Initial Award of Frederic Mishkin Iceland Prize for Intellectual Integrity: Calomiris, Higgins, and Mason Paper on Mortgage Settlement

It seems more than a bit peculiar that, per American Banker, financial services industry participants have paid for three academics to issue a lengthy paper attacking a leaked draft settlement between state attorneys general and mortgage servicers. We have pointed out in multiple posts that the state AGs bargaining position is weak due to the lack of investigations. If the banks don’t like the terms, they can tell the AGs to see them in court.

But far more interesting is how embarrassingly bad this paper, “The Economics of the Proposed Mortgage Servicer Settlement,” by Charles Calomiris, Eric Higgins, and Joe Mason, is, yet how the economics discipline continues to tolerate special-interest-group- favoring PR masquerading as research.

In real academic disciplines, investigators and professors who serve big corporate funders have their output viewed with appropriate skepticism, and if they do so often enough, their reputation takes a permanent hit. Scientists who went into the employ of tobacco companies could anticipate they’d never leave that backwater. Even the great unwashed public knows that drug company funded research isn’t what it is cracked up to be.

But in the never-never realm of reality denial within the Beltway, as long as you can get a PhD or better to grace the latest offering from the Ministry of Truth, it gives useful cover to Congresscritters and other message amplifiers who will spout whatever big donor nonsense they are being asked to endorse this week.

The Academy Award winning documentary Inside Job depicted how the fish has rotted from the head in the economics academy, using former Harvard dean Larry Summers, former Fed vice chairman Frederic Mishkin and Columbia Business School dean Glenn Hubbard as object lessons.

Despite our publication of Academic Choice theory, which provides more formal support for the Inside Job observations, we’ve seen perilous little in the way of a change in attitudes from within the academy. So to make a wee additional contribution on this front, we are inaugurating the Frederic Mishkin Iceland Prize and making Calomiris, Higgins, and Mason its initial recipients based on their remarkable work as exemplified in this paper.

First and foremost is that this article goes well beyond the normal boundaries of shilldom, which is generally confined to cherry picking of data and artful framing. There are multiple, gross distortions, which call into question either the writers’ honesty or their knowledge of the basics in the mortgage servicing arena. But that level of inaccuracy is necessary to create the simulacrum their patrons desire, that of a parallel universe in which servicers are virtuous, borrowers are scheming, and the rule of law operates only for the benefit of corporate interests.

Another one of its distinctive contributions is the multiple layering of what mere mortals would call “stupid”. For instance, this paper cites earlier work on strategic default and mortgage mods that is analytically dubious. So it creates a steaming edifice of garbage but via its extensive citations, it hews to the form of normal academic output, making it look legitimate to those who don’t know the terrain.

Let’s look at the paper in some detail. It is so wrongheaded in so many places that a detailed shred would tax the patience of readers. So for the most part, I’ll stick to broader issues.

Attack on principal mods based on inaccurate and misleading reporting of history. The main reason for this paper being issued is most likely to be to demonize the notion of principal mods generally rather than the 50 state AG settlement proposal since any deal would be negotiated and completely voluntary (note that the paper’s depicting them as “government mandated” is one of its many distortions).

First, it charges that principal mods don’t work. Any honest appraisal can’t possibly conclude that, since in every local/regional market housing downturn prior to 1995, mortgage mods to borrowers with viable income was standard practice by banks. Moreover, Wilbur Ross, who has also recently engaged in deep principal mods, reported results far better than that of shallower payment mods, and Chris Flowers is rumored to have developed a template for principal mods based on his experience with IndyMac. So the article argues from irrelevant examples to do so, such as HAMP, which was a five year payment reduction program. Saying HAMP failed to work is like saying aspirin failed to cure pneumonia and therefore there is no point in prescribing antibiotics.

But we get sanctimonious nonsense like this:

Moreover, the settlement assumes, without any apparent evidentiary basis, that there should have been more modifications than have been made thus far. We are not aware of any disclosure or discussion of any criterion by which advocates of the settlement have reached that conclusion, nor a statistical analysis in support of that view.

Given that they fail to offer anything remotely approaching that standard of proof for their position, it’s more than a tad disingenuous for them to then use the unverifiable claim that they know of no evidence to mean that there is no counterevidence of the sort we cited above. As Tom Adams translated by e-mail:

Other than thousands of forged documents, false fees and charges, collapsed law firms, plummeting home prices, abandoned communities, and insolvent lenders and builders, we are not aware of any evidence that foreclosure is not a better route to fixing the housing problem, said Mason.

