Consumer Law & Policy Blog

Times Reports on Postal Savings Banks and Countrywide Settlement

Today's Times has an interesting op-ed piece, "Mailing Our Way to Solvency," about the use of postal savings bank, which existed in this country until 1966 and still exist in some other countries.  The author suggests that postal savings banks could help address four problems: "the almost 10 percent of Americans without a bank account; the concerns of all Americans about the security of their savings; the growing indebtedness of the country to foreign governments and financial institutions; and underinvestment in public assets like sewer systems and bridges."

In other consumer news in today's issue, the Times reports "Countrywide to Set Aside $8.4 Billion in Loan Aid."  The money will be used to modify home loans and is part of a settlement agreement with eleven states that have sued Countrywide.  The aid will affect about 400,000 borrowers and Countrywide will also waive some fees and provide additional funds "to help people in foreclosure and relocating." 

Times Reports on Causes of Mortgage Crisis, FDA Problems, and More

Robert Frank has a terrific column in today's Times, "Pursuit of an Edge, In Steroids or Stocks," explaining why fund managers were willing to invest in subprime mortgage-backed securities.  The entire piece is worth reading, but here are some excerpts:

If one fund posts higher earnings than others, money immediately flows into it. And because managers’ pay depends primarily on how much money a fund oversees, managers want to post relatively high returns at every moment.

One way to bolster a fund’s return is to invest in slightly riskier assets. (Such investments generally pay higher returns because risk-averse investors would otherwise be unwilling to hold them.) Before the current crisis, once some fund managers started offering higher-paying mortgage-backed securities, others felt growing pressure to follow suit, lest their customers desert them.

* * *

* * * Many money managers knew that these securities were risky. As long as housing prices kept rising, however, they also knew that portfolios with high concentrations of the riskier assets would post higher returns, enabling them to attract additional investors. More important, they assumed that if things went wrong, there would be safety in numbers.

The bailout suggests that last assumption is correct, because if the crisis were not pervasive, we probably would not have had a bailout.

And here is an editorial in today's paper, with the alarming title, "A Tale of Taint." about how the FDA hired a public relations firm (isn't that a wonderful use of taxpayer dollars at an underfunded agency?). The FDA was able to dispense with competitive bidding because it hired a minority contractor.  But the contractor then turned around and subcontracted the work to a "preferred Washington firm." 

The Times reported on Wednesday that "Many Foods Will Soon Be Labeled by Country of Origin."  Or at least meats, produce, and some nuts will be. 

On Sunday September 21, economist Robert J. Shiller had a column, "The Mortgages of the Future."  He argues for the creation of "continuous-workout mortgage" under which payments could be restructured routinely to respond to the changing ability of the borrower to make payments.

A Bit More on Blaiming the CRA

A couple of weeks ago Alan had a thoughtful post here about  the ridiculous claims that the subprime crisis was caused by the Community Reinvestment Act.  I've been meaning to pile on.  One of the arguments critics of the CRA made before the meltdown occurred was that the CRA was unnecessary because lenders are eager to lend to CRA-eligible borrowers.  See Jeffery W. Gunther, Kelly Klemme and Kenneth J. Robinson, Redlining or Red Herring, Southwest Econ., May/June 1999.  So the CRA is unnecessary because lenders would want to lend to subprime borrowers even in its absence, but the CRA caused the crisis because without it, lenders wouldn't have made the loans that got into trouble! 

