From MND:
A Georgetown law professor is proposing that a Resolution Trust Corporation (RTC) like entity might be the key to getting the housing market back on track.
In Clearing the Mortgage Market through Principal Reduction: A Bad Bank for Housing (RTC 2.0) Adam J. Levitin considers ways in which negative equity problems might be addressed and assesses the feasibility of using a “bad bank” entity for pooling and standardized restructuring and resecuritization of underwater mortgages. This is the first of two MND articles summarizing the paper which Levitin wrote for The Big Picture, a Wall Street oriented blog.
Levitin says that the housing market is not clearing and has not since at least 2008 and possibly 2006. He defines “clearing” as a climate in which willing buyers and willing sellers are able to meet on a price. One reason for this failure is negative equity which currently affects 27.1 percent of all residential mortgages. The average negative equity is $65,000, considerably greater than the average household disposable income of $49,777.
“The depth of negative equity,” Levitin says, “is likely to increase as housing prices drop” due to foreclosures and lack of upkeep on properties where homeowners see no upside to further spending. Negative equity impedes clearing because even where buyer and seller are able to meet on a price they often cannot close the deal because the seller cannot pay the additional $65,000.
At the heart of the problem then is that mortgages, unlike houses, are not marked to market but are carried at book value. If they were marked to market they would track home values but a change in accounting is unlikely and ill-advised so we must look to other ways of clearing the market.
To date there has been only one – foreclosure, a method that is slow, inefficient and rife with negative externalities on neighbors, communities, and local governments. Foreclosures can also result in over-clearing. For various reasons the market for distressed properties is thin, bids are heavily discounted, and market prices are driven even lower.
Market clearing is not just a housing problem; it is dragging down the whole economy, diminishing household demand and casting a liability that is weighing down the financial sector. Until the market clears financial institutions will continue to have unrecognized losses and will be carrying assets at inflated values beyond their loss reserves. Continued litigation over servicing and securitization issues present further uncertainties.
Levitin said that while not every dollar of the $700 billion in negative equity needs to be eliminated, substantial inroads must be made so any approach to clearing the market must have sufficient scope, even at the expense of compromising on other factors. “Without an overriding macro-economic impact goal, principal reductions will result in little more than charity toward a population of more-or-less deserving borrowers.” In addition the problem is not with underwater and defaulted loans – which will eventually clear through foreclosure, but underwater and performing loans, a much vaster universe.
Levitin sees five major approaches to dealing with negative equity.
The first is to do nothing based on the idea that doing something is costly and has uncertain benefit; maybe negative equity will go away on its own. Doing nothing lets financial institutions delay or possibly avoid loss recognition, continue collecting servicing income and write off losses against earnings over time.
The second strategy is to concentrate on making mortgages more affordable while keeping principal balances intact. Mortgage modifications and refinancing are examples of this and have been the routes largely followed by financial institutions and the government.
The rationale for the affordability strategy is two-fold. First, foreclosures for affordability reasons are prevented and second, increasing affordability makes it less likely that homeowners will strategically default on underwater properties. Affordability, however, only clears the market indirectly. By avoiding foreclosures some downward pressure on housing markets is eliminated but the negative equity may still result in foreclosures or distress sales triggered by life-cycle events like death or divorce.
The third strategy is voluntary principal reduction. Some of this has occurred but as the exception rather than the rule. Their conservator has expressly forbidden Fannie Mae and Freddie Mac from reducing principal making a large segment of the market simply ineligible.
Even among non-GSE mortgages principal reduction is rare. Out of more than a million HAMP permanent modifications only 51,732 (through March 2012) have involved principal reduction and OCC reports that principal reductions account for only 5 percent of modifications among institutions it regulates. OCC says reductions are much more likely to be undertaken on portfolio loans than on private-label securitized loans; 20.2 percent of portfolio loan modifications between 2009-2011 involved principal reduction compared to 3.1 percent of private-label securitized loans.
Among the reasons for the scarcity are a lack of capacity on the part of servicers, communication problems between borrower and servicer, legal constraints because of pooling and servicing agreements, the constantly shifting requirements of the HAMP program, complication from second liens, and the desire to delay or avoid loss recognition. Principal reductions, if done en masse could raise capital adequacy issues for some lenders. Other constraints are a reduction in servicing income via a reduction in principal volume and what Levitin describes as a free-riding problem. Any one lender or servicer has loans that are so geographically dispersed that large scale reductions would be unlikely to unfreeze the market enough to offset the costs of a single lender while benefiting many who do not participate. Only with several large servicers acting in concert would any one of them achieve sufficient benefits.
