Extreme Measures IV: Sheila Bair of the FDIC on Subprimes

By way of background, an Extreme Measure is a recommendation to take a radical and, upon examination, unworkable approach to a pressing problem. We’ve only been on this beat recently, but so far, the Extreme Measures we’ve seen have had to do with the US housing crisis or the credit contraction.

The first was from Bill Gross at Pimco, who suggested that the US government “rescue” the 2 millionish homeowners who stood to lose their homes. A second came from Gillian Tett, the capital markets editor at the Financial Times, who argued that investment bankers should decompose CDOs and other structured credits into their constituent parts. Third was an article by Cambiz Alikhani of Arundel Iveagh Investment Management in the Financial Times, “Banks should form a bail-out vehicle to ease the credit crisis.” All ideas had considerable high-concept appeal but broke down when inspected closely.

The latest comes from Sheila Bair, chairman of the FDIC, who proposed yesterday that mortgage servicers freeze all adjustable rate mortgages facing resets at their current rates. From the Wall Street Journal:

A top bank regulator urged loan servicers to consider wholesale conversions of certain adjustable-rate subprime loans into fixed-rate products to prevent major housing problems from escalating.

“We don’t have a lot of good options here,” Federal Deposit Insurance Corp. Chairman Sheila Bair said in an interview after addressing an investors conference in New York. “And just to foreclose on all of these properties is not a good option for anybody.”

Such rate changes are difficult, though, because many of these subprime mortgages were securitized and packaged into trusts. As the loan quality has deteriorated major, Wall Street banks have experienced sizable losses.

Nevertheless, her comments reflect the heightened pressure policymakers are trying to convey to a fragmented and slow-moving mortgage industry.

Moody’s Investor Service released a study last month that showed that most servicers had modified only 1% of a sample of loans that reset into higher monthly payments this year. It also found that subprime servicers weren’t reaching out to borrowers to rework loan terms.

Subprime adjustable-rate mortgages valued at close to $600 billion are expected to reset into higher monthly payments by the end of next year.

Ms. Bair recommended making the wholesale adjustments for owner-occupied mortgages where borrowers are current on the loans. This would exclude homes bought by speculators.

Her suggestion would most likely affect loans that have a low starter rate for two or three years and reset to much higher rates. Many of those loans are adjusting now and have helped push a record number of homeowners into the foreclosure process.

“Keep it at the starter rate,” Ms. Bair said at the Clayton Annual Investor Conference. “Convert it into a fixed rate. Make it permanent. And get on with it.”

Ms. Bair and other federal regulators likely couldn’t force servicers to make these changes, but her message might be interpreted as a warning to loan servicers about potential legislation, said Howard Glaser, an industry consultant based in Washington.

Congress is responding in other areas. The House approved legislation providing tax relief to homeowners facing foreclosure.

The bill, approved 386-27, would let a homeowner exclude from income the value of debt forgiven if the owner reworks the terms of a mortgage with his or her lender. Currently, forgiven debt is treated as income and subject to tax.

The bill was backed by business groups but received measured support from the White House, which objects to making the tax break permanent. President Bush is pushing an alternative that would protect homeowners from the debt-forgiveness tax for three years.

This may sound like an elegant solution, since it addresses the problem raised in the Financial Times yesterday, namely, that mortgage servicers don’t have the staff capacity (or a financial incentive) to renegotiate troubled mortgages, since it’s a time-consuming, one-on-one process. Bair’s suggestion is a one-size-fits-all approach that would presumably work in many cases.

In fact, many of these deals were so dodgy that they were underwater almost from the outset, so this remedy wouldn’t be as effective as it might seem. As Dean Baker told us in his “News Flash: The Problem With ARMs is Not Resets“:

Most of the news reporting on the subprime meltdown has focused on the problems that borrowers face when their loans reset from low teaser rates to much higher fixed rates. While this is a big issue for millions of borrowers, resetting subprimes are just a single wave in an ocean of bad mortgage debt.

This can be seen from the fact that many of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance.

Since no mortgages had reset at the 10-month point, clearly there were other problems. Either borrowers could not afford even the low teaser rates or they were defaulting because they realized that their homes were worth less than their mortgages. The latter problem will only get worse as house prices continue to decline in response to the glut of housing on the market (the inventory of unsold new homes is 50 percent above the previous record and the number of vacant ownership units is almost twice the previous peak) and tightening credit conditions curtailing demand.

