Wednesday, November 12, 2008

Loan Modifications

As I mentioned in my post discussing HRC's letter to Bush & the Senate leadership, a crucial financial event that has to happen is the revaluation of houses sold since 2002. They should never have risen to the levels they did, the exotic loan vehicles used are unsustainable (Barry Ritholz on The Big Picture argues that many were issued knowing they were impossible to pay back), and the looming tidal wave of probable foreclosures can only be reduced (there is no way to stop it) is through loan modifications.

Modifications can take a number forms - reduce interest rates, change loan types, forgive outstanding interest, extend the term of the loan, and (the most radical) reduce the loan principal. (Note - these may be other ways to modify the loans than this that I don't know about since I"m not in the industry.)

This NYT article in today's edition, Lawmakers Debate Loan Modification, discusses some of the difficulties in trying to achieve these modifications. BS and buck-passing figure prominently:
The problem is that financial executives have competing views on whether mortgages that were packaged — or securitized, in industry parlance — can be modified or not. These mortgages are no longer owned by the banks that service them; they are instead owned by numerous investors, and some in the industry think the investors might sue banks that modify mortgages. ...

At the hearing, panelists disagreed on whether modification was allowed with bundles of mortgages that were resold. An executive from Bank of America said that the contracts behind some securitizations expressly prohibited changes to the underlying mortgages. The executive, Michael Gross, managing director of loan administration loss mitigation at Bank of America, said that banks had more flexibility to modify the rules in loans that they still held.

But an executive with the American Securitization Forum, an industry group, said that contracts did allow bundled mortgages to be modified. The forum is in discussions with a range of investors who bought mortgage bonds to streamline the process of such modification, said Thomas Deutsch, deputy executive director of the group. ...

Mr. Deutsch’s assertion faced skepticism among lawmakers. Barney Frank, Democrat of Massachusetts and chairman of the committee, said he was hearing evidence that servicers were having trouble modifying loans that were securitized.

“They can’t get this worked out,” Mr. Frank said. “Who am I going to believe? You or my own eyes?”

The loans were bundled and sold as securities, and the holders of those securities are unwilling to eat the losses, except some say they don't object, but others are threatening to sue. The servicers (the people who collect the money, but who don't hold the risk) are claiming that they will be sued if they modify.

Well, we've got a chicken/egg situation here. The underlying asset simply aren't worth their sales prices anymore. Some are a little bit off. Some, especially the biggest bubble markets, are off by 1/4, 1/3 or even 1/2 the original price. Even some that have not lost a great deal of value, maybe a less than 10% decline, were sold using loan products (Interest Only, ARMs with extreme resets, etc.) that the borrowers are going to default.

The bubble value of the house is going to be lost. Period. That basic fact needs to be drilled into people's heads. We are not going to maintain the bubble prices because they have no basis in reality. Anyone who thinks it can be sustained is spitting into the wind. The question is who will bear the loss.

So, how can this happen in a way that does not involve the full force of the tidal wave crashing down on the financial shore?

I've spoken before about the HOLC/HOME program promoted by sensible economists and politicians. I have also spoken about the need to allow any homeowner, endangered or not, to make use of this program to reduce their principal, though with a penalty for anyone who sells before the full term of the revised loan for more than the value of the original loan. One commenter said that some profit needed to go back to the investors while I was more hard-nosed and said they needed to take on the risk for their investments.

But maybe we can adjust the program to sweeten the deal for these securities holders and get them to agree to loan restructuring rather than suing banks. Instead of only dealing with home owners, perhaps the securities people can say they will accept the revaluation of their securities and continue to hold them or they can sell them back to the HOME program for the revalued price and and take a financial loss in exchange for jettisoning risk. If they continue to hold and they allow the revaluation, then, should the homes sell before the maturity date and should the sale price be greater than the revised loan amount, the difference goes to the securities holder (original investor), not the government. If they continue to hold the securities, then there is no reason the servicers can't administer the situation and it stays off government books.

The immediate problem I see here is that these securities are not necessarily composed of entire loans, but are often are built from "tranches" - slices of loans that are valued according to the probability of them being paid back. (This is a layman's definition. Please go to a real econoblog like Calculated Risk for detailed information about tranches) The coordination costs alone make this of limited use, but it is one way to try to address restructuring value, debt and risk in a way that reduces crisis, encourages housing stability and does not enrich free riders at the expense of true risk takers.

Alternatively, recombined securities could be revalued and resold without tranches and with very easy to understand levels of risk. A house with an original loan of $450K and a revised loan of $300K is worth the latter amount but may return the former if sold before the 30-year term is up. A good number of these houses will probably sell within twenty years, and while they may not regain the original $450K value, they may be worth $365K - and the extra $65K goes to the investors. At worst, the investor receives the full value of the $300K on the 30-year loan held to maturity and the home owner has exchanged future potential returns for current financial salvation.

A very, very smart home owner who knows they won't be going anywhere for 30 years and is not distressed, but falls within the time frame, can greatly reduce home costs, freeing up household income for other things. Which is a boon to the broader economy because people need to spend to fend off recession and depression. In short, it increases liquidity of earnings very fast and keeps them liquid in the future. If home owners default, the value if lost anyway and the larger the number of defaults the more depressed the housing market becomes until slack is taken up. If we are heading into a wide-spread depression, that could be a very long time.

So, those are my thoughts after reading this article. Losses are going to happen. Revaluation with special conditions for recouping original values is one way to free up consumer cash while defending original loan obligations.



Koshem Bos said...

The mortgages sold since 2002 are estimated at between 4-5 million. You can relatively easily assess the real value of the property mortgaged and automate it. If you trace it through to the securities (claims that tracing is impossible are ridiculous because the security is worth the sum, possibly fragments of the actual mortgages) It is possible to assess the real values of the securities at the time of assessment. A regulation or a law may force the owners of the securities to adjust their values according to the assessment. Since the vast majority of securities lost value you can then reduce the principals involved.

Special cases can be handled manually.

It's not brain surgery.

Unknown said...

When I bought my first home back in 1971 (23 years old!), before the first bubble, I did it for the tax deduction. It turned out to be a good investment too. Those who can deduct their mortgage are better off than those who rent. The mortgage payment, plus taxes, insurance, and maintenance is normally higher than rent, unless one has a huge down-payment, but the deduction makes owning a home still worthwhile. There is also the added benefit of not getting a note from the landlord that one must vacate for whatever reason.

harpie said...

This is tangential, but there would be some extra money to spend in our family budget if property taxes were revalued downward along with the property values. Something tells me, though, that I'm just blowing bubbles with that wish.

“No matter how cynical I get, I just can’t keep up!”-Lily Tomlin