To Bailout or Not to Bailout: Mortgage Mess Endgames Emerging

In the last week, several ideas for fixing the housing market have surfaced. One is the Third Way proposal, which appears to be an Administration trial balloon. Predictably, it is yet anther bailout, with plenty of smoke and mirrors to disguise that fact.

A second proposal, from Sheila Bair yesterday, is to establish a “foreclosure claims commission“. This is in keeping with the direction that Iowa’s Tom Miller has been pushing for with the 50 state attorneys general investigation. This scheme sounds more promising that the Third Way proposal, but is very likely to wind up in bailout territory.

Third is a not-widely-covered plan by Senator Jeff Merkley which has two provisions that would force banks to address the fact that mortgages are deeply under water. That makes it firmly anti-bailout (or more accurately, any resulting bailouts would be explicit as opposed to buried in various mortgage market gimmies to banks). It would thus speed recognition of housing market losses, force debt writedowns, and accelerate repricing and clearing of the housing market.

The Merkley proposal is pro consumer and pro investor; the other two are pro bank. Sadly, it isn’t hard to see which is likely to prevail in the absence of public pressure.

The Bair proposal was presented at the Mortgage Bankers Association meeting in DC, In addition to the not-very-fleshed out idea of a claims fund, she also proposed a list of fairly modest but still badly needed servicing reforms, the biggest being required write downs of second mortgages when the servicer is negotiating the first mortgage with a borrower, and a independent process for appealing loss mitigation turn-downs. The latter is useful but needs to be made broader. Borrowers still lack any recourse save costly and time-consuming litigation if they believe servicers have made errors, so independent review should include a disclosure and dispute process for routine servicing.

The restitution fund concept is worrisome. It is not yet clear whether it will be funded, which means it could be a joint private/public kitty. The provision of any explicit government funding in the absence of a serious investigation, including possible criminal action, is not warranted. The hallmark of this financial crisis is no perps, save some foot soldiers (the hapless robosigners, for instance) have been identified, much less held to account.

And even the private funding model is likely to prove unsatisfactory. HousingWire suggested that it might be based on the BP restitution fund. That’s a red flag. The BP fund was seen as a win for the embattled oil company, since BP was given several years to contribute money to the fund. In addition, even though the fund in theory did not limit BP’s liabilities, most investors reacted as if the damage had been capped. And given that any participant in the fund claims process had to waive his rights to litigate, the process did serve to limit exposure (particularly of the punitive damages sort). Moreover, many people who applied for damages were deemed not to be eligible because the harm they suffered was allegedly too indirect (think hotel owners in affected areas). Others were denied because they could not document revenue and expenses (many small fishermen run heavily cash-based operations that are not hugely profitable even in the best of times).

So it is also easy to imagine, as with the various government mortgage mod programs, that the banks will run the process and will use strict documentation requirements as a way to limit payouts, when their abuse of the documentation procedures they created is at the root of this crisis.

By contrast, there is much to like about the Merkley proposal, which was covered by Dave Dayen at FireDogLake. It has two mechanisms to force banks to recognize and realize losses on underwater mortgages, and thus put an end to “extend and pretend”.

First is a “national short refinance program”. Per Dayen:

When a bank sends a home into foreclosure, it becomes an REO property, to be sold at auction at a large loss for the investors. Instead of going through the long process of resale, with the attendant upkeep that has to be spent by the bank on the home, and the disruption to the property values from having a vacant home in their neighborhood, this short refi program would allow qualified families facing eviction to refinance to an FHA-guaranteed mortgage based on current property values and interest rates. In the interim the family could stay in the home during the appraisal, new underwriting and final resolution. Many families would be able to pay a reduced payment if the home was written down to real value. The investor would get a bigger payoff than selling a vacant home in foreclosure. Neighbors would see their communities stabilized without a vacant property in their midst. And the family would get to stay in their home.

The main effect of the FHA short refi program is likely not to be a wave of mass refis, but to force servicers to offer deep principal mods. If a mortgage leaves the pool via a refi, the servicer loses all of the fees associated with that loan. If the servicer concludes a mod, it still gets ongoing servicing income, but on a lower principal balance.

