President Obama recently unveiled an initiative designed to support the housing market and reduce the catastrophic number of foreclosures. While the GSE-centric plan generally represents an incremental change from earlier programs, its controversial inclusion of a proposal for bankruptcy cram-downs may ultimately aid large numbers of homeowners by increasing the number of loans that ultimately are modified.
Although containing provisions designed to stimulate refinancings and stabilize the GSEs, the proposal focuses on reducing home foreclosures and facilitating large-scale loan modifications. While the Administration will release more detailed guidelines in early March, most of the provisions are similar to Bush Administration initiatives that failed to help many homeowners. In addition, the proposal ignores important attributes of the current mortgage market. For example, provisions to pay cash fees to servicers that modify loans create apparent conflicts of interest in cases where loans were packaged in securitizations. While servicers have a fiduciary responsibility to maximize the proceeds paid to securitization trusts, direct payments to servicers create incentives to modify loans even in cases where a modification might be sub-optimal. The acceptance of such payments could be grounds for investor lawsuits, and suggests that such payments are unlikely to motivate servicers to modify loans aggressively without receiving some form of legal protection. In addition, a provision that would pay "mortgage holders" $1,500 to modify troubled loans before they become delinquent overlooks the complexities associated with securitization. MBS deals don't have one "mortgage holder," but rather tranches with a variety of risk profiles and interests. The plan does not recognize this fact, nor does it address issues such as how incentive payments should be divided among bondholders.
The major difference between this plan and earlier ones is the provision for "judicial modifications," or bankruptcy-related cram-downs. Although they are a subject of controversy, cram-downs may be the only way to substantially increase the number of loans being modified. While the conflicts that have inhibited servicers' willingness to modify loans would not disappear, the threat of losses resulting from judicial intervention would serve to motivate the disparate interests to cooperate.
Lenders have fiercely resisted the concept of bankruptcy cram-downs, arguing that they increase the risk and uncertainty associated with mortgage lending and will lead to higher mortgage rates. The Mortgage Bankers Association is on record that cram-down legislation would cause mortgage rates to increase by 150 basis points. In light of the dislocations and torments endured over the past few years, this claim seems fanciful. While such a provision may marginally increase rates, lenders already recognize that lending against residential real estate is fundamentally riskier than the historical experience through 2005 would suggest. Asset-based lending is predicated on the notion that asset values are stable. The disasters of the last few years have demonstrated that lenders must account for possible declines in the value of residential loan collateral when underwriting and pricing loans. In my estimation, the value that these insights have had on loan pricing dwarfs the potential rate impact of cram-down provisions, at least as currently envisioned by the Administration.
While an unfortunate outgrowth of the financial crisis, bankruptcy cram-downs should begin to break the logjam impeding widespread loan modifications. For a variety of reasons, servicers and bondholders have not aggressively acted to alter the terms of large numbers of delinquent loans. The cram-down proposal will create incentives for all parties to overcome systematic