers are short when big money is being lost); if it’s a package, they sign on or not. If the lender can get the mortgage holder into a loan they can actually pay on at a realistic collateral value, we get a solution that has some payoff for everyone that’s higher than foreclosure, and faster and far less costly than bankruptcy. Sure, the lender would love to sell at 75 of face and get out: who’s going to buy a sick goat which may be a-dyin’ though? If for whatever reason the mortgage holder mails them the keys, they lender sure isn’t getting 75 of face in this market, with asset values still heading down.

    The issue isn’t necessarily to ‘keep the borrower in their home,’ it’s to get a controlled asset devaluation in a market context where this must proceed on an individual mortgage basis which is facilitated with a minimum of public intervention and maximum of clarity and speed for the two parties to a mortgage contract. There is no procedure to make this possible—so let’s make one.

  11. Anonymous

    It should be worked out on a case by case basis between Householder and Mortgage holder.

    Maybe regional guidelines are published on equity price changes on a month by month basis to give bothe sides a guideline to start from but it needs to be handled case by case or its open to systematic abuse by either of the two parties.

    I can see a lot of people being mighty pisssed off at write downs on both sides of that deal….

    As an outsider looking in it still seems to me that a lot of people in Gov,Media,Banks, Investors and homeowners seem to have way underestimated the size of the issue up till now.

    The next few Qtr’s will be very interesting

  12. Anonymous

    Excuse me for being uninformed.
    Now the excuse for not allowing cramdowns are that this would violate contracts because the mortgages have been bundled together to form a SIV.
    But that SIV is not worth the face value. They have been “marked to market. Now am I incorrect in assuming that in theory all of the mortgagees could get together and f anbuy the SIV at this reduced price unbundle it and get their mortgage back at this reduced rate. Maybe then these mortgages could e turned into Primes.
    Second point. Negotiations as descried above between Lender and Borrower should be done in front of a judge.
    But these can be lawyers “deputized” for that purpose. NYC traffic court seems to have done this quite well.

  13. Anonymous

    I’m a cancer survivor, that is the cancer is gone but so are all my assets. I had excellent insurance but with the loss if income, co-pays and deductibles I went broke.

    Lost the house, credit cards, etc.
    But within weeks I had new credit cards, got business & personal loans from my bank etc. Once you go broke banks like to lend to you since the new bankruptcy law makes your debt and you an indentured servant.

    Point is, savvy investors know to walk away from a bad investment; people who are underwater on a house should just get out. Take the credit hit and move on with their lives. The banks certainly do not care about them personally so trying to make the best out of a bad situation is not in the consumer’s best interest

  14. Anonymous

    I love it when smart people try to come up with solutions to the worlds problems. Guess what none of the above approaches will be implemented. The reasons are all known.
    We live in a democracy and politicians are going to do very little to implement what they don’t understand at this point. They will be afraid of the unknown consequences of their actions and how that might affect their carriers.
    So good luck with solving this issues, oh yah, once your done with home mortgages you can think about commercial property, then auto loans, student loans,…etc.

  15. S

    …add on the derivative implications to employment prospects as a result of the great leverage sucking sound. The birth death adjustment doesn’t pay minimum wage. Agreeing to take a loss and being able to take a loss are different. The problem is the later not the former. The Fed has already told you how they plan to deal with this.

  16. Anonymous

    To simplistic a fix to a complex problem.

    In reality, entertaining bankruptcy court would force the note holder to come forwarded. The note has been leveraged 10 or more time and is nowhere to be found. The property owner could walk payment free until such time the note is produced and action is brought by the note holder and not the servicer.

    Meantime, the banks continue their meltdown.

  17. earthday

    Yes, it would seem the real problem with this fix is that there aren’t two parties to the contract. The servicer is not the same as the holder of the mortgage and even identifying the holder would appear to be problematic at the moment. In the past, when the banks owned the mortgage, this sort of solution could have worked. Probably not now.
    And of course, the banks don’t have the capital to take those kinds of write-downs anyway. They’re doing everything they can right now to create higher prices for their assets just to stay alive (ie: reclassifying them as Level 3 so they can price them with models, repackaging them into new CLOs to swap for Treasuries at the Fed, etc.)

  18. Jonathan

    I say just let all the homes go into foreclosure. Let the banks bust. Then years later after the horrible recession, I buy a ton of houses with the money I have been saving and rule the tenants with a spiked pitiless gauntlet of torment. Sounds fair to me.

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