Sunday, November 28, 2010

Why we (still) need Cramdown

Recently, I ran into Phillip Swagel's account of his time in the Treasury during the worst days of 2007-2008. While I think many people glazed over the lengthy section on homeowner assistance, I think this portion unwittingly provides an excellent overview of why some sort of cramdown legislation (ie, allowing bankruptcy courts to write down principal due on a mortgage) makes a lot of sense, and why past attempts to resolve the housing crisis through servicer-started modifications haven't been enough. I say "unwittingly" because Swagel was, in fact, opposed to cramdown.

Some background: as Michael Konczal, Yves Smith, and others have emphasized: every foreclosure represents a missed opportunity to renegotiate debt with a borrower. I think this is a bit overstated -- some people really are in the wrong house, not the wrong mortgage. Some foreclosures are inevitable, and the historical record on this issue is difficult to interpret. But certainly the number of forced sales represents a huge market failure. Banks and borrowers alike would be both better off if more housing principal was written down though some sort of modification.

Not Enough Mods

The first problem is that servicers aren't doing enough modifications, which involve both what I'll call "informational" problems as well as other "institutional" problems. The informational problems center around the difficulties in identifying troubled borrowers and extending them modifications. One way to solve this problem would be to extend an automatic modification to all borrowers who are behind on their payments. As we (may) have found out in response to Countrywide's announced modification strategy (which limited eligibility to such delinquent borrowers), this could be a recipe to encourage others to miss payments as well to qualify. There are some people who recover from delinquency to making payments on their own, and a mass-modification approach would write down their mortgages too.

So servicers, in general, adopt their own screening processes for dealing with modification requests. The problem here is that the scale of the problem has overwhelmed every existing servicer. In the past few years, servicers have grown rapidly on the assumption that the business is prone to economies of scale -- that larger companies are more profitable. This is true if every borrower makes their payment, in which case the servicer does little other than forward payments. But in bad times, servicing transforms into a business that requires a great deal of case-by-case dealing with individual borrowers (Amar Bhide style). It's simply difficult to scale up operations to deal with the scale of housing problems and hire the necessary loan officers. So you end up with a world in which the vast majority of delinquent borrowers fail to receive a modification after several months-- something like 90% by one estimate.

Aside from the various difficulties that individual servicers and banks have with sorting and dealing with delinquent borrowers; there is broader "social fairness" point. The issue is to what degree public money ought to be directed towards indignent borrowers who fail to make payments on enormous McMansions. Remember that the infamous rant on the trading desks that started the whole Tea Party idea was primarily about venting against such borrowers receiving too much assistance. These concerns seem to have played a large role, according to Swagel, in limiting government involvement.

Then; there are the institutional problems, as Swagel lists in exhaustive detail. Second-liens attached to properties have the power to hold up a modification on the first mortgage; as they view the resulting higher cash flows as going primarily to the holder of the first mortgage. Securitized mortgages in general face institutional problems in providing for sufficient modifications, as the servicers on loans that were packaged and sliced are rarely properly compensated for bothering to modify a loan. Even among "portfolio" loans held by banks; banks are reluctant to realize capital losses on mortgages by writing down the principal. Finally -- there are broader social external consequences of foreclosure that banks don't take into account -- like the effects on nearby housing prices, and municipal revenues -- that mean we probably need more modifications than banks would prefer. It appears that Treasury has known much of this for quite some time.

Mods of the Wrong Type

Aside from extending too few modifications, servicers and banks are also extending modifications of the wrong type. Driven by the pressure to meet the demands of bondholders (in the case of securitized mortgages), or avoid realizing capital losses (in the case of portfolio loans and those held by Fannie/Freddie); private modification efforts have often worked by lowering the interest rate faced by the borrower; while in many cases extending the length of the loan. The principal on the loan then frequently does not change; this means that the economic value of the mortgage remains the same. If that property was underwater -- the mortgage worth less than value of the property -- this doesn't help at all.

Modifications, too often, only targeted the "front-end" debt-to-income ratio. That is, mortgages were only restructured so as to allow homeowners to pay at most about a third of their income on their mortgage. However, this ignores the various other debt commitments borrowers face -- like credit card and auto debt -- which are frequently binding constraints. While computing modifications on a front-end basis is a lot easier, it also leaves many homeowners with more debt commitments than cash flow.

It's easy to say "this is all obvious now"; but I think you could have said the same even before the crisis. Without really changing the structure of a mortgage by writing down its principal, you don't change the economic decision available to consumers.

