How the Fannie and Freddie Could, But Won’t, Cut the Housing Gordian Knot

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The ongoing, still unresolved issue of the mortgage mess is that irresponsible, unaccountable, self-serving “agents” called servicers manage foreclosures and mortgage modifications. Pretty much anyone who has looked at the problem argues that mortgage modifications to viable borrowers would lead to lower losses to investors and less damage to the housing markets than the Mellonite “Liquidate real estate” program in place now.

The reason we seem unable to get off this destructive path is servicers are paid to foreclose, and not to modify, hence they have set themselves up pretty much only to foreclose. And even with bribes like HAMP 2.0 (and increasingly, threats, like pending legislation in California and other states that puts more teeth in the requirement that a servicer negotiate with a stressed borrower), servicers really can’t be bothered. Part of it is their existing software platforms are held together with bubble gum and rubber bands; the other part is that they’d have to create new infrastructure, with very different staffing and management approaches than in their existing businesses. I’ve had “special servicers,” the boutiques that are set up to do high-touch servicing, tell me that it takes five times the staff levels of regular servicers to handle mods, and they think their business has scale limits (as in once a special servicer gets too large, it has to start increasing the standardization of its operations, which undermines doing mods well).

So it appears servicers need more pressure applied to them to make them offer mods to borrowers. Adam Levitin has come up with a new idea that could be implemented readily, at least for Fannie and Freddie borrowers:

Under current bankruptcy law, a Chapter 13 plan may be confirmed only if secured creditors receive their collateral, receive the value of their collateral, or consent to the plan. The legislative proposals for cramdown all sought to enable involuntary modification of mortgages; cramdown was to be the stick that would encourage voluntary modifications.

But we could have voluntary cramdown under existing law and this could be done on a large scale staring immediately. Specifically, FHFA could require the GSEs to adopt a policy of consenting to Chapter 13 plans that have cramdown. (FHA/VA/Ginnie Mae could adopt a parallel policy for government insured loans.) Such a policy would address the two major objections that have been raised to principal reduction by the GSEs: the much dreaded (and overstated, imho) moral hazard problem and the second lien free-rider problem.

There is actually a bit of an operational issue, which may not be trivial. Levitin noted in an earlier post that:

The GSEs claim that when a loan defaults, the property is automatically transferred to the servicer, so that the servicer can foreclose in its own name (and Fannie and Freddie’s names never appear, which would be bad for P.R.). It’s not clear how this automatic transfer actually works–I don’t know of any legal mechanism that blesses it, but maybe it can be brought into the scope of UCC Article 9 (other than in South Carolina).

I’m going to address this matter in a separate post, but this does raise the question of who is actually the foreclosing party and how the GSEs compel them to play ball (since the whole problem to date has been reluctance to discipline servicers). But we’ll assume this issue can be finessed. He also pointed out that unsecured creditors might throw a spanner in the works.

But the real point of cramdown, or a cramdown variant threat, is to force servicers and second lien holders, who foot drag and obstruct, respectively, to cooperate. If Levitin’s scheme is perceived to have good odds of working, and better yet, survives any initial challenges, it would make a huge difference. It would provide a means for getting principal mods, which a newly released study shows have lower redefault rates than other types of mods.

But Levitin points his finger at the real problem, Ed DeMarco at the FHFA and Shaun Donovan at HUD, without acknowledging that the Administration IS the problem. Now, admittedly, DeMarco is now difficult to dislodge. If he were removed, he’d be replaced initially by another acting director, chosen from his deputies, who are all of similar views to him, and he has staunchly refused to consider principal mods. A permanent director would be subject to Seante approval, and the Republicans, who quite like DeMarco, would fight anyone more borrower-friendly being put in his place. They already did so with Obama nominee Joseph Smith, whose nomination was approved by the Senate Banking Committee but blocked from reaching a Senate vote, and the bone of contention was that Smith was perceived by Republicans as being willing to do principal mods.

But it also happens that the Administration is well served having DeMarco in place as a house stooge. That way, the failure of Obama policies can be pinned on FHFA intransigence rather than a series of half-hearted remedies: HAMP, HARP, HAMP 2.0, and of course, the bank gimmie branded as a mortgage “settlement”. So Levitin’s clever approach is a reminder that there are lots of potential remedies to the housing mess. The problem is that any that solution that will do lasting good would reveal the near or actual insolvency of the four biggest US banks by forcing them to write down their second liens. Since that’s what both parties are determined to avoid, zombification, continued abuse of borrowers, and posturing will continue to be the order of the day.

