The growing urgency to implement an effective fix for the deepening U.S. financial crisis is pushing policymakers to consider measures that were roundly rejected as too risky not very long ago. The limited success of the first $350 billion in TARP funds and the government's wavering on how best to dispose of the toxic assets that are clogging banks' balance sheets—and preventing a rebound in the credit markets—has added to the sense of urgency.
Former Treasury Secretary Henry Paulson favored using the financial rescue funds to recapitalize banks and other institutions seen as most critical to the health of the global financial system. But persisting doubts about the quality of assets on banks' books amid further deterioration in home prices has stymied the government's efforts to make inroads toward reviving the financial industry. Now that the estimated number of U.S. home foreclosures may be as much as four times the 2 million projected in late 2007, more serious attention is being given to the idea of using taxpayer money to get at the meat of the problem: the underwater mortgages that precipitated the whole mess. There are efforts afoot to improve the success rate of home loan modifications (popularly known as "mods"), which basically change the terms of the mortgage in question to improve the odds that the homeowner will be able to keep up with monthly payments. Fewer busted mortgages, the thinking goes, will lead to fewer foreclosures, which could potentially slow the rate of decline in home prices.
The Federal Deposit Insurance Corp. early on saw the need to address the financial crisis at its roots by modifying mortgages in order to prevent many more foreclosures and halt the cycle of declining home prices. But the FDIC's own plan, which places priority on a risk-sharing arrangement under which the government would absorb up to 50% of the losses for second defaults and a reduction of the borrower's monthly payment to 31% of his income, has come under fire recently. The big problem, critics say, is that the plan does not require balance writedowns by lenders on loans that exceed the underlying property value except as a last resort. Nor does the FDIC proposal provide either a way for the government to be repaid or sufficient incentives to encourage loan servicing firms to modify more mortgages.
The version of the TARP Reform and Accountability Act of 2009 that the House passed on Jan. 21, which revises the Emergency Economic Stabilization Act of 2008, provides guarantees for certain losses incurred if a modified loan should subsequently re-default. FDIC spokesman Andrew Gray sees that as "recognition there is clear direction under EESA to implement the loss-sharing program" and sees the program proposed by FDIC as a "good means to achieve this." He adds that any foreclosure mitigation program will ultimately be a collaborative process with the Obama Administration.
Restrictions in the FDIC plan on loss sharing for mortgages with negative equity and for loans that re-default within six months aren't likely to stimulate many more modifications, wrote Jack Guttentag, professor emeritus of finance at the Wharton School of the University of Pennsylvania, in a Dec. 20 op-ed in The Washington Post. Guttentag's own plan, posted on his Web site, proposes that negative equity on all modified loans be eliminated, since negative equity is one of the main reasons for high re-default rates on modified loans. His plan also provides incentives for servicers and investors to write down loan balances, with the government sharing writedown costs and back-stopping payment insurance on modified loans, and includes a mechanism for repaying government outlays when the economy recovers. It also re-underwrites modified Loans to minimize re-default rates and provide a basis for setting insurance premiums.
A major obstacle to implementing an effective loan modification plan has been the difficulty of determining property values, which is essential if lenders and loan servicers are to consider modifications before starting foreclosure proceedings on delinquent homeowners.
If a loss-sharing provision ends up as part of any loan modification plan the Obama Administration decides to adopt, the FDIC will be required to monitor any losses resulting from re-defaults. Smithfield & Wainwright, a real estate appraisal firm in Jacksonville, Fla., says the Mo-Mod appraisal process it has devised would not only provide the FDIC with tools it needs for oversight and accountability but would also provide a data feed to the Federal Housing Authority, the Housing & Urban Development Dept., Fannie Mae, Freddie Mac and other loan servicers to help with repackaging modified mortgages for securitization and quicker liquidation of foreclosed properties. The firm's chief executive, Hogan Copeland, says the Appraisal Institute's nationwide network of 23,000 members could process up to 500,000 mods a month using Mo-Mod.
Incentives for Servicers
Yet another proposal, issued by three faculty members at the Columbia Business School on Jan. 7, likens the staggering task of getting consensus on loan mods among a vast number of investors in securitized pools of mortgages to that of large companies trying to get creditors to agree to debt restructuring. The proposal recommends two ways to get around barriers that keep third-party servicers from successfully managing the foreclosure crisis: an incentive fee structure that increases payments to servicers and better matches their incentives with those of investors, and legislation that would remove explicit barriers to modification of pooling and servicing agreements and reduce the risk of lawsuits for servicers who modify loans.
Professors Christopher Mayer, Edward Morrison, and Tomasz Piskorski, who collaborated on the plan, said it "might prevent as many as 1 million foreclosures at a cost of no more than $10.7 billion that can be funded by TARP money." They also said it would be much less costly to taxpayers than other proposals under consideration, with no requirement to provide pricey loan guarantees and losses for bad loans accruing to private investors instead of taxpayers.
