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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.

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.

How Big a Problem is Mortgage Fraud?

December 27, 2009

Whether you find a recent post on the blog Seeking Alpha completely persuasive or not, it’s a useful reminder that at least part of the reason for the mortgage crisis was fraud, pure and simple.  (Thanks to former colleague John Fulford for linking me to this post.) Whether through predatory use of unsuitable products to churn mortgage debt through unsophisticated/greedy/ignorant homebuyers/refinancers, through total misrepresentation of a borrower’s qualfications in order to write a loan and earn a fee, or through blatant disregard of investors’ terms and conditions for qualified loans in securitizations, there can’t be any doubt that the mortgage system at the height of the housing bubble was riddled with fraud. 

Hopefully, aggrieved investors will prosecute those who defrauded them.  Hopefully, as Seeking Alpha suggests, we’ll see some perp walks and folks learning how to accessorize orange jump suits.  

But what to learn from all this, and what to do about it in the future?

1. When investors require reps and warrants, they must put in place reliable quality control systems to actually check whether their counterparties are playing fair.  Folks inside every securitizer/investor/lender will push back on tough QC procedures—they alienate the client, they push business to others with fewer qualms, “my comp is based on what I sell, and your dumb procedures are costing me money.”  The example cited in the Seeking Alpha post make it clear that the fraud was there to be found from the start.  Why should it take a forensic review of the securities to ferret it out?  Unless the mortgage industry gets way more serious about how they review and manage counterparties, the sheer volume of the US housing market is an open invitation to commit fraud.  Chances of being caught are small, the cost of paying up can be negligible, and if the risks are sliced into dozens or scores of pieces held by hundreds of investors, who’s gonna know or even care? 
2. Every player in the mortgage conveyor belt should get paid not for production but for long-term performance.  Brokers can be paid a portion of their fee on delivery, the rest over the first three years, when early payment defaults are most likely to show up.  If they underwrite solid borrowers, they will get paid.  If they cheat or cut corners, it’s their compensation that’s at risk.  The same right on up the chain.  During the height of the boom a secondary market colleague who should know told me one of his customers replied to voiced concerns about credit quality in the loans he was delivering, “Hey, we are simply a conveyor belt.  We move the loan from the originator to you.  The rest is not our problem.” 
3. Housing and mortgage counseling by unrelated parties should be mandatory for any low downpayment or equity stripping refinancings.  First time homebuyers are especially vulnerable, but owners suckered by refinancing offers also ended up with toxic mortgages that are putting them out of their homes. 
4. Disclosures at loan settlement should be clearer than they are today, and delivered to borrowers with plenty of time to review them.  The Federal Reserve Board recently closed a months-long comment period on changes to its Regulation Z, covering Truth-In-Lending disclosures.  They recommended a heap of really good changes.  They’ve received strong support from Consumer Federation of America, National Consumer Law Center, Center for Responsible Lending and others.  (Check out the Fed’s regulatory pages to see copies of these and other comments on the proposed rule.)

New Sheriff In Town?

December 23, 2009

With close to 30 percent market share and razor thin capital margins, the FHA is in greater need of tough oversight and management than perhaps ever before.  Happily, HUD Secretary Shaun S. Donovan and his FHA Commissioner, David Stevens, seem to understand this.  

In the face of fears that FHA’s rocketing share of single family financing is drawing in many of the unscrupulous brokers who plagued subprime lending in recent years, the agency has adopted a new “get tough” policy and is using its administrative authorities aggressively.

A recent article in National Mortgage News chronicles this recent activity.  The Donovan quote from a consumer group meeting is actually from Consumer Federation of America’s annual Financial Services Conference earlier in December.  You can see the whole speech on C-SPAN.  It’s good to have a new sheriff in town!

Next Steps for Fannie and Freddie?

December 23, 2009

Next Steps for Fannie and Freddie?

The Financial Times yesterday today published a summary piece on what’s likely to happen next to Fannie Mae and Freddie Mac.  The Obama Administration has committed to laying out options in its February, 2010 budget submission.  But the folks responsible for producing them may rue this promise made earlier in 2009 when the rest of the Administration’s financial modernization package was unveiled.

The government’s unprecedented and aggressive support for the the mortgage markets hinges almost entirely on the continued role the two companies play in the market.  The private securitization market is dead.  Recent research from JP Morgan suggests that it will remain that way from some time to come.

The Federal Reserve’s $1.25 trillion purchase program for Fannie and Freddie MBS is supposed to wind down in the first quarter of 2010.  But many observers doubt they will be able to do so in the face of likely political opposition to moves that could raise interest rates for consumers, as phasing out the program might do.

The two companies also are playing a crucial role in administering the Administration’s Making Home Affordable” mortgage modification program.  Once restructured, it isn’t clear how that capacity could be easily replicated.

Perhaps because they were the first crippled financial patients to go under the knife in 2008, the terms of their government assistance are significantly more onerous than those that Bank of America and other major lenders had to agree to.  The dividend on the preferred stock held by Treasury in return for its investments in the two companies—now totaling $112 billion—is 10 percent, for instance, higher than that imposed on other bailees.  Neither company is likely to be able to pay back what they owe, in addition to their divident payments, anytime soon.

It can be argued that the government has the two companies exactly where it wants them:  firmly under government control, but not on the government’s balance sheet.  They can be used to further public policy goals without interference from shareholders or private owners, at a time when the government has few similarly powerful direct levers to work in the economy.

So the question essentially should come down to this:  what is the rush to alter the current structure?  With many trillions of outstanding MBS under their guarantee, and a combined market share exceeding 70 percent now, a great deal of the housing market’s immediate and near future health seems likely to ride on the two companies and the market’s faith in their guarantees on the securities.  And the only way to guarantee that for the moment, it seems, is through the continued support of the current system, however creaky it may be.  The Financial Times piece summarizes a series of potential paths the Administration could choose.  Having spent many hours over the last year with colleagues in the progressive policy sector trying to develop a workable successor model, I’m skeptical of their chances for success in the short run.  I look forward to working with them, and hope that something durable and workable can emerge.  But mostly I’m anxious that politics and theory are not allowed to trump pragmatism when it comes to the question of timing.  Rushing to a solution merely for the sake of having one is not the right path.