Category Archives: Guest Post

This guest post was submitted by Peter Fox-Penner, a leading expert on regulation at The Brattle Group.  The views expressed here are those of the author alone.

Improving the regulation of the financial sector is a prime topic of conversation amongst financial economists, and appropriately so.  Most agree that massive failures of financial regulation were one, if not perhaps the largest, cause of the 2008 meltdown.     

When the conversation turns to the specifics of what needs to be regulated, how regulation should work, and what agencies should be involved, the range of views is tremendous.  There is agreement that some kind of prudent regulation is needed, as is investor and consumer protection, but that’s about it.  Fueled by billions of dollars of lobbying and purchased research, everyone has their own idea.  One super-regulator?  Council of regulators?  Control bankers compensation schemes?  Exchange-trade them?  The cacophony is deafening. 

As an industrial organization economist, I think this discussion would benefit greatly from a consensus on the role and goals of financial regulation.  Paul Joskow, a dean in the IO economics community, recently noted that:

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There’s another problem with trying to deal with the foreclosure problem – the most obvious solution, mortgage cramdowns, are very unpopular. They failed to pass last spring, and are probably even less likely to pass now. People don’t like thinking that they are rewarding those who made bad mortgage decisions. Very few people have ever come close to trading a credit default swap – every adult has had to make a choice about mortgages over the past 10 years, and rewarding, in the words of CNBC, “the losers” is a political no-go in the United States.

What is another choice? How about “Right To Rent”? Here’s Simon Johnson back in November of 2008 calling what would happen over the next 10 months and then suggesting a version of Right To Rent:

Washington is beginning to turn its attention to housing, and there is progress on plans to make it easier to modify delinquent mortgages where there is a win-win solution for the borrower and the lender.

At best, though, this is only a partial solution. Many homeowners will be unable to afford any mortgage that lenders will accept. Complicated relationships between servicers and secondary-market investors will make it difficult, impossible or illegal to restructure many mortgages…

In addition to limiting the number of foreclosures, it will be critical to manage the flow of foreclosed properties onto the market. Otherwise, the mounting wave of foreclosed condos and single-family homes threatens to push housing prices far below long-term sustainable levels, inflicting unneeded pain on homeowners and the economy…. Here are some ways to facilitate an orderly unwinding of real estate…

The borrower turns over the deed to the servicer and rents the property back from the mortgage investor for some period of time. At the end of the period, the renter can get a new mortgage from the investor at prevailing market rates if the borrower qualifies; if not, the property goes on the market.

I want to take that idea and flesh it out further. I think the best approach is the version suggested by Dean Baker’s, who also originated the idea, described here:

There is an easier route. In recognition of the extraordinary situation created by the housing bubble and its collapse, Congress could approve a temporary change to the rules governing the foreclosure process. This change would give homeowners facing foreclosure the right to stay in their homes, paying the market rent for a substantial period of time (eg seven to 10 years).

This change would have two effects. First, it would immediately give housing security to the millions of families facing foreclosure. If they like the house, the neighbourhood, the schools for their kids, they would have the option to remain there for a substantial period of time.

Also by keeping homes occupied, this rule change can help prevent the blight of foreclosures that has depressed property values in many areas. Vacant homes are often not maintained and can become havens for drug use and crime.

Dean Baker has had this proposal out there for a while, since at least 2007. Felix Salmon had it as one of his Fixing The World Ideas in The Atlantic Monthly. Some conservative economists, including Andrew Samwick have signed on, and there’s a version of a bill floating out there.

So what are the advantages? The foreclosure is avoided, keeping pressure off the community and not displacing a family. The rent is set by an appraiser to the neighborhood renting value, and reassessed whenever either the lender or borrower requests it at their cost. This prevents it from becoming a de facto form of rent control, while the externality effect of people losing the value of being able to sell their home because of foreclosures down the block has gone away, not to mention the more general social cost of abandoned housing.

Now is this a gift to those who made terrible decisions? No. As opposed to a normal foreclosure in most states, it is purposely designed so that any equity built up in the loan isn’t transferred over to the consumer. Normally if the bank sells your house for more than the loan outstanding plus fees in a foreclosure, you get the remainder. Not so with Right to Rent, the bank gets all that upside and the other party gets their equity wiped out.

Some versions of similar plans are designed so the bank is required to sell back to the renter first at a later date; I see no reason for this, as the bank will almost certainly offer it first to the people at the property if they can afford it. If they sell it to someone else however, the person still gets to rent their home. Personally I’d like to see the timeframe for the home rental to be on the order of 3-5 years, though that is debatable. Ideally it would also have accelerated eviction rules, so that people who couldn’t even afford the rent aren’t still living in said property.

This requires no taxpayer funding, and can be done in our very efficient bankruptcy courts. How great of a deal is that?

What are the downsides? It is an intrusion onto the property rights of the lender. The lender can still sell, but will sell with a tenant attached to the property. For the time being, the social costs being accumulated by neighborhoods as properties sit vacant is devastating, enough so that we need to take action. Lendors will become landlords, though there are a lot number of civic groups, third parties, businesses, etc. who can contract that labor out if it can’t be done in-house.

