naked capitalism

Are we going to finally start seeing some pointed mainstream media coverage of the Administration’s limp wristed, industry-favoring financial “reform” plans? While it has been woefully slow in coming, the answer appears to be yes. One has to wonder whether the more skeptical coverage follows the increasing evidence that things may not be working out as planned, or simply Obama’s plunging poll numbers. And that isn’t necessarily the fault of the reporters; it may reflect editorial “priorities”.

The object lesson of the day is Peter Goodman’s story at the New York Times on the Treasury’s mortgage mod program (hat tip DoctoRx), which was old Bush/Paulson wine in new bottles. And mirabile dictu, the headline of the article is refreshingly blunt: “U.S. Loan Effort Is Seen as Adding to Housing Woes.” While no one has said as much, Home Affordable Modification Program, like the Paulson Hope Alliance Now, looks designed to work very narrowly within existing securitization rules to so as to minimize the odds that any mortgages modifications under the program could be challenged in court. However, the resulting program is an abortion. It gives little in the way of real benefits to borrowers. So called “permanent mods” are in fact only a five year payment reduction, which makes sense only if the borrower believes both his income will improve markedly between now and then (given stagnant worker incomes since 1973 and deflationary pressures, that is unlikely to apply for most people) and that the value of his house will appreciate considerably over that timeframe as well. Of course, Treasury may harbor fantasies like that, which might explain why they thought this dubious program was viable.

The results to date, in terms of permanent mods, are underwhelming:

As of mid-December, some 759,000 homeowners had received loan modifications on a trial basis typically lasting three to five months. But only about 31,000 had received permanent modifications — a step that requires borrowers to make timely trial payments and submit paperwork verifying their financial situation.

But we need to step back a second. The idea that mods would be a good idea is well founded; it’s just that securitization stands in the way. In the stone ages of banking, banks routinely did mods. Their experience in most cases was if a borrower was remotely viable (as in he had an income), the bank would take lower losses if it kept him in the house than if it foreclosed. With real estate prices down 30-40%, and significant foreclosure costs on top of that, it isn’t hard to see that from an economic standpoint, investors could take a big reduction in principal and still come out ahead. And as we have noted here earlier, Wilbur Ross, hardly a shrinking violet, argued for them in a chat with Housing Wire:

Ross has plenty of skin in the mortgage servicing game, as he owns Irving, Tex.-based American Home Mortgage Servicing, Inc.,….he thinks the best way to motivate lenders, servicers, and homeowners work together on modifications requires far more than what’s been proposed so far. In particular, he believes that what’s needed is aggressive principal modifications for borrowers most in need. He has said that his American Home servicing shop has seen six-month recidivism rates below 20 percent — compared to the 50 or 60 percent standard in the industry — because the servicer has been aggressively looking to cut principal balances.

“The price of housing needs to be cleaned out. The Obama administration could right-size every underwater home and reduce principal to fit the current market value of the home. If they are going to deal with it they have to deal with it in a severe way.”

There are two major obstacles. One is that servicers were never ever set up to do mods, or much of anything on an individual basis. Servicers are factories and pretty much everything customer-facing staff does is routinized (note that this is an impediment separate and apart from the fact that they get paid to do foreclosures, while the fees paid by Treasury to do mods are not only less attractive, but even from the outset appeared too small relative to the changes in procedures required). Note that Ross is probably not doing mods on an individual basis, but likely has some templates and might go as far as allowing for latitude within certain parameters. Any informed reader input would be helpful.

The second obstacle is the securitizations themselves. As I understand it, losses from mods are distributed differently than losses from foreclosures. Crudely speaking losses from foreclosures work up through the capital structure, hitting the equity layer first, then the next highest tranche, and so on. By contrast, mods are distributed across all tranches. That means investor in the top tranches, the AAA and AA layers, would object to mods, since they’d take hits they would not face in the event of foreclosures.

Note that Ross has spent his career in bankruptcy, which is more legally-intensive than other types of deal-making, and he believes the Administration could have cut this Gordian knot. It chose to in the GM and Chrysler bankruptcies; I have to admit I was proven wrong there, since I had doubts that a judge would accede to some of the aggressive measures.

And before I get howls from the “sanctity of contracts” crowd, I must remind readers that contracts are renegotiated ALL THE TIME, particularly when circumstances move outside the parameters envisioned by the parties to an agreement. Did any of the “sanctity of contracts” crowd object to this story in the Wall Street Journal:

Until a little more than a year ago, major airlines were so keen to enlist regional carriers’ smaller planes and cheaper crews to help them expand their footprints that they often guaranteed the regional carriers double-digit profit margins while the majors bought the fuel, set the schedules and sold the tickets. The regionals snapped up new planes—mostly 50-seater jets—to meet the demand.

The major airlines now think those deals too generous, according to people familiar with the carriers’ thinking, and want their regional partners to shoulder more risk or at least share some of the sacrifice as the majors lose money.

Some of the big airlines are risking lawsuits to terminate those contracts or are putting smaller amounts of new work up for bid on tougher terms.