The second mechanism is judicial modifications, aka bankruptcy cramdowns. In pretty much every other type of secured lending, save for residential mortgages (which were exempted via legislation), when the borrower goes into bankruptcy, the secured debt is written down to the value of the debt, and any amount owing beyond that is added to unsecured debts. The idea is commonsensical: you can’t say a $200,000 mortgage is “secured” by a house now worth $160,000. The court process is well established and not controversial (as in you don’t see fulminating about abuses).

The scaremongering by the banking industry used to forestall judicial foreclosures is that every Tom, Dick, and Harry will run to the courthouse to get out of his mortgage, As anyone who has contemplated or gone though bankruptcy knows, it’s a very painful, humiliating, and disruptive process. And the widespread use of background checks as part of employment screening, with a bad credit record seen as a sign of bad character, is yet another deterrent. Correspondents of mine who would be ideal candidates (for instance, one is underwater due to investments gone sour and Chinese drywall making a sale of their home impossible, yet still have decent cashflow from their main business) are still loath to file.

Proof of the legitimacy of judicial mods as an option comes from the fact that most mortgage backed securities investors favor it, because they see it as a device for servicers to offer principal mods. With servicer fees and expenses coming first out of mortgage cashflow, the costly foreclosure process comes out of investors’ hides. All but a small percentage prefer principal mods because it will produce lower losses to them than costly foreclosures and sales of distressed property.

The Merkley plan has some other promising elements, such as requiring servicers to have a single point of contact (the Bair servicing reforms include this idea), a broad third party review process for mortgage mods (similar to successful programs at the state level) and the end of the “dual track” process (which keep the foreclosure process in motion while mod discussions are underway; this idea was present in a watered down form in the Bair speech as part of the foreclosure “settlement”).

Frankly, although individual borrowers may continue to suffer, the best prospect for an equitable long term solution is to let the wheels of justice continue to grind on. The outburst of reform ideas seems to be the direct result of the Massachusetts Supreme Judicial Court Ibanez decision. The terms of debate are, perversely, still very much skewed in favor of banks despite the considerable harm they have done to homeowners, investors, and communities. But judges are increasingly abandoning the assumption that banks must be right in foreclosure cases, and a more objective posture is sure to put the banking industry even more on the back foot. Letting the courts continue to do their work offers the best hope of exposing, and therefore ultimately remedying, large-scale misconduct by the securitization industry.

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  1. attempter

    I wasn’t gonna say it, but since Yves did:

    Frankly, although individual borrowers may continue to suffer, the best prospect for an equitable long term solution is to let the wheels of justice continue to grind on.

    Yes. No “reform” is mean to be anything but a way to prop up the zombie banks and save them from yet another disaster of their own creation. Even if something like the Merkley proposal (which has no chance of enactment anyway) could temporarily help some debtors, this is still just dragging out the agony. The best thing for all of us would be if this mortgage disaster follows through along the complete line of its logic. That offers the best chance to generate real legal and political blows against the banks.

  2. Expat

    Hello Mrs. Blessing Faith. I am a legit borrower. I need to borrow some money in order to become very rich. An honest man (also legit) from Nigeria has promised me thirty million dollars if I help him move money out of a de-activated bank account. In order to do so, I need one hundred thousand dollars (he needs to prepay some banking fees and “grease some wheels”).

    Please, Mrs. Bleeding Faith. Lend me the money. After my Nigerian contact, Dr. Feelgood Ebola-Monkey, sends me the thirty million, I will pay you back. Really. Legit.

  3. Conscience of a conservative

    The Merkley plan basically aims to keep more people in their homes. It puts the tax-payer on the hook if they fall back into delinquency. The only silver-lining is that the new loan is done based on today’s market value. I suspect that those that applaud this plan are doing so by virtue of keeping people in their homes. While admirable , it’s a little romantic, as statistics show that recidivism for such loans/borrowers are high.