The most important reason that mods have failed to date is servicers have every reason to make them fail. Servicers earn fees related to various activities in foreclosure. They don’t get any compensation to do mods. They can execute foreclosures in a very streamlined (indeed, overly streamlined, as the number of abuses attests) manner. Mods, by contrast, are costly. They are tantamount to underwriting a new loan and have good odds of not working if not done on bespoke or partially bespoke basis (initial screening out to eliminate obvious non-candidates, with more individualized evaluation of the balance). The servicers have never invested to build the infrastructure to do it correctly. And for that reason, servicers have also falsely claimed that the pooling and servicing agreements don’t permit them to do mods, when that is true only for a subset of deals. So their past failures were predictable and in no way constitute proof that the principal mods don’t work.

Complete whitewashing of servicer actions and incentives. Reading Calomiris et al., you’d never have the foggiest idea that servicers engaged in robosiging and forgeries, pyramiding/junk fee created foreclosures, and cheating investors via fee double-dipping (as with broker price opinions) and improperly using principal repayments from current borrowers to reimburse themselves for principal and interest advances on delinquent borrowers, along with all too frequent operational incompetence.

The paper has the gall to insinuate that the proposed settlement, which we attacked because for the most part all it does is call for the servicers to obey existing statutes (why do we need to negotiate with them to do that?) could undermine the rule of law. Yet it ignores the elephant in the room, that banks have bolstered their income in this line of business with institutionalized fraud. So to argue that that the reduced returns the banks would experience by finally cleaning up their act represents some sort of broader social harm is utterly backwards. By the same logic, we should allow, and maybe even incentivize drug dealing, child prostitution, and counterfeiting since they are all GDP enhancing. As Adam Levitin writes:

The AG settlement would make servicers comply with existing law in judicial foreclosure states. In other words, it would make servicers give mortgagors what they had bargained for–adherence to judicial foreclosure rules….

Finally, back to that 20-45bp number. The calculation of this figure is really pretty silly and not a serious academic exercise. It’s a guess. It’s also a very unfair figure to pin on the settlement. If the residential private-label MBS market is to get restarted, mortgage servicing will have to be radically reformed. There’s no doubt that going forward servicing will cost more. Servicers massively underpriced relative to the costs of performing their contracts. This has nothing to do with the AG settlement proposal. The real question is whether the AG settlement proposal will add costs to mortgage servicing above and beyond the costs that will be imposed by the market. It’s far from clear whether there are any given how skittish private-label MBS investors are (and rightfully so).

I would have thought that rule of law was priceless; that without it markets could not function, homo homini lupus and all that. But apparently, rule of law is not even worth a lousy 20bps.

Yet the paper attempts a finesse via a false claim that struck yours truly and Mike Konczal, that servicers have a fiduciary duty to investors and therefore, by Panglossian extension, must already be behaving correctly.

Earth to base: servicers are NOT fiduciaries. They have only contractual obligations to investors. And even the “trustees” which are parties distinct from the servicers, are not the sort of trustees with broad discretion to handle the affairs of widows and orphans and are thus held to a fiduciary’s standard of care. Konczal cites a post by Adam Levitin:

A securitization trustee is not a general purpose fiduciary; it is a corporate trustee with very narrow duties defined by contract, and entitled to rely on information supplied by the servicer. So we’ve got a case of feral financial institutions, a sort of servicers run wild, with both homeowners and MBS investors bearing the costs of unnecessary foreclosures, all because servicers misjudged the housing market and didn’t charge enough to cover the costs of properly performing their contractual duties.

Distorted macroeconomic analysis. This part is stunningly bad. Conceptually, they argue for the Mellonite position that foreclosures need to happen for the markets to clear. Funny, that’s the reverse of the position that the government has taken at every turn with the banks, where overt and covert bailouts (like the Fed’s super low interest rates) and extend and pretend are the order of the day. So by that logic, Calomiris and his co-consipriators should also be in favor of wiping out second mortgages on seriously upside-down borrowers, which would require the four biggest banks to be recapitalized.

First, they ignore the fact that we have so much inventory overhang that dumping more homes into foreclosure is simply going to lead them to sit vacant and unsold. Banks do a terrible job of securing and maintaining them; they too often wind up being vandalized, stripped for copper, or simply get musty and moldy. Indeed, that’s one of the big reasons for foreclosure times becoming so protracted: banks are keeping borrowers in homes because they remain on the hook for property taxes, plus they take care of home maintenance. So the actions of the banks themselves to date contradict the argument made in the paper.

Second, normal creditor behavior in every other lending product is to prefer a restructuring whenever possible to liquidation because it maximizes value. So why should mortgages be different? That alone means that having the only way to deal with delinquency be to foreclose results in unnecessary foreclosures. The fact that investors suffer losses of anywhere from 50% to over 70% on a foreclosure also means they’d be happy to take a writedown to a borrower with adequate income rather than proceed inexorably to a foreclosure.