Crucially, according to Swagel's account, all of these bad characteristics (which were initially the product of constraints faced by private subprime servicers) became written into government policy through the IndyMac modification effort (overseen by the FDIC) and HAMP.


Cramdown actually solves all of these problems. Rather than requiring banks to sort through millions of modification requests, bankruptcy puts the onus on borrowers and bankruptcy trustees. The homeowner actually needs to go ahead and file, which -- given the massive stigma and damage to credit that results -- represents a huge deterrent to casual filers. Upon filing for a Chapter 13 plan; borrowers' mortgage debt (along with all of their other debt) is instantly written down to a perhaps sustainable level, with little fuss. Bankruptcy can't do many things; but it is very good at filtering between types of borrowers. All the reasons why we have wimpy and too few modifications immediately vanish. Plus -- by granting homeowners a powerful stick -- servicers may be more aggressive in modifying on their own.

It also solves the "indigent borrower" issue. While many people are upset about government-sponsored HAMP efforts, many people at least see bankruptcy as characteristic of America's failure-tolerant culture. The costs of bankruptcy are principally borne by the borrower; not by taxpayers.

After outlining the various reasons that existing modification policy failed; Swagel provides an entirely unconvincing argument for why Treasury fought hard to avoid cramdown legislation (which did in fact pass the House): it would have drained "private capital" from the housing market.

The fairest way to interpret this statement is that Treasury at the time was concerned about maintaining supply and demand in the housing market. While cramdown would have reduced the flow of distressed properties hitting the market (by putting those borrowers in bankruptcy, and allowing them to meet smaller monthly payments); it may have also reduced the capital available for new borrowers. The net effect, in a given moment, is hard to figure out; but clearly Treasury was worried that it may force prices to go down even further.

But this is a very short-term assessment, a trend that seems to be inevitable during the course of a crisis. Sure, we have have temporarily lowered the flow of new buyers. But the long-term impact of fewer distressed properties hitting the market would have been massive. At what point should Treasury deal with the short-term pain to secure a huge long-term benefit? Also, as has been the case for quite some time, there is virtually no private money in the mortgage market. Virtually all mortgage originations are financed by the government, through Fannie/Freddie/FHA. Having less private capital flow into the mortgage market would be basically costless right now.

This other problem with this argument is that it completely fails to evaluate the costs and benefits of more private capital, instead seeing that as some sort of ultimate good (much like "liquidity" is often treated). Personally, I think higher capital costs for high-risk borrowers (resulting in smaller houses and more renting) would be phenomenal. We could even design cramdown to avoid impacts on future crises -- for instance, by making it retroactive only. Swagel might complain that this still signals to lenders that our approach to contracts has gotten more flexible. This may be the case, but that really seems a second-order consideration for (hypothetical) future private lenders.

Also, what's the alternative? Instead of cramdown, we got a horrible 50 billion dollar modification plan (HAMP) that has perpetuated all of the bad practices of previous subprime modification efforts. Suppose we think of cramdown as some sort of "tax" on all people with bad credit to benefit some homeowners who file for bankruptcy, paid for out of the higher cost of privately provided credit. By what logic is that better than an actual, massive, tax that redistributes income from renters to homeowners in a massively inefficient manner? Swagel might argue that he didn't institute HAMP. But as he argues elsewhere, there is a natural continuity between the Bush and Obama Administrations on housing policy. And the Bush Treasury's failure to properly put in modifications led directly to the Obama's Administration's push on this issue.

The last argument Swagel gives is that cramdown would revive the 2005 bankruptcy legislation. Personally, I see that as a good thing; given that I view that legislation as the source of all current evils (for instance, see this Michelle White paper on how making bankruptcy harder encouraged the foreclosure crisis). But then, as with so much of Swagel's account, this debate turns into unverifiable accounts on political possibilities. Well, the reality is that the House passed cramdown legislation without broader implications. Perhaps the Senate could have as well, if Treasury and other stakeholders were as committed to the idea as they were to HAMP and other abominations.

I can't guarantee that cramdown would have "worked." But I can guarantee that it would have allowed as many people that tried to qualify for HAMP a better way to afford their mortgage, without costing taxpayers 50 billion dollars. A lot of the criticism and commentary over the Treasury has focused on their high profile decisions to bail/not bail out Lehman, AIG, etc. But I hope more people look at their approach to homeowner assistance, and their decision on cramdown in particular.

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