    People who don’t pay their loans should not keep their home. Ordinarily this is the case, but in the current mess we’re seeing the banks have abused the system and have not followed the rules and I think broken the law in too many instances. This is why the Bair proposal makes the most sense. We need to make sure the process is fair and that the servicer is following correct procedures, but we do need to clear the system and process foreclosures.

    1. Art Vandeley


      You bring up a good point about the recidivism rate on defaulted loans. We’re currently seeing high levels of re-defaults on 5 yr payment reduction trial mods (Extend and Pretend legacy mods), leaving borrowers with 150%+ LTV, and no shot in 15 years in having equity in their home. Many borrowers in distress tend to stay in distress, no matter the condition of the housing market.

      In many ways, FHA’s Hope For Homeowner plan was supposed to do what the Merkley plan is proposing. The guidelines were nearly impossible to qualify for, very few lenders offered the program, and very few servicers were willing to issue a short payoff.

      I’d hope the Merkley plan forces servicers to issue a short payoff upon receiving a loan approval and estimated HUD1 for the new loan.

      In the meantime, the industry will just keep extending and pretending with re-defaults under the status quo.

      1. Leviathan

        You should check out this academic paper from 2010 on the New Deal HOLC (which Hillary briefly talked about reviving during the 08 campaign).

        Bottom line: even in the New Deal, mortgage relief for homedebtors was a backdoor bailout to the banks who were overpaid on the bum mortgages to persuade them to let the serfs go. Principal reduction was widespread, but not as deep as it should have been (i.e. debtors could pay the mortgage but were underwater for years and years). But the most interesting point, perhaps, is that redefault was not a big problem, because people got back some stake in their houses.

    2. masaccio

      You raise a good point. The problem is as commenter Art Vandely says, that the principle mods are too low, and do nothing about the rest of the debt. That is true of part one of the Merkley Plan as well. It fixes the home loan, but does nothing about the rest of the debt.

      Chapter 13 fixes that problem. The liens are modified to the current value of the residence, and if the homeowner can make that payment, all of the rest of the homeowner’s debt is dealt with by the Plan. The Plan will provide that payments come directly from the homeowner’s employer(s) to the Chapter 13 Trustee. The homeowner has enough to live on in accordance with the rules of Chapter 13, and to make the house payment as modified.

      All of the income beyond the amounts allowed under Chapter 13 goes to pay unsecured creditors, pro rata. The difference between the original amount owed and the revised loan is treated as unsecured debt, so it gets part of any payment.

      After a Chapter 13, assuming that the homeowners keep their jobs, the entire debt load is manageable, and there is considerable incentive to stay on payments.

      Chapter 13 imposes fair rules about that excess income, and that is one reason people won’t rush into bankruptcy to fix mortgages. If they can live without bankruptcy, they will use the first part of Merkley.

      1. smellslikechapter11

        Can’t cram a lender on your residence in chapter 13 or 11 since the 2005 amendments as you suggest.

        Now if you could, that might force servicers and banks to write down their loans to current value without breaching their duties to their investors because of the threat of cram down.

        I still think that this is the one of the biggest reasons it is taking so long for the market to clear. I might be myopic becuase I am a BK lawyer, but i do believe the issue is very significant.

  4. Francois T

    Any plan must be driven by an imperative to force the banks to stop flouting the law. The “need to process and clear the backlog of foreclosures” ought tobe subordinate to the rule of law.

    I personally do not give a hoot about the effect this would have on the banks. They risk capital (OPM in reality) while constantly giving a fat middle finger to two centuries of established real estate law. And, we should exhibit ANY kind of restraint toward those bandits because…what exactly?

    Of course, as long as wee have Model T3* Geithner droid serving as agent of ObamaNet for banks…

    *Turbo Tax Timmy

  5. MinnItMan

    As it stands now with my caseload, the best result I’ve been gotten has gone to my “least-deserving” client who also happens to be a close friend. He is lucky enough to have had his lender provide a robo-signed affidavit to the court which was really stinking up the lender’s case, and now, seems to have induced it to just walk away from it slowly, hoping the stench won’t follow it. My client sent a Christmas card to the signer.