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  1. ifthethunderdontgetya™³²®©

    But Levitin points his finger at the real problem, Ed DeMarco at the FHFA and Shaun Donovan at HUD, without acknowledging that the Administration IS the problem.

    Thanks for putting this in plain language.

    I’ve worked in the business (as an underwiter, not a servicer), but I have trouble explaining it to people (for instance, my relatives).

    1. just me

      Right, what’s missing from Obama’s State of the Union speech?

      And tonight, I’m asking my Attorney General to create a special unit of federal prosecutors and leading state attorneys general to expand our investigations into the abusive lending and packaging of risky mortgages that led to the housing crisis. This new unit will hold accountable those who broke the law, speed assistance to homeowners, and help turn the page on an era of recklessness that hurt so many Americans.

      Mortgage servicers?

      And actual staffing and a phone?

  2. steelhead23

    If the holders of second liens are concerned that through a normal foreclosure, they would be left holding a bag of nothing, one might expect that they would be downright anxious for some form of mod that preserved a fraction of their interest in the property and claim on the debtor. Does anyone know – is there any evidence of such interest on the part of second lien holders, or are they holding their breath and closing their eyes until “it all goes away?” Or is this another situation where the overarching fear is of a derivatives Godzilla, that could be unleashed by realizing losses?

  3. Kent Willard

    The FHA has more 90+ delinquent loans than Fannie Mae, but many fewer modifications (~ 1/3rd) than Fannie Mae. Seems like an opportunity for FHA to show the industry how to do loss mitigation.

  4. Matt

    Any thoughts on the plan San Bernardino County is investigating – using eminent domain to seize mortgages at their current value, giving the homeowners new mortgages (so that they are not underwater), and then issuing new securities? It would seem that if this went forward, it might motivate investors to force servicers to actually act on their behalf.

    1. Yves Smith Post author

      I’m going to get around to that in the next few days. Short version: 1. It won’t go anywhere and 2. Even if it did, it’s not a good idea.

  5. Smellslikechapter11

    As a bankruptcy lawyer of many years, I wish there was an executive go around of the cram down restrictions on primary residences. However, there might be some constitutional problems with approach.

    I would point out that before the change in the cram down provisions in 2005 there were no great problems with the moral hazard created by the bankruptcy code that impeded home lending because as we all know there were shortage of home loans. Given that worst subprime abuses took place after that date, one might argue that the real moral hazard was making lenders feel invincible enough to make those crazy subprime loans.

  6. Richard Davet

    You can’t fix “fatally flawed”, its dead. The GSE Business Model was declared fatally flawed by every creditable scholar.Shut the GSEs down and next week we will have a better mortgage business without any government involvement (free market).A “fix” is also fatal, as it diverts the remedy to a later date which casts a pall on the economy.

    1. Yves Smith Post author

      It appears you did not read the post. This has nothing to do with fixing or extending the life of the GSEs. It has to do with the mortgages they insure.

    2. Binky Bear

      1. Argument from authority with no citation-less valuable than “some dude on the internet says X” because the internet is searchable. GSEs worked well for half a century or more-why did things go south when they did? See Barry Ritholtz’ The Big Lie series, because this position is directly addressed.
      (Short summary: Europe had a real estate crisis with no GSEs and no CRA, no ACORN, etc., so any explanation of the crisis must also address why the RE market, residential and commercial, boomed and crashed around the world simultaneously. Why? Originator, servicer, and banker fraud.)
      2. As follows from Ritholz’ The Big Lie series, the work of the folks at CalculatedRisk and right here at Naked Capitalism, it is clear that the unregulated free market in mortgages became gangster capitalism at its worst. Freedom shouldn’t mean license, and this nation has spent nearly 2.5 centuries evolving away from unregulated capitalism.

  7. scraping_by

    The housing crisis seems to have a recurring theme of bad mental frames, play pretend, and perverse incentives.

    The epidemic of fraudulent mortgages was driven by upfront fees from consumers and investors. Instead of investing in homes, Countryside and its ilk gamed the system to skim a few nickles off transaction costs. Financial transactions seen as a cash flow to be diverted.

    The “settlement” has a truly appalling provision to allow three to five per cent of all mortgages to be posted, serviced, and foreclosed incorrectly with no legal consequence. A legal, moral question of property rights is turned into a management information system question about the accuracy of databases.

