Another idea

By Alan White

Instead of buying mortgage-backed securities from banks, Treasury could buy the mortgages themselves from the servicers of mortgage-backed securities at a discount via a reverse auction. As written, I believe the Paulson plan would actually permit this modern version of the Homeowners Loan Corporation. Here's how it would work.

A typical pool of say $500 million in subprime loans now has a third or so of its mortgages delinquent or in foreclosure. If the servicer forecloses, it will likely recover only about 60% of principal on a given mortgage. The servicer might agree to accept 80% of the balance due in a sale to Treasury. A competing servicer might accept 75%, and the lowest bidder would be able to unload its loans at a higher-than-currently-expected return. Once the servicer sells the mortgage, it is treated as prepaid, the loss is realized, and all the mystery about the value of the securities related to that mortgage pool is resolved. All the financial institutions wondering how to value that security will be paid, and can fix the value and stop writing it down. If the servicer loses 25% on one-third of its mortgages, and the other two-thirds are repaid, the pool will lose about 8%. (At 75% or more recovery on the underlying mortgages, the AAA securities will be paid in full, typically, while junior tranches will absorb losses.)

Once Treasury buys a mortgage, it can be restructured, as FDIC is doing with IndyMac mortgages now, and in some cases the homeowner could repay the Treasury the discounted purchase price, or even the original loan amount, while in other cases there would likely be a loss.

How much would this cost? There are about 5 million mortgages now delinquent or in foreclosure, with perhaps another 2 million in danger. Let's assume half of those mortgages (3.5 million) would meet whatever standards the Treasury might set (occupied by a homeowner with a pulse, house is still standing, etc.) Let's further assume that the average balance is $250,000 and the average purchase price @ 80% is $200,000. Let's see, $200,000 times 3.5 million equals . . . $700 billion. Recoveries would depend on the reliability of Main Street in meeting its obligations, not the reliability of Wall Street.

Comments

[Jeff]

This presumes that the assets for which these mortgages have been granted are actually worth what they were purported to be worth. In many places the problem is that no one knows what the market value of these assets is; there was such a balloon in 'prices' but I don't know what the bottom of that market is. In different areas these debts are more toxic than others for that reason. I think that this is a losing proposition either way.

[Alan White]

Adam is right that for Treasury to buy loans from securitized mortgage trusts, there is a need for a legislative fix to the tax provisions on REMICs. I think a narrow amendment tailored to allow purchases of distressed mortgages from the current crisis, limited in the same ways that the proposed bankruptcy amendment for mortgage modification was drafted, could fix this problem.

[Adam Levitin]

Alan, I'm dubious whether the trusts can sell the assets. Consider the following PSA language:

"[T]he Trustee shall not (a) sell or permit the sale of all or any portion of the Mortgage Loans or of any investment of deposits in an Account unless such sale is as a result of a repurchase of the Mortgage Loans pursuant to this Agreement [for loans with defective or missing documentation] or the Trustee has received a REMIC Opinion prepared at the expense of the Trust Fund..."

And also:

"None of the Depositor, the Securities Administrator, the Master Servicer or the Trustee shall sell, dispose of or substitute for any of the Mortgage Loans (except in connection with (i) the foreclosure of a Mortgage Loan, including but not limited to, the acquisition or sale of a Mortgaged Property acquired by deed in lieu of foreclosure, (ii) the bankruptcy of REMIC I, (iii) the termination of REMIC I pursuant to Article X of this Agreement, (iv) a substitution pursuant to Article II of this Agreement or (v) a purchase of Mortgage Loans pursuant to Article II of this Agreement), nor acquire any assets for any Trust REMIC (other than REO Property acquired in respect of a defaulted Mortgage Loan), nor sell or dispose of any investments in the Collection Account or the Distribution Account for gain, nor accept any contributions to any Trust REMIC after the Closing Date (other than a Qualified Substitute Mortgage Loan delivered in accordance with Section 2.03), unless it has received an Opinion of Counsel, addressed to the Trustee and the Securities Administrator (at the expense of the party seeking to cause such sale, disposition, substitution, acquisition or contribution but in no event at the expense of the Trustee) that such sale, disposition, substitution, acquisition or contribution will not (a) affect adversely the status of any Trust REMIC as a REMIC or (b) cause any Trust REMIC to be subject to a tax on “prohibited transactions” or “contributions” pursuant to the REMIC Provisions."

Selling the underlying mortgages could create tax problems for the trust--if it loses its pass-thru REMIC status, the value of the MBS are really kaput, and the trustee or servicer is looking at suits for breach of contract (the Castle amendment has no bearing on this, as it is break of K, not fiduciary duties).

[Jason Kilborn]

Was the math producing exactly $700 billion a wild coinidence, or did you stay up nights for several days getting this to work? ;-) Totally interesting idea, though I'm still confused about the exact extent of servicers' ability to do this sort of deal without running into trouble from cantankerous ZZZ tranche investors who claim that this deal modifies the PSA and violates the Indenture Trust Act, as Adam Levitin argues.

[Brian]

Wow. Very interesting.