    Unlike attempter, I don’t think that what is bad for the banks is necessarily good for the rest of us, but I otherwise get his point. Real change from consumerist habits of debt and egregious misuse of resources on so many different levels is unlikely until we see truly Gothic times. But, I don’t know if the desired change would happen then, either.

    While I generally have been in favor of something like Sen. Merkley’s proposal, I don’t necessarily think that it will just be the banks opposed to it (again). There are a lot of rent-seekers in a commodified housing market, and IMO, cram-downs will at least have the temporary effect of draining whatever money is still sloshing around in the system to pay their fees, to their extreme displeasure. The [multi]-trllion dollar question is what happens to “price discovery” where the real estate transactional financing complex operates somewhat sanely (financing at 97% of current prices, in my crystal ball, looks a lot like 110% at next year’s – and beyond’s prices, and thus doesn’t yet qualify as “sane”).

    Back to watch justice grind on.

  6. Investor Parasite

    Cram-f$%king-down! Why is the Oligarchy so resistant? Need we ask?
    This is war:

    “If you make less than $114,000 a year (90% of us), you’ve been financially damaged by the flow of income to the richest 1% of Americans over the past 30 years.”

  7. liberal

    One good long-term solution to this mess is to drastically increase property taxes. That way, as I think Michael Hudson has pointed out repeatedly, rent is paid to local governments instead of banks. Of course, current property owners (myself included) will take a huge hit.

    1. taxpayer

      We owners will take a hit whether our property taxes are raised or not. How much is real estate worth in a municipality which is bankrupt, or in a school district which can’t afford to pay their teachers? And do we really want to live in such places? At least if property taxes are raised, local services might be maintained.

      But I think Hudson had other reasons for recommending property taxes over income or sales tax. Note that the housing price collapse has been worst, for the most part, in states where property taxes (as a percentage of value) are low (California, Florida, Nevada). Places like Illinois and Texas, with higher property taxes, have suffered less.

  8. eagerly beaverly

    Wrong, wrong and wrong again. Its a cultural meme that bankruptcy is so bad, when in reality, it is quite painless. And if you time it right, you wont be harassed by even a single creditor. Some cultures in our fair country handle bk so much different than the middle class quasi_suburban folk who look upon bk as a personal failure (in a rigged marketplace nonetheless) rather than an important tool to fend off creditors.

    “It’s a very painful, humiliating, and disruptive process. “

  9. lambert strether

    The real answer is, as it has been since 2008, HOLC:

    The original HOLC, launched in 1933, bought mortgages from failed banks and modified the terms so families could make affordable payments while keeping their homes. The original HOLC returned a profit to the Treasury and saved one million homes. We can save roughly three times that many today.

    Of course, since that’s a New Deal program that actually worked, it’s off the table in Versailles, including the administration, career “progressives,” and Obama’s rump Ds.

    None so blind…

  10. Leviathan

    Is the Merkley proposal legitimate or is it political grandstanding? The question needs to be asked in all seriousness. I mean, I give the guy props for putting this out there, but where is his back-up? I’m no fan of Sen. Durden, but he was number 2 in the senate when he put up his cram-down legislation waaayyyy back in 2009 (or was it 08?) and he made a genuine effort to get backers. Where are Merkley’s cosigners? House partner?

    I thought so.

  11. Paul Tioxon

    Merkle’s legislation points to equity of the homeowner taking precedent over the banks right to act on a non performing loan. Furthermore, since the banks have found relief from the government in various forms, too many to recite yet again, they were made whole, for the most part. The banks continue to receive massive support in every manner to make them materially better, if they have not yet completely achieved that recuperation as of today. Now, as to the rest of society, in particular the citizenry as homeowners, where is their relief?

    The banks lend knowing that a percentage of loans will fail. The massive scale of failed loans, due to every scenario known and the newly invented ones of our time, exceeds even the reserves and built in pricing for risk of normally accepted levels of loss. There seems no way that banks can ever be made whole due to the overwhelming inflation of housing values that now lost, can never be recaptured. It serves the public good to allow people who want to and are able, to stay in their homes. Since the banks can not be made whole, at least the equity of our citizens in the form of their communal lives can be preserved as much as possible, based on current price levels for the homes and incomes of the homeowners.