The final factor that impedes voluntary principal reductions is moral hazard, namely that reducing principal on defaulted loans could encourage borrowers who are paying as agreed to default to obtain the same benefit. Levitin said it is not clear how much this concern has actually prevented reductions and how much is a rhetorical device to shift attention away from some of the other factors.
Even though low, the numbers of principal reductions still overstate their impact. While principal may be forgiven, Letivin said that borrowers are almost never put into positive equity because that would enable refinancing and the loss of income to the servicer. In short, voluntary principal reductions are rare and of questionable impact in terms of reducing defaults and while there are several options to improving them such as more generous incentive payments to servicers (something which subsequently has happened), or if political pressure should reverse the decision and allow the GSEs to participate in the HAMP principal reduction program, it isn’t clear if these would produce reductions of the number and amount to help clear the market.
Short sales would have a similar effect on clearing the market as principal reduction but the event sequencing differences are important. In a short sale the principal forgiveness occurs only when a short sale is in process whereas a modification can occur at any time. If lenders are slow or stingy in dealing with a short sale offer it can chill future transactions.
Several factors mitigate against short sales. First such a sale forces the lender to immediately recognize loss even if it is not certain that loss would ultimately occur without the sale. Second, lenders are concerned about collusion between buyer and seller and third, the presence of a second lien on the property makes a short sale (as well as voluntary principal reduction) “a non-starter.”
Finally, to the method Letivin is espousing for clearing the market, involuntary principal reductions. He sees two major approaches to these. The first is a bankruptcy “cramdown” in which a judge can unilaterally reduce the principal balance to more closely match the actual value of the home. While cramdowns are permitted for second or vacation homes, they are currently prohibited for primary residences and a change would require Congressional action. Cramdown is appealing in that it deals with negative equity, offers impartial judicial valuation, addresses moral hazard concerns by requiring bankruptcy and its costs, and could be limited by a cut-off date. It also offers a judicial airing of all claims and defenses to the mortgage and creates incentives for voluntary principal reductions in the face of bankruptcy. It has, however, been politically charged and Congress appears to have little appetite to revisit the subject.
The second method is through the government’s eminent domain “taking power.” This would, in theory, allow the federal government to “take” all underwater mortgages by paying their owners the market value of the mortgages which might not match the property value but would be much closer than the unpaid mortgage balance. Eminent domain requires “just compensation” for the taking and mortgagees could always litigate over whether the compensation was just but that would not impinge on the government’s ability to take the property only the cost of doing so. Having taken the mortgages, the government could then reduce the principal balances to that “just” price and either manage the restructured mortgages itself or resecuritize them with or without a guarantee.
While a “takings” approach is theoretically possible (and is under serious discussion by two local governments in California) it would be an unprecedented use of a power which has traditionally been used for physical rather than financial assets. Therefore there is some question about its Constitutionality.
Constitutional or not, it would have problems not the least of which is its cost. It would also impose a huge operational burden on the government and would, most importantly, entail significant political risk. Eminent domain is never popular and its use in such a context might be extremely unpopular politically.
Finally there is the option of negotiated principal reductions. These would be semi-voluntary with the reductions done by mortgagees but in the face of litigation or in response to pressure from regulators. Negotiation would be with the regulator or litigant rather than with individual homeowners.
There are two variants to this. The reductions could be achieved as part of a litigation settlement, possibly following suit by state attorneys general against large financial institutions including the GSEs. Alternatively the federal government could force participation in principal reductions by leveraging the ability to do FHA lending or do business with the GSEs. Similarly Treasury could make its continued support of the GSEs contingent on both the GSEs and its customers participating. Levitin said his point is not to name the levers that government might use in accomplishing this, merely to point out that there are levers if there is political will.
In a second article we will summarize the transactional framework that Letivin suggests for structuring a massive principal reduction effort.
The difference between the RTC back in the day and a proposed RTC now is that back then some banks went out of business.
A bad bank now is just a way for banks to dump their bad paper on a single intity that will eventually be bailed out by government. Effectively dumping all the garbage on taxpayers.
It’s too late for this as the money that would have gone into an RTC type “bad bank” has already been blown. I saw suggestions regarding this tactic 3 years ago, but they were ignored. Bill Black even went on a campaign about it to no avail. Why? The banksters would have BK’d without the free cheese.
An attempt to do that now only proves that the goobermint tactics (QE, etc.) have failed – the banks will still get eaten alive – so, in another attempt to save their buddies, they want to toss more taxpayer money to the squid.
Shadash nailed it.
“A Georgetown law professor is proposing…”
Why read and further?