Yves here. To be clear, it’s completely kosher for the big carriers to try to secure better terms when a contract comes up for renewal, quite another to try to screw business partners who made substantial investments based on their partner’s obligations (but as an aside, these were not exactly the most credit worth partners to begin with). Nevertheless, the bigger point is that in the real world, parties to an agreement can and do take extreme measures to force changes in terms. To pretend that this sort of thing does not happen is naive, particularly when the provisions that are causing trouble now were routinely waived in the past. I was at the 2008 Milken Conference, and Lew Ranieri, the father of the mortgage backed securities business, seemed gobsmacked to learn that securitization agreements were seen as a obstacle to mods. In his day, they were done as a matter of course. And here we have a case where badly designed contracts are having widespread adverse consequences.

So let us look at the NYT article. It is striking that the article presents some long-standing objections to both the Obama and Bush mod programs as if they were new: that the programs at most kick the can down the road, when it would be more salutary to take the losses and let housing prices find a bottom; that borrowers themselves are probably ill served by participating:

….desperate homeowners have sent payments to banks in often-futile efforts to keep their homes, which some see as wasting dollars they could have saved in preparation for moving to cheaper rental residences. Some borrowers have seen their credit tarnished while falsely assuming that loan modifications involved no negative reports to credit agencies.

Some experts argue the program has impeded economic recovery by delaying a wrenching yet cleansing process through which borrowers give up unaffordable homes and banks fully reckon with their disastrous bets on real estate, enabling money to flow more freely through the financial system.

Yves here. None of this is new. But get this presumably unintended confession:

The Treasury Department publicly maintains that its program is on track. “The program is meeting its intended goal of providing immediate relief to homeowners across the country,” a department spokeswoman, Meg Reilly, wrote in an e-mail message.

Yves here. “Immediate relief”? That sounds like an Alka-Seltzer ad. But these problems are too deep seated to remedied by a little “pop, pop, fizz, fizz”; it is not a boon to underwater borrowers to give them mere palliatives. The story indicates that Treasury is becoming more realistic about the magnitude of the problem, but is not willing to do anything that might inconvenience the banker or investor classes (even if, as we and Ross noted above, they would actually come out better overall if they took a little short-term pain):

But behind the scenes, Treasury officials appear to have concluded that growing numbers of delinquent borrowers simply lack enough income to afford their homes and must be eased out.

In late November, with scant public disclosure, the Treasury Department started the Foreclosure Alternatives Program, through which it will encourage arrangements that result in distressed borrowers surrendering their homes. The program will pay incentives to mortgage companies that allow homeowners to sell properties for less than they owe on their mortgages — short sales, in real estate parlance. The government will also pay incentives to mortgage companies that allow delinquent borrowers to hand over their deeds in lieu of foreclosing.

Yves here. Thus, I wonder if the Times is willing to depict HAMP as a failure because the Treasury is now forced to ‘fess up, even though the piece presents the efforts to pretend otherwise:

Ms. Reilly….said the foreclosure alternatives program did not represent a new policy. “We have said from the start that modifications will not be the solution for all homeowners and will not solve the housing crisis alone,” Ms. Reilly said by e-mail. “This has always been a multi-pronged effort.”

Yves here. Please, this is an insult to the audience’s intelligence. If this new program was part of a “multi-pronged effort”, why is it being introduced now, as opposed to in parallel with HAMP?

Note also that some critics of the initial plan are also leery of letting nature take its course:

Mr. [Mark] Zandi [chief economist of Moody's] proposes that the Treasury Department push banks to write down some loan balances by reimbursing the companies for their losses. He pointedly rejects the notion that government ought to get out of the way and let foreclosures work their way through the market, saying that course risks a surge of foreclosures and declining house prices that could pull the economy back into recession.

“We want to overwhelm this problem,” he said. “If we do go back into recession, it will be very difficult to get out.”

This exchange gets at the heart of the matter:

“This is a conscious choice we made, not to start with principal reduction,” Mr. Geithner told the Congressional Oversight Panel. “We thought it would be dramatically more expensive for the American taxpayer, harder to justify, create much greater risk of unfairness.”

Mr. Geithner’s explanation did not satisfy the panel’s chairwoman, Elizabeth Warren.

“Are we creating a program in which we’re talking about potentially spending $75 billion to try to modify people into mortgages that will reduce the number of foreclosures in the short term, but just kick the can down the road?” she asked, raising the prospect “that we’ll be looking at an economy with elevated mortgage foreclosures not just for a year or two, but for many years. How do you deal with that problem, Mr. Secretary?”

And the big obstacle is presumably not the servicers, but the Administration’s commitment to “extend and pretend”. In many cases, the bank that is running the servicer holds some of the same paper and would have to mark it down in the event of a deep principal mod. Moreover, if mods like this were to become popular, former AAA paper would have to be written down even further. Quelle horreur!

Approaches that are sensible, likely to work, but possibly damaging to the fragile banking establishment are apparently to be avoided at all costs.