  12. Tommy

    Those underwater mortgage owners who put 20% down and are still making payments on their primary homes should be forcibly bailed out by the banks so that their mortgage reflects the real market value of their property. Why? Because in America, a bailout shouldn’t be the exlusive domain of the predator class. Otherwise, these underwater mortgage owners should be given the right to walkaway from their mortgages without allowing banks any recourse.

    1. Fran

      Yes. I feel very badly for the people who have equity and are making payments on overpriced houses. If they sell or walk away, they lose all of their equity. I know of a young couple who used their savings for a down payment and now stand to lose a couple/few hundred thousand dollars that way. The banks drove the bubble up with their loose lending in the sub prime market.

  13. Ron

    The reality is that we cannot save the banks nor the upside down homeowner both at drowning in debt and bk!These latest attempts to promote some some end game lack any details, for example how would current market value be calculated because the government has propped up home pricing using low down FHA loans along with the FED buying mortgage paper all artificially keeping home prices from falling back to trend so current market value is in fact bubble pricing and home price resell values will continue to fall nationally until it comes into line with household income!
    Its a real mess and will get much worse as the pool of credit worthy buyers continues to shrink,the pool of negative equity homeowners continues to grow due to government financing schemes,structural unemployment, the list is long but you get the idea.

  14. Leviathan

    Check out the paper I reference in my response above. You are right, valuations would almost surely be artificially high, and people would STILL be underwater. But they might survive at that level, and the economy might be helped by their lazarus-like resurrection.

    At the end of the day you are going to have to give people a chance to step down (up?) from their mortgages without the threat of losing their credit for 2-7 years.

    Why are homeowners the only people punished for the crisis? How will the housing market stabilize without letting them back in?

  15. The Answer

    Merkley’s plan is the only thing that will work. Have the FHA or some other government agency, pay the investors full face value of all their mortgages. Turn around and refinance them at 70% of principal at a 5% rate. Over 30 years the goverenment will be paid back $1.35 for every dollar that they paid investors.

    Some people will still fall back into default and at that point the government has the new buyer assume the mortgage. It is all pretty simple and would work.

    The investors get whole. Homeowners who are upside down or have less than 30% equity benefit. The banks who don’t own the loans, but only get paid for servicing them for the investors, could continue servicing them for the government agency, thus retaining some servicing income. T

    1. masaccio

      The idea of bailing out the investors is a non-starter. Every time it has been trotted out, from late 2008 forward, the firestorm of criticism from all sides, left, right, center, indifferent, and ignorant, has forced even this bank bootlicking congress and this craven Treasury Secretary and this spineless administration to deny they ever said anything that even sounded like more bailout.

      1. Art Vandeley

        Agree that bailing out (verb) the investors is a non-starter. The citizens have taken on trillions of investor losses over the last 3 years and besides, Hank Paulson isn’t here to scare the bejesus out of the masses to save his cohorts.

        A problem with any pro-borrower balance reduction legislation is it negates the FASB 166 & 167 suspension of mark to market accounting that’s keeping the TBTF’s propped up. The banking lobby will keep fighting any move aimed at principal reductions.

        I think Merkley’s bill dies pretty quickly and we’re left cleaning up the mess ever so slowly, as the taxpayer gets to pick up the tab on the next generation of backdoor bank bailouts that are guaranteed to come.

  16. Ron

    Lets understand that home resell value longterm rest upon household income. Look if we could wave a magic wane and fix the market I would be all for it but don’t believe for one second that any of these so called fixes will provide any remedy for the homeowner unless the mortgage was crammed down not to the so called home market value but the ability of the homeowner to pay! That is if they had a household income of 60K the max mortgage debt based on a 30% Debt to income basis would not exceed 180K. Believe me nothing like that will happen in Calif or other high mortgage states since the existing mortgage is probably between 350K to 750K.
    Most if not all these save the homeowner ideas based around homes current market value are bank schemes nothing more and they will fail not only for the homeowner who takes they bad deals but the taxpayers who will pick up the tab. The banks are going to fail anyway and need to be recapitalized the government/bond/stock holders/taxpayers need to face that reality.