Mortgage Crisis Scholarship

The mortgage crisis is rightfully drawing the attention of scholars.  Here are links to a few papers on SSRN:

My St. John's colleague, Vincent DiLorenzo, is working on "Mortgage Market Deregulation and Equity Stripping Under Sanction of Law."  The abstract reads as follows:

Who is to blame for the large mortgage market losses borne by consumers, communities, the financial services industry and others? This paper explores government's responsibility. It explores whether the decision to deregulate the mortgage market to a degree that permitted both unsafe and unfair mortgage practices was the decision of Congress or the federal regulatory agencies. Part one of this paper explores Congress' viewpoint toward deregulation of the mortgage market. It differentiates two types of deregulation: (a) lifting of statutory requirements and substituting regulatory constraints, and (b) lifting of all government mandates and substituting a preference for market forces to police abusive practices. This paper examines Congress' actions and motivations over a thirty year period and initially concludes that Congress embraced the former view and not the latter. This view was consistently embraced in the period 1982 to 1994 to address unsafe banking practices and unfair banking practices. Unfortunately, Congress then provided mixed signals regarding its deregulation viewpoint in legislative enactments in 1994 when faced with unfair banking practices. This permitted regulatory agencies to continue to pursue a deregulatory agenda even when faced with evidence of abusive lending practices.

Part two of this paper explores the viewpoint of the federal regulatory agencies toward deregulation of the mortgage market. It examines the actions and viewpoints of the federal banking regulators in the last three decades. Two conclusions emerge. First, the agencies preferred a free market approach and implemented such an approach whenever statutes provided the discretion to do so. Second, the regulatory agencies embraced a decision making model that relied on predictions of net societal benefits as the determinant of a decision to intervene in the mortgage markets. Such a viewpoint led the agencies to typically shun government intervention. That decision led to equity stripping for over a decade, especially in low-income communities, more equity stripping in recent years as lax lending practices led to defaults and foreclosures, and even more in the coming year as foreclosures multiply.

Adam Levitin of Georgetown has written "Resolving the Foreclosure Crisis: Modification of Mortgages in Bankruptcy," 2009 Wisconsin L. Rev. ----.  Here's the abstract:

For over a century, bankruptcy has been the primary legal mechanism for resolving consumer financial distress. In the current foreclosure crisis, however, the bankruptcy system has been ineffective because of the special protection it gives most home mortgages. Debtors may modify the terms of all debts in bankruptcy except those secured by mortgages on their principal residences. A bankrupt debtor who wishes to keep her house must pay the mortgage according to its original terms down to the last penny. As a result, many homeowners who are unable to meet their mortgage payments are losing their homes in foreclosure, thereby creating significant economic and social deadweight costs and further depressing the housing market.

This Article empirically tests the economic assumption underlying the policy against bankruptcy modification of home mortgage debt - namely that protecting lenders from losses in bankruptcy encourages them to lend more and at lower rates, and thus encourages homeownership. The data show that the assumption is mistaken; permitting modification would have little or no impact on mortgage credit cost or availability. Because lenders face smaller losses from bankruptcy modification than from foreclosure, the market is unlikely to price against bankruptcy modification.

In light of market neutrality, the Article argues that permitting modification of home mortgages in bankruptcy presents the best solution to the foreclosure crisis. Unlike any other proposed response, bankruptcy modification offers immediate relief, solves the market problems created by securitization, addresses both problems of payment reset shock and negative equity, screens out speculators, spreads burdens between borrowers and lenders, and avoids both the costs and moral hazard of a government bailout. As the foreclosure crisis deepens, bankruptcy modification presents the best and least invasive method of stabilizing the housing market.

Lauren E. Willis of Loyola L.A. has written "Stabilize Home Mortgage Borrowers, and the Financial System Will Follow;" Alan White quoted some of her views here.  At the risk of repetition, the abstract follows:

To halt the Great Depression, the federal government nullified all clauses in contracts that pegged debt to the price of gold. By taking these contracts off the gold standard, debts were reduced by roughly 40 percent. Economist Randall Kroszner, now a governor on the Federal Reserve Board, examined the effects of this sweeping debt reduction and found that both stocks and bonds responded favorably. Investors and creditors decided that the elimination of debt overhang and the avoidance of threatened corporate bankruptcies more than offset the cost to creditors of receiving 60 cents on the dollar. And the taxpayer did not pay a penny.

