Long-Term Solutions, Deleveraging, and Mortgage Modification

Photo by Jonny Thirkill

So the Dow has bounced back over 400 points in the latest roller-coaster move. It's hard in these trampoline-like days to tell at any given moment whether we're still falling or bouncing back. Apparently, investors were heartened by rumors that the Feds are considering longer-term solutions to the credit crisis, including a "new government entity to help Wall Street unwind its disastrous credit bets" (a "bad bank" or latter-day Resolution Trust Corporation to take on the worst toxic mortgage-related securities and other investments). The basic idea seems to be that banks need to jettison once and for all the disastrous investments they have made, put the losses behind them, and go and sin no more.

Or banks could just get a reality check! That this crisis is of their creation is now clear. That they continue to foster the illusion that they need not act rationally to cooperate in its resolution is maddening. One of the most informed and engaging experts on the mess in the home mortgage market, Alan White at Valparaiso, has a fantastic new post today over at the Consumer Law & Policy Blog reminding us of just how irrational and stubbornly unwilling to accept reality the major mortgage banks are being. Though they claim to be on board with the notion of acknowledging reality and writing down mortgages to the (vastly lower) value of the collateral-homes, they are backing up these words with action in only a small fraction of cases. Sure, they'll cut people a break on interest and maybe fees, but modify mortgages to reduce principle--Heaven forbid! White presented to Congress evidence that banks are taking the necessary bottom line action and writing down mortgage principle in only 2% of cases. As White explains, the half-hearted Hope for Homeowners program is a cruel joke, offering relief to those facing foreclosure only if their banks were willing to accept the reality of property values and forego some of the principle on their mortgage loans (which has, not suprisingly, not happened in most cases). The FDIC is doing the right thing and setting an example by aggressively modifying IndyMac mortgages (FDIC is now the conservator of IndyMac), so why can't this reality check be extended to the broader market?

When asked about their willingness to take decisive action along the lines of the FDIC-IndyMac program, major commercial bank representatives explained, according to White, "take 10% off the loan balance, rather than foreclose at a 40% loss? This was described as the least-preferred option, and none were willing to answer what percentage of their loan mods involved any principal write-down." Ridiculous, even reckless in this era when the bottom line--the point at which the financial crisis will hit bottom and truly bounce back--depends on establishing that mortgage collateral is fairly valued at levels that allow folks to stay in their homes or allow the banks to recoup real value in foreclosure sales (rather than evicting people, taking huge losses, externalizing even further losses onto communities and the entire housing market, and then asking for redemption from the Feds in the form of a new RTC . . . revolting!). Entertaining the fantasy that the housing market will bring back the losses that are causing this spiraling financial crisis (the root of all the ills from sub-prime bond investments and credit-default swaps, etc.) is, in a word, irresponsible.

So what's the Fed to do? Well, the Fed can't do much, judging by yesterday's stock dive (Dow up 140 points on Tuesday on rumors that the Fed wills save AIG; Dow down 450 points on Wednesday because the Fed saved AIG!!??). A higher authority should step in and do at least one simple thing: amend § 1322(b)(2) of the Bankruptcy Code to treat claims secured by home mortgages just like most other secured claims; that is, allow the claim to be written down to the value of the collateral (the home), rather than forcing the law to continue to entertain the fantasy that the claim and the home are worth the inflated price originally paid. Better yet, allow mortgages to be forcibly written down to the value of the home without bankruptcy, but in any event, the special-interest gift to mortgage lenders and MBS investors in § 1322(b)(2) seems increasingly unwarranted. The notion that subjecting mortgages to "lien stripping" in this way would drive up rates was refuted, in my view quite convincingly, by a clever analysis presented in a recent paper (versions one and two) by Adam Levitin and Joshua Goodman, in which they explain that allowing forcible modification of mortgages in bankruptcy would likely result in an interest rate increase of at most 15 basis points (0.15%)!

Rather than waiting for Treasury and the Fed to turn the financial system upside-down based on questionable regulatory authority, the real regulatory power center of our political system, Congress, should introduce law(s) based on a new policy for mortgage bankers and investors in mortgage-backed securities: GET REAL!