    1. Grinder

      “Lets understand that home resell value longterm rest upon household income.”

      100% correct. Now what will the impact of globalization have on median incomes? What is modified to be affordable today doesn’t mean it’ll be affordable tomorrow. This isn’t a comment to knock globalization, but rather there’s too much debt relative to future earning capacity.

  17. Rob134

    “Letting the courts continue to do their work offers the best hope of exposing, and therefore ultimately remedying, large-scale misconduct by the securitization industry.”

    A most excellent summation!

    I have more trust in the County and State Judges than I do the entire Federal Judicial System, especially the County Judges. They primarily owe their position to, and answer to, the people, not Corporations.

  18. MinnItMan

    It depends on what you mean by “recission.” Statutory recission won’t work for most people because it’s usually exceedingly restricted on time-lines. Equitable recission suggests some delicious results (clawbacks from sellers, that is builders – who are now broke, unfortunately. Smug retrirees listening to RusHanity, opposing cramdown ’cause they always paid, and only by their frugal living made out?), but the road is long and winding and you got to have demonstrably blameless parties asking. I’m just saying. Equitable cases can be great. But they usually suck. Also, recission is rarely available for purchases.

  19. skyblu5555

    No No No No to any proposal that leaves tax payers on the hook. This entire mess would not have occurred as deeply and widely across the mortgage/real estate market without the development of the MERS, Mortgage Electronic Registry System that is at the heart of this criminal syndicate.

    I sure wish Eric Holder would get to the bottom of this criminal syndicate; apply forfeiture law to take all of the wealth from those indicated and sentenced and use this money to help homeowners stay in their homes.

    Sorry all, but in this case its the wealth of those at the heart of this process and those who colluded with them to create this disaster who ARE the ones whose assets should be seized under the law and used to begin to right these terrible hideous wrongs.

    Real estate industrial fraudsters; banksters and quants… we will find you. There is no place to hide.

  20. dejavuagain

    Let the course of justice continue.

    In the meantime, reform the entire MBS process, get rid of tranches, get rid of cash flow guarantees when mortgages are not being paid, get rid of MERS or make it truly authoritative. require recording of all mortgages and notes, make it unlawful (criminal) for a second mortgagee to take payments when the first mortgage is not being paid, require attorneys providing opinions to Trust to engage in due diligence of loan files and not rely upon assumptions. etc.


  21. Justicia

    Early on, when this train started going off the rails, I read a proposal (forgot where) to force the banks to convert the debt owed on homes that are underwater to equity — i.e., the principal would be reduced and the bank would own a % interest equal to the reduction. If the home latter sold for a profit, the bank would share in proportion to its equity interest. If it sold at a loss, the bank would at least have collected the reduced amount.

    It sounded very sensible to me. Of course the banksters don’t want to take the haircut. But now it’s clear that their likely to get their heads chopped off once the suckers (ah, investors) who thought they had bought mortgage-backed securities only to find that they’re unsecured creditors start suing for fraud. (That haircut looks a lot better than treble damages for securities fraud.)

  22. Opinionated Bloviator

    It is becoming increasingly obvious that there are only 2 real choices left. End the extend,pretend BAILOUT frauds and break up the TBTF into bite sized chunks or suffer a currency crisis and economic collapse. Those are our only 2 options. Pick one.

  23. morpheus


    Friends, Americans, countrymen, lend me your ears;

    What are we to do? The republic is in trouble. Talk and more talk won’t carry the day.

    Read “Common Sense 3.1” at ( )

    We don’t have to live like this anymore. “Spread the News”

  24. David from

    Walking away from your mortgage is unethical and you will likely be denied from getting a new mortgage for seven years. Survey shows, however, most homeowners wouldn’t walk away from their mortgage and still continue to make those payments.

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