This trick could only be performed once, now that gold clauses are out. So is there a way to eliminate today's mortgage debt overhang, staunch foreclosures, and restore liquidity and stability in our financial markets? Yes. We have not yet used our most potent weapon against the crisis: eminent domain.

John Tatom of Indiana's Business School has written "The U.S. Foreclosure Crisis: A Two-Pronged Assault on the U.S. Economy."  A final abstract:

The U.S. mortgage loan foreclosure crisis has been called the worst financial crisis since the great depression. There are two distinct channels of influence of the subprime problem. The first is the rise in foreclosures that affects homeowners and the real estate industry most directly. The second channel is financial, flowing from the effects on lenders' financial viability and on financial markets. The timing of developments in these two channels will determine how fast markets work through these problems and restore stability and growth to the nation's housing and financial markets. The problem is rooted in the housing market, and this market is likely to be very slow to adjust. It takes time for good mortgages to go bad and to then move through to the end of the foreclosure process. While financial markets work much more quickly, they will be held hostage to the unfolding effects of the foreclosures in the housing markets and among lenders. Mortgage loan related losses will continue along with foreclosures over the next year or so and these losses will plague firms even if they have already taken adequate write-downs on their asset values. Complicating the picture is the response of the Federal Reserve, which has reacted chaotically by creating new lending programs that have transformed its credit supply from government securities to private financial institutions, and in the process, violated the first rule of central banking to lend liberally in a liquidity crisis. This failure, compounded by providing a backstop to questionable securities, has slowed market adjustment and risks lengthening and deepening the financial crisis. This paper reviews the emergence of the foreclosure crisis and its real impacts in the economy, the financial market effects of the surge in mortgage foreclosures, the monetary policy response to the problem, and provides an assessment of the outlook for the crisis.

Stabilize Home Mortgage Borrowers with Eminent Domain

By Lauren E. Willis [reprinted here with permission]

Edward Leamer’s “trickle up” economic plan is a good start, but if a downward spiral is a serious possibility in the economy right now, we need not a trickle but a flood. We need to quick-take homes by eminent domain, prepay mortgage balances that are not extinguished (mortgage debt beyond the market value of the home would be extinguished), and sell the homes back to the homeowners using fixed-rate mortgages with affordable monthly payments. This would eliminate today’s mortgage debt overhang, staunch foreclosures, and restore liquidity and stability in our financial markets.

To halt the Great Depression, the federal government nullified all clauses in contracts that pegged debt to the price of gold. By taking these contracts off the gold standard, debts were reduced by roughly 40 percent. Economist Randall Kroszner, now a governor on the Federal Reserve Board, examined the effects of this sweeping debt reduction and found that both stocks and bonds responded favorably. Investors and creditors decided that the elimination of debt overhang and the avoidance of threatened corporate bankruptcies more than offset the cost to creditors of receiving 60 cents on the dollar. And the taxpayer did not pay a penny.

This trick could only be performed once, now that gold clauses are out. But we still have a potent weapon against the crisis: eminent domain.

Query About the Bailout Mechanism

Now that the House has rejected the bailout proposal in its present incarnation (see here), perhaps those who know more about this subject than I do can help me understand something: if the problem is with the freezing of credit, why doesn't Congress simply create a mechanism to lend money to credit-worthy borrowers (perhaps by providing money to lenders for that specific purpose, or by paying lenders a service fee to provide the necessary services to choose credit-worthy lenders, service loans, etc.), rather than by buying assets of uncertain value?

Homeowners and the Bailout

By Alan White

For homeowners as well as for banks, the bailout deal announced today could be a turning point, or it could be more of the same, depending on what Treasury actually does with its enormous new powers. Treasury could buy mortgage securities at deep discounts, causing banks and investors to absorb losses (much of which they have already reserved for), and then aggressively restructure the underlying mortgage debt, passing on writedowns to homeowners in distress. Or Treasury could pay high prices for the securities to bail out financial institutions and then continue the senseless foreclosure policy servicers are currently following, losing billions by foreclosing and reselling homes.

The bill (download here, but be warned there is a lot of server traffic now) requires Federal contractors (who will now be hired in droves) to develop foreclosure prevention plans, and submit monthly reports to Congress on the number of foreclosures and the number and type of modifications. This is all still precatory, in a sense, but has the potential to change the paradigm in mortgage servicing and start a process of genuine mortgage restructuring. Treasury can imitate the FDIC in its takeover of IndyMac, or it could continue accepting the bland assurances of HOPE NOW.

The foreclosure provisions are in sections 109 and 110. The Treasury Secretary is directed to implement a plan to maximize assistance for homeowners, and to consent (as owner or investor) to reasonable requests for loan restructuring, including interest and principal write-downs.

On the other hand, it is unfortunate that the bankruptcy modification tool was not incorporated in the legislation. Giving bankruptcy courts the ability to rework the subprime mortgages of 2005-2007 when servicers refuse to do so voluntarily would add real impetus to the restructuring effort, and as Adam Levitin has demonstrated, would not impair the future supply or price of mortgage credit.

It may also become quickly apparent that Congress needs to tinker with some tax law provisions that drive the limitations in pooling and servicing contracts that in turn govern securitized mortgages. Servicers are prevented from doing anything that endangers the special tax status of mortgage trusts they administer. This may mean that Treasury cannot effectively tell servicers what to do, or buy mortgages out of securitized pools, without some adjustments to the REMIC tax provisions. In my view, if there is a will to restructure mortgages, a way will be found.

On a related note, Ruth Simon reports in today's Wall Street Journal that the kind of modifications offered to homeowners in foreclosure matters a great deal in how well these homeowners do making their new payments. Not surprisingly, modifications that reduce interest, principal and monthly payments have much higher success rates than the other kind (where payments and principal are increased to recoup interest arrears.)

Times Article on Impact of Bailout on Distressed Homeowners

Amid the welter of articles on the bailout proposal is this one in today's Times on the impact of the bill on homeowners: "A Bill Encouraging to Distressed Homeowners, but Its Reach is Unclear."  An excerpt:

The legislation does take steps to help some troubled borrowers modify their mortgages. As part of the package, the Treasury Department would purchase problematic mortgage-related assets. The bill would also set up a program to assist homeowners by encouraging the companies that service the mortgage-related assets the Treasury owns to take advantage of the Hope for Homeowners program.

The article also notes that the bill does not give bankruptcy courts the power to alter the terms of mortgages on primary residences.  It also quotes our own Alan White.  A copy of the bill is available here.

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.

Moral Hazard and the Bailout: A One-Minute Play

Time: Five years or so in the future.  Setting: Exterior of a dilapidated home. DRACO rings the home's doorbell.

Jorkins: Hello?

Draco: Good morning. I couldn't help but notice that the siding on your home looks, well, it looks as if it needs a bit of work.

Jorkins: It does, yes, but who can afford it? Social Security goes only so far, you know.

Draco: Have you thought about taking out a loan? You could fix up the rest of your place too. I represent Malfoy Lending and we have some very affordable loans. We could also find you someone to replace that siding. Anyway, let me just give you these forms to read and fill out.

Jorkins: Oh dear, I'm not very good with forms.

Draco: I can help you with that.

Jorkins: How affordable is this loan? I don't have a lot of money to pay it back.

Draco: Not to worry. We have loans that start with a low rate and when the rates go up in a few years, your home will be worth so much more that you'll be able to refinance, so that won't be a problem.

Jorkins: And you'll help me refinance then?

Draco: Well, I probably won't be in the company then. I'm shifting fields. But if it's not me, someone else can help you.

Jorkins: But what if prices don't go up in time?

Draco: No problem. If worse comes to worst, we can always get another bailout.

Postscript: Of course, this is completely unfair because changes in the law will prevent the making of loans that cannot be repaid.  Or will they?