The authors contend that banks now use NPV analysis to decide whether to offer a mod. That’s false (Felix Salmon simply hooted at how ridiculous this claim was). While HAMP required the use of NPV analysis for participating servicers, it was otherwise used only for comparing a short sale to a foreclosure, and then only by servicers like Litton which were more serious about handling delinquent borrowers than the bulk of the industry.

Felix also jumped on a stunning misrepresentation in the paper:

As for the authors’ attempts to quantify the costs of the settlement, they use numbers in the CFPB report uncovered by Shahien Nasiripour which says that “effective special servicing of delinquent loans would have cost 75 bps/yr more than the actual costs incurred” — except the way they put it is very different:

The CFPB recently estimated that five servicers avoided $24 billion in costs between 2007 and 2010, yielding a 75 basis-point reduction in interest rates.

Er no, the CFPB nowhere says or even hints that there was any kind of reduction in interest rates as a result of the banks’ broken servicing operations. (And it wasn’t five servicers, it was nine.)

This bit of dishonesty is the basis for their argument that the cost of lending will rise. And note how gross a misrepresentation this is. Not only do they say that the 75 basis points applied to market interest rates, when in fact it was servicing fees, but they further tried to apply a figure that related only to distressed mortgages to the entire mortgage market. This is in other words is a distortion on multiple axes.

The article also astonishingly ignores second order effects of unnecessary foreclosures: sales at distressed prices, the high odds of overshoot of housing prices to the downside, clogging of the courtrooms, and perhaps most important, increased legal challenges to foreclosures Do they really want more borrowers chipping away at the foundations of the mortgage industrial complex? Major investors have examined chain of title issues and the impact of major rulings like Ibanez in this area. Many think the problems are serious and have been loath to take action themselves against the originators and trustees because doing so has the potential to create a new financial crisis. In other words, Calomiris, Higgins and Mason should be more careful about what they wish for.

Other data/factual distortions. There are SO many things that are just plain wrong that one wonders how the authors can assert expertise with a straight face. To pick just a few:

Option ARMs. The paper focuses on an alleged wave of Option ARM resets in 2011. The argument is muddied, but the assertion is that these borrowers can’t be saved but will chew up mod capacity. That analysis relies on a Jan 2010 study by Laurie Goodman. It was an outlier at the time, since it assumed a high default rate, plus a payment shock that assumed increases in LIBOR The LIBOR increases have not materialized.

And they also fail to quantify how many Option ARM resets there will be. Guess what? Not many. Of the original balances, half have defaulted, and 25% has paid down. Calculated Risk, who is normally relentless on this beat, wrote two post in early 2010 on how the feared 2011 resets were not going to amount to much, and has not even bothered returning to the topic since then.

Bank equity discussion. This is rich (p 13):

….the effects of transferring resources from banks to borrowers could reduce lending and hamper short term economic growth and employment (as bank equity capital is the basis on which the supply of lending is based.

I guess the authors have not heard of securitization. But a 1999 Calomiris paper seems to exhibit a passing acquaintance with it, since he mentions, “But lenders realize that the securitization that provides their funding base…”. The bigger issue is that the relatively paltry sums that the writers get so exercised about is not going to impair bank capital in any meaningful way, and banks have reserves piled up at the Fed, which confirms that they have boatloads of unused lending capacity.

South African consumer credit reference. There are a lot of lower level howlers, like the one mentioned above. Another is the fact that the authors are so desperate to prove that borrowers behave badly that they cite a study of South African consumer finance study as a basis for arguing about the danger of encouraging strategic defaults. This is so apples and oranges as to be offensive. Consumer finance in South Africa, which does not have our credit reporting system, is not at all comparable to the US. The negative consequences of defaulting on consumer credit and on housing debt in the US are much higher, thanks to our extensive and speedy credit reporting, which is widely used in job screening. And that’s before we get to the considerable emotional attachment to primary residences.

I have to wonder whether the sponsors of this study had to shop to get such a bending-over-backwards-to-be-favorable report, as issuers often did with rating agencies, or whether the authors’ willingness to accede to the propaganda needs of the banks is so well established that it was an easy decision. And like rating agencies, these economists bear no costs of their bogus, irresponsible, client-pleasing analysis. As Outis Philalithopoulos observed:

….an economist has an incentive to propound theories that CEOs and financial institutions find attractive. Even if adoption of these theories leads to substantial public costs, these costs will not be shouldered by the economist personally.

So naming and shaming will have to do until the discipline decided to do a better job of policing its members.