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Principal Reductions Redux
January 07, 2010
Just a day after I posted my blog entry on principal reductions as a way to help prevent foreclosures, the New York Times Sunday Magazine posted an article on its website by Roger Lowenstein providing an eloquent and trenchant examination of the “moral hazards” of principal reductions and owners’ so-called strategic defaults. A very insightful piece, worth your time.
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Won’t Be Fooled Again?
January 06, 2010
The New York Times’ David Leonhardt has a trenchant piece published in its January 5, 2010 edition that highlights a critical lesson of the financial crisis. Summarizing Bernanke’s recent speech before the American Economic Association in which he blamed lax regulation rather than interest rate decisions for the mortgage and finance crisis, Leonhardt notes that while asset bubbles of any kind are hard to call, the Fed and other regulators had plenty of warning. Experts within and outside of the government amassed and arrayed all kinds of data pointing to unsustainable housing price growth. And consumer advocates and others were clamoring for the Fed and other regulators to spike the dangerous mortgages that helped fuel the bubble using regulatory authorities they already had. Leonhardt asks,
So why did Mr. Greenspan and Mr. Bernanke get it wrong?
The answer seems to be more psychological than economic. They got trapped in an echo chamber of conventional wisdom. Real estate agents, home builders, Wall Street executives, many economists and millions of homeowners were all saying that home prices would not drop, and the typically sober-minded officials at the Fed persuaded themselves that it was true. “We’ve never had a decline in house prices on a nationwide basis,” Mr. Bernanke said on CNBC in 2005.
He and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars, and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions. It’s an entirely human mistake.
Which is why it is likely to happen again.
He might have added CIA officials who invited last week’s suicide bomber/triple agent onto their base where he blew up himself and seven officers, or all of the intelligence agency employees who handled intelligence about the Under-Bomber but were unable to put the puzzle pieces together and stop him.
Human frailty and the reluctance of large organizations to change course when confronted with complex datasets and decisions that challenge orthodoxy are constants. This is especially true when entrenched interests—both inside and outside organizations — stand to lose if policies are changed. As Leonhardt points out, acknowledging failure and analyzing its roots is the first step in reducing the chances of it happening again. Organizational cultures have to support contrary views and reward decision making that forces people outside of the comfortable boxes in which they live day to day. Breeding a culture of curiousity and challenge makes big shots uncomfortable. But it can also spark unconventional thinking that puts old “certainties” under pressure and forces recognition—or at least preparation for—events that rock the boat and shift key assumptions.
This is one reason that the proposals to create a Consumer Financial Protection Agency make so much sense to me. Opponents, including Bernanke, argue that a separate agency will separate prudential from consumer oversight and regulation. This disconnect will weaken regulators’ ability to see the “big picture,” and potentially put the two at odds. Bankers argue that this potential tension will put them in an untenable position and at a minimum greatly increase their regulatory burdens.
But the prudential agencies subordinated consumer interests consistently to those of the companies they were regulating. The Fed and other prudential regulators had all the regulatory tools they needed to spike the excesses of the mortgage industry that led to the crisis. Indeed, consumer advocates and others implored them to do so. They did not. An agency tasked with examining these issues from a consumer protection point of view is likely to see things differently and challenge the orthodox views of a regulator tuned to a safety and soundness frequency.
When something ain’t broke, it’s reasonable to argue against fixing it. But broken systems that fail to work as designed should be fixed. A total shift of responsibility that puts consumer protection first is one way to do it.
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Change We Could Believe In?
January 05, 2010
As the New Year gets underway, the housing market’s continuing weakness and the Obama Administration’s loan modification plan’s poor performance have refocused attention on what better ways there might be to prevent foreclosures and keep people in their homes.
The urgent need for change is clear:
- The Making Home Affordable mortgage modification program has produced close to 700,000 trial modifications, but to date only about 30,000 of those have been finalized. We won’t know until well into 2010 whether the Administration’s initiative in the 3rd quarter of 2009 significantly accelerated these conversions or not.
- Meanwhile foreclosures in 2009 likely will reach 2 million. There is no indication that 2010 will be significantly better, as loan performance, particularly among prime borrowers, continued to weaken through 3Q09.
- The Comptroller of the Currency’s last report on the performance of modified loans documents that an alarming 61 percent of all borrowers that had received any kind of modification—through the Obama plan or directly from the lender—were seriously delinquent 12 months after the modification. Loans modified in the third quarter of 2008, when actual reductions in interest rate and principal were more common, show a significantly lower early redefault rate, suggesting that their long-term performance will be better, but still suffer from significant redefaults as currently structured. Too few Making Home Affordable loan modifications have been finalized to know how they will perform.
- Significant numbers of borrowers across the credit spectrum owe more than the current market value of their homes. These “underwater” mortgages make it difficult for families to move for employment or other reasons, or to refinance for a lower rate.
- A study by the New York Federal Reserve concluded that modifications that reduced payments by reducing prinicipal performed better than those that reduced payments through interest rate reductions.
Shifting the focus of the Making Home Affordable program to principal reductions, rather than interest rate reductions, offers an immediate step that could improve the program’s success rate, give borrowers a more attractive long-term stake in their homes, and reduce the long-term handicap assisted borrowers face when their loans remain underwater.
Principal reductions, however, face some potent obstacles.