"A homeowner is a candidate for loan modification when her income is sufficient to make payments that, over time, exceed the foreclosure value of her home," the Columbia proposal said.
Norm Miller, a professor at the University of San Diego's Burnham-Moores Center for Real Estate, says he likes the Columbia proposal but thinks the cost to incentivize servicers would fall between $50 billion and $100 billion for the borrowers who qualify for modifications.
If loan servicers remain resistant to modifying a substantially larger number of mortgages, the remedy for the looming foreclosure crisis could be in bankruptcy court. Currently, the U.S, bankruptcy code prohibits modifications to a mortgage on a debtor's principal residence, but on Jan. 6, Senator Dick Durbin (D-Ill.) re-introduced a bill that would amend the code by removing that prohibition, extending the time frame allowed for repayment in order to lower monthly payments, and permitting bankruptcy judges to replace variable interest rates with a new interest rate that would keep the mortgage affordable over the long term while also compensating creditors for risk. The bill would also allow judges to waive prepayment penalties and enable debtors to maintain their legal claims against predatory lenders while in bankruptcy. A parallel bill was introduced in the House the same day.
Durbin and other Democrats are pushing to attach the bill to the economic stimulus package, but that "will be difficult because we've heard that Obama wants the stimulus package to pass both houses [of Congress] by 80%, and having this as an attachment would cause a lot of Republicans not to vote for the stimulus," says Paul Miller, a financial institutions analyst at Friedman Billings Ramsey (FBR) in Arlington, Va.
Even if Durbin's bill doesn't get attached to the stimulus package, the groundswell of support for the bill from the more liberal faction in Congress gives it a good chance of being attached to another piece of legislation, adds Miller. Three prior attempts to pass the bill over the past 14 months met with stiff opposition from mortgage lenders and Republicans.
Opposition to the bill stems from the notion that so-called "cramdowns," which force creditors to accept modified terms on outstanding debt they are owed, are usually bad for the market in the long run because they would spur lenders to require higher interest rates for future mortgages to compensate for the possibility of being stripped of control over assets, Miller says. It's also still unclear if the Durbin bill would be unconstitutional since Congress is prohibited from interfering with a contract such as a mortgage loan, he says.
Mayer and his colleagues at Columbia contend that Congress does have Constitutional authority to modify the terms of securitization contracts under the Commerce and Spending clauses. They recommend passing a law that eliminates explicit limits on modifications but say this legislation should only apply for up to three years, long enough to allow for a recovery in the housing markets and the broader economy.
It's easier to do a cramdown when the loans are still held by the banks that originated them, since banks are subject to federal supervision, while holders of securitized assets are not, according to Richard Green, director of the Lusk Center for Real Estate at the University of Southern California in Los Angeles. Cramdowns on securitized loans are also tougher because it's harder to identify the owners of the mortgages, he says.
"That's why it's hard to come up with a practical mass-modification program," says Green. "Under normal circumstances, I think cramming down mortgages is a terrible idea, but these are not normal circumstances."
A year ago, the notion of revising the bankruptcy code to allow for loan modifications would have raised fierce objections over the moral hazard of allowing homeowners to escape their contractual obligations. But the urgency of the real estate crisis has changed many people's thinking, while others "have made the judgment that the moral hazard ship sailed a long time ago," says Green. "Things have reached such crisis proportions, we have to put such niceties aside and get ourselves through this." The only cure, he adds, is a mass-modification program, which is what the government used in the Great Depression.
Mitigating Moral Hazards
One way to reduce the moral hazard risk, he says, would be some kind of clawback provision in the modified loans that require borrowers, in exchange for getting a new loan worth 90% of the reduced home value, to pay any profits they make on the sale of the home at a price higher than the new mortgage value, up to the original value of the mortgage, to the government. "I'm not naïve—I don't think that would fully repay the cost of a program like this, but it would at least say to people this is not a free ticket to future riches," says Green.
Besides legal issues, there would be logistical snags in attempting a large-scale loan modification effort through the bankruptcy courts, says Green. Servicers can't handle the heavy of volume of requests for modifications, so shifting that authority to the courts would presumably run into similar capacity constraints, he says.
Norm Miller at the University of San Diego is less sanguine about the role that mortgage modifications can play in resolving the housing crisis. He believes only 25% of delinquent mortgages qualify for modifications based on the 38% of income requirement, since he estimates that homeowners who have lost their jobs, died, or gotten a divorce account for half the defaults, while another 25% are due to higher resets of adjustable-rate mortgages that borrowers can no longer afford and loans that are underwater. Modifications will also work only in markets where home prices for the most part have stabilized.
"There are probably a few million people out there thinking this TARP money is going to help me stay in my house. We don't want to artificially prop up the process beyond what the fundamentals will support because all that does is delay the problem," he says.