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
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
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
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