    And the best way out, renegotiation of impaired loans, is held up because servicing fees are up front and admitting second liens are worthless would tell the truth about banks. The question is framed as the survival of a few privileged institutions rather than the efficient flow of money.

    Time for a new world view.

  8. Art Vandeley

    Great reminder about the second mortgage mark-to-model charade of the 4 largest and insolvent banks. Had they securitized all those HELOCs and sold to state pension funds, these homes would have been foreclosed by now. Instead, they hold up short sales an extra 6-12 months, or days before foreclosure auction, in order to push out realizing the loss.

    How soon can these banks be broken up?

  9. Guy Fawkes

    What increasingly gets forgotton is integrity of title and chain of title is all but forgotten.

    We have a real problem with the banks having totally taken our land registry and it’s integrity off the table. Property ownership has been one of the reasons the U.S. differs from other western nations because land owners have legitimate title and GUARANTEED title to their land. This has been one of the reasons for our wealth creation in the U.S. And the banks have thrown this whole concept down the drain.

    Why is no one talking about this? We need to stop the erosion of land record integrity NOW.

    1. josiah

      Why is no one talking about this?

      Because it’s such a clusterf*ck that TPTB issued a de facto gag order lest the sheeple stir from their collective trance.

  10. Mattie

    No seconds, no problem, right? What about no credit card debt either? That leaves you with the suckers who bought at the tippy top of the market on the basis of juiced appraisals and other origination ‘irregularities.’ How many of them are in the GSE pool of 2M grossly underwater, yet current, borrowers? And what is Mr DeMarco’s excuse for not righting the wrongs done to this group before it’s too late?

  11. stripes

    Peaceful non compliance and non conformity is the most honorable form of patriotism. How about if no one renews their drivers license, everyone cuts up the debit and credit cards and stops participating…..they are out of business.

  12. Matt

    Just an update on BofA spins of 200,000 refinancings of non GSE loans, ( probably BofA seconds ), that somehow someway, BofA is having trouble getting takers.

    And most recently…
    It was targeted, at least 60 days late Jan 2012, and new payment would be 25 percent more of current income, and tested to insure foreclosure would bring less to the investors.

  13. Westcoastliberal

    The real truth is, no one owns this foreclosed real estate and the closest in fact to ownership is indeed the borrower. Title on the lender’s side is clouded since none of the mortgages perfected the trust, and the borrower is the only party who can actually prove they have skin in the game. Everything else is bullshit and the servicers know this, but hey blow smoke and the judges, unfortunately, buy it.

  14. Steve Bradley

    Your final sentence assumes that there will be no nationwide borrower revolt against lenders. If that were to happen, the crisis would end in a week–or less. I discuss this with my real estate agent colleagues all the time. While the official position of NAR and CAR is that “foreclosures need to move swiftly,” many of us who work in the industry deplore the awful abuse that borrowers have experienced, and I can tell you from my perspective that the personal disaster I have seen beggars the imagination–and all to “save the banks reputations.” So what? everyone already knows that the banking industry is insolvent, if they have a brain.

  15. Debcoop

    There IS a solution to the De Marco problem. It is true removing him just puts someone else in place from the other directors with the same views, probably. And a permanent replacement can’t get through the Senate.

    HOWEVER, the president can make a recess appointment. And depending upon when the appointee can be in there for almost two years.

    Quite long enough to change and effectuate a significant policy change and to make it effect the housing market.


    You are letting the president off the hook by acting as though the two possibilities you mention are the only ones. And ironically you are also shielding De Marco from any pressure as well. If DeMarco thought a recess appointment over him was a possibility he might actually DO The right thing.

  16. Charles Reed

    Huge problem and Faniie & Freddie plus Ginnie know it is they are saying the defaulting loan titles automatically transfers to the Servicers. Houston you got a few trillion dollars of mortgage backed securities that don’t have any underlying collateral that they are allowing a Servicer to foreclose upon.

    Because attorney are not up on banking law these agencies have been able to get away with murder however what done in the dark show through in the light.

    Massachusetts Supreme Court just put a big hole through Fannie Mae case v. Eaton where it a part of law that the party foreclosing must actual own the debt and be in title as that owner to foreclose. In the case of Ginnie Mae they neither own the debt or are in title at the local counties, and have as much rights as a man on the moon to foreclose, because the fact is they never purchase a single loan.

    Its called holder in due course…..can you say put a fork in them!

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