What are your critiques? Thoughts? Personally, in terms of our current political dialogue, I wonder if the type of social conservative who is willing to lock up large segments of the population to prevent a “broken window” from forming would be willing to ask a lender to take a small haircut to save the entire house from rotting in foreclosure, windows included. Nothing increases the “disorder” of a neighborhood than having foreclosed houses rotting away on them…

Obama’s mortgage modification plan, HAMP (Home Afforable Modification Program), isn’t working very well. Designed to help prevent foreclosures by incentivizing and giving legal protection to previously indifferent middle-men servicers it isn’t producing anywhere near the number of modifications that were anticipated. Is it likely to work in the future? My guess is no. Let’s discuss some reasons why.

Servicers Gaming the System Over the past few months, more and more stories have come out about servicers finding ways to line their pockets while consumers and investors are getting shortchanged. The one that brought the gaming issue to everyone’s attention is Peter Goodman’s article in the New York Times. Here are my favorite three since then:

Story One, Financial Times:

JPMorgan Chase, one of the first mega banks to champion the national home loan modification effort, has struck a sour chord with some investors over the risk of moral hazard posed by certain loan modifications.

Chase Mortgage, as servicer of several Washington Mutual option ARM securitizations it inherited last year in acquiring WAMU, has in several cases modified borrower loan payments to a rate that essentially equals its unusually high servicing fee, according to an analysis by Debtwire ABS. Simultaneously, Chase is cutting off the cash flow to the trust that owns the mortgage. In some cases, Chase is collecting more than half of a borrower’s monthly payment as its fee.

Story Two, Credit Slips

Countrywide Home Loans (which is now part of Bank of America) has been the subject of proceedings in several bankruptcy courts because of the shoddy recordkeeping behind their claims in bankruptcy cases. Judge Marilyn Shea-Stonum of the U.S. Bankruptcy Court for the Northern District of Ohio recently sanctioned Countrywide for its conduct in these cases…The resulting opinion makes extensive reference to Credit Slips regular blogger Katie Porter and guest blogger Tara Twomey’s excellent Mortgage Study that documented the extent to which bankruptcy claims by mortgage servicers were often erroneous and not supported by evidence. Specifically, the court adopted Porter’s recommendation from a Texas Law Review article that mortgage servicers should disclose the amounts they are owed based on a standard form. Judge Shea-Stonum found that such a requirement would prevent future misconduct by Countrywide.

Mary Kane, Washington Independent

Even as the Obama administration presses the lending industry to get more mortgage loans modified, the practice of forcing borrowers to sign away their legal rights in order to get their loans reworked is a tactic that some servicers just won’t give up on…

In a dramatic confrontation last July, Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, told representatives of Bank of America to get rid of waivers in their agreements. His pronouncement came after Bank of America representatives denied they were using the waivers – and Julia Gordon, senior policy counsel at the Center for Responsible Lending, produced one from her briefcase.

Check out those stories. The first has the servicers set the payment to maximize their fees, and not anything beyond (to make sure very poor and desperate mortgage holders are able to pay each month), making sure their interests are above the lender’s ones. The second one shows that it is very difficult to determine incompetence from maliciousness with the way that servicers are handling their documents on the borrowers end. And the third would be a great piece of classic comedy if it wasn’t so terrible. I bet these guys sleep like babies at night too.

The servicer’s interests are their own – and if they can rent-seek at the expense of the parties at either end, ‘nudging’ them with $1,000 isn’t going to make a big difference.

Redefault Risk There’s another story where the servicers aren’t modifying loans because it isn’t profitable for the lenders. There’s a very influencial Boston Federal Reserve paper by Manuel Adelino, Kristopher Gerardi, and Paul S. Willen titled “Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization.” They point out that, according to their regressions, redefault risk is very high – the chances that even under a modification there will still be a foreclosures, so why not foreclosure immediately?

I’d recommend Levitin’s critique (Part 1, Part 2), notably that the securitization regression doesn’t control for type of modification, specifically they don’t variable whether or not the modification involved principal reduction, which is probably does for the on-book loans and not for the off-book loans.

But regardless, this is a valid argument as U3 unemployment starts its final march to 10% we are going to see consumers become riskier and riskier, and that will be a problem for modification that will get worse before it gets better.

General Inexperience Servicers were never designed to do this kind of work; they don’t underwrite, and paying them $1,000 isn’t going to give them the experience needed for underwriting. It’s hard work that requires experience and dedication, skills that we don’t have currently. (Isn’t it amazing with the amount of money we’ve put into the real estate finance sector over the past decade we have a giant labor surplus of people who can bundle mortgages into bonds but nobody who can actually underwrite a mortgages well?)

But isn’t it at least possible that as the sophistication of the servicers increase, they’ll become equally good at learning how to game the system? I don’t mean this as a gotcha point, because I think it is the fundamental problem here, and there isn’t any way to break it. The servicers get paid when they have to get involved, and learning the contracts better will give them more reasons to get involved.

It’s been know for several years now that this was a weak spot in the mortgage backed security instruments. In the words of the creator of this instrument, Lewis Ranieri in 2008: ” The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary. And part of our dilemma here is ‘who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?’ … have to cut the gordian knot of the securitization of these loans because otherwise if we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy.”

He’s right of course; the people we are trying to ‘nudge’ into acting as the fiduciary are going to be more than happy to rent-seek these instruments while they crush the consumer economy. This ‘gordian knot’ has to be broken, but it’ll need to be done outside the instruments – in the bankruptcy court.