Hhhm. Bair doesn’t seem to know her own agency’s data.

But that’s actually a minor problem, believe it or not. The real problem is that there is absolutely no way that her proposal could possibly be acted upon.

The reason is simple. Mortgage servicers have no obligation to borrowers. Zero. Zip. Nada. They are the agents of the investors (technically, the agreement is with the legal entity that holds the mortgages). The only basis for them to do a loan modification is first, if it is permitted by the trust indenture (many restrict “loss mitigation” mods, the kind that help borrowers) and second, only if it appears likely to improve returns to the investors.

If a borrower is having trouble, modifying a loan may merely serve to forestall the inevitable. And in a deteriorating housing market, delay means a foreclosure sale at a lower price.

The article notes that banking regulators can’t require mortgage servicers to take those steps, but an industry consultant opined that they might do so to forestall legislation.

Dream on. The servicing agreements are contracts governed by state law. The Feds can’t willy nilly override them. To do so would raise fundamental federal/state law issues, which in turn would lead to years of court challenges.

Moreover, what is the basis for this intervention in private contracts? Essentially, this is a forced redistribution from investors to borrowers. Perhaps I am not thinking broadly enough, but I can’t recall a precedent for Congress enacting a law to redistribute the results of contracts executed between private parties. The only basis I know of for the government to take wealth from a private party (aside from taxation or seizure of property obtained by criminal means) is eminent domain, when the government seizes property for public use (although that notion has been strained by cases where real estate has been turned over to private parties for development).

As much as I wish an idea like Bair’s could be put into practice, we need to recognize what it is: an expropriation of investor assets. As such, it will never happen. Ir faces way way too many legal obstacles, as well as huge resistance from the securities industry and investor groups. Anyone worried about the competitiveness of US markets would be dead set against a move like this. Who would ever buy a US security after it was established that the government could rewrite its terms?

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  1. Anonymous

    Mortgage sevicers are absolutely obliged the lender. A measure like this (even if it could be sorted out legally and ethically) would have a further chilling effect on the MBS/CDO iceberg. Not only would record defaults still be in view, but also subterranean returns going to middle men who can’t service the debt they took on to purchase this garbage in the first place. And so on down the line. Ridiculous.

  2. a

    Don’t understand this proposal either. The term of the loan would presumably explode should the monthly payment stay constant. A 30-year loan becomes a 50-year loan ??

    Let me guess, another Bush appointee…

  3. a

    Reading over at Calculated Risk, it seems that most people are interpretting this proposal as one where the term stays the same. In other words, the borrower makes off like a bandit. That’s pretty clearly a disaster for the lenders; getting 2% for 27 years is a lot different than getting 8%. That’s going to make a lot of CDOs – the ones that are supposed to be getting this interest – nigh worthless.

    Competence in government does matter; too bad Americans don’t know that.

  4. Kathryn

    The reason that a Bair style bailout would be in the investors best interest (help the mortgagee stay and pay at a discounted rate) is that the alternative is a foreclosure sale for < 50% of valuation. The choice for the investor is not 100% payments or 100% foreclosure sale!

    Just look at the foreclosure sale prices vs outstanding mortgage values. This would not be a government "forced" restatement of loans but an expedient ER triage staunching of bleeding compared to the foreclosure sales process which can take longer than a year.

  5. Anonymous

    Okay, hindsight is 20/20 and it’s not fair to comment on an article more than a year after it’s written, but boy time sure did make the writer of this article look like an idiot.

  6. Yves Smith

    I beg to differ.

    First, the IndyMac mods have been tried on only 3,000-4,000 mortgages. way way too few and way way too early to reach ANY conclusions.

    Second, and far more important, the mods the Feds are trying to force on the servicers are too shallow to do any good. You clearly have not read the details of the FDIC plan. Mortgage counselors (and they, unlike servicers, have a good feel for borrowers’ ability to pay) have been telling me for 6 months (and recall the housing market is deteriorating all this time) that mods with no principal reduction will fail. And given how far the markets have fallen plus the cost of foreclosure, a principal reduction would be a win-win in theory, but in practice, it would often hit certain layers of a tranched deal worse than others.

    The MBS do allow for mortgages to be bought out of the pools….at face value, which solves no borrower problems.

    The FDIC is throwing a lot of energy behind a program that will yield very very little. Check back in a year and I guarantee the current Bair approach will have been abandoned for something that allows for more borrower relief.

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