- Moral Hazard Principal reductions, this argument goes, encourage borrowers to renege on their obligations. Ultimately, it continues, this will increase borrowing costs for everyone, as lenders charge for the risk of nonpayment of principal. Borrowers who can still make the scheduled payments on their mortgages will stop doing so in order to qualify to have their total obligation reduced. Neighbors who don’t receive help will resent those that do, and like-situated households will receive differential treatment of their obligations simply because one chooses to make their payments and the other doesn’t.
Moral hazard is a serious problem that needs to be addressed. But it can be managed and contained by using the same criteria that have been applied to the current interest rate writedowns, limiting it to a owner occupants in homes below a ceiling value, that were originated before the start of the modification program, for instance. The current program poses similar issues—some borrowers get their interest rates reduced, others do not. It’s not fair. Public policy is full of “borderline” issues where only a small difference separates those who receive support and those who do not. Helping borrowers stay in their homes creates broader social benefit by reducing foreclosures, vacancies and blight. Stabilizing neighborhoods and home prices benefits every owner in the neighborhood.
Moreover, many of the loans made at the height of the housing bubble were inflated to begin with, sometimes with extraneous charges and bogus fees, and yield spread premiums to brokers paid for by borrowers. They were made possible only by qualifying borrowers with artificially low rates while lenders knew they would be unable to make payments on the ultimate, higher rates. And so on. In this case, where is the moral hazard: on the borrower that has been victimized by crappy underwriting and dangerous products, or on the lenders who should have known better? - Write downs Forgiving principal on the loan means that the investor holding the mortgage has to take a write down on its value. Lenders and investors hate this. But in the current modification program lenders and investors already are accepting a real loss of anticipated return on their loan by accepting a lower interest rate. What they are avoiding is having to recognize a loss today on a loan they are still holding on their books. But if the net present value of a principal write down to the borrower is greater than a foreclosure is likely to net, then it is no different than the costs lenders already are willing to bear in reducing their note rates. If the government used its Making Home Affordable funds to match write downs of principal, it surely would reduce lenders’ asset value. But it could provide a far greater return through stabilization of the housing, increased likelihood of a successful modification, and restoration of equity potential for the borrower.
Write downs could force lenders to increase their capital again, as the value of the assets they hold are reduced by the principal reductions. But if the assets they hold are being artificially propped up through modifications that ultimately won’t succeed, or that leave the borrower in a long-term negative equity position that keeps them locked in their homes, isn’t it better to take the pain now and deal with it, rather than allow zombie portfolios to stumble along while hoping that time will wipe out the problem? - Participation Lenders are voluntary participants in the Making Home Affordable program. Requiring principal reductions could drive them out of the program. But the banking sector continues to benefit from the wide array of liquidity efforts that support the system. These could be used to “encourage” lenders to participate. Also, as the crisis has dragged on and more borrowers seem to be willing to walk away from their underwater mortgages, lenders’ attitudes about principal reduction ought to be changing. Taking a calculated hit now surely is a better choice for shareholders and the nation than gambling on a much greater loss down the road.
In point of fact, lenders are already making principal reduction modifications. In the New York Fed study sample, 7 percent received principal reductions, averaging 20 percent. The OCC report states that 13.2 percent of the modifications in 3Q09 received them. This is an increase over 10 percent in 2Q09 and 3 percent in 1Q09. By far the largest share of these—37 percent of all modifications they made—were offered by lenders holding the loans in portfolio. A negligible number—rounded to 0.0 percent—were made for loans held by investors. This suggests where the pressure needs to be applied most heavily—on the securities portfolios and on Fannie Mae and Freddie Mac, who together did only 134 compared to 17,259 by portfolio lenders. Why are portfolio lenders so much more willing to offer principal reductions in their own modification programs?
The drumbeat for some kind of change is growing. The New York Times’ January 5 editorial concluded that “To avert the worst, the White House should alter its loan-modification effort to emphasize principal reduction.”
Sounds like change we could believe in.
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Setting Pay at Bailed Out Companies
January 03, 2010
Steven Brill’s long January 3, 2010 New York Times Sunday Magazine piece on Kenneth Feinberg’s experience in setting executive pay at the “TARP 7,” as he calls them, illuminates how wide the gulf between top compensation at financial companies and the plight of working Americans really has become. This should be must-read material for anyone concerned with social justice in America.
It also highlights the discouraging lack of progress that has been made to date in cementing real reforms in the way financial companies are run and their leaders compensated. If the near-collapse of the world’s financial system isn’t enough of a goad to get this done, what is?
The most telling part of this long piece is AIG’s representation that it would be unfair to force its executives to take the lion’s share of their compensation in company stock, because it is “essentially worthless,” as its vice-chair is quoted as saying. The compromise Feinberg adopted retained the structure, but perhaps not the substance, of his original demand. But all the worker bee suckers in AIG—and by extension all the other companies under Feinberg’s supervision—probably won’t have the chance to shift out of the “essentially worthless” stock in their ESOPs, or maybe in their 401(k)s, if they’re really unlucky. And the folks who lost their jobs and homes as a result of these financial companies’ mistakes won’t get any “do-overs,” either.
House Financial Services Chairman Barney Frank (D-MA) is at his best in this article, a refreshing voice of genuine progressivism. We can only hope that his sensible and straightforward observations about this compensation adventure spreads to more of his colleagues.
Also in this Sunday Magazine is a provocative piece by Matt Bai considering the distance between the populist demands of the Democratic left and what Bai calls the President’s “progressivism.” These two bookends of the Magazine offer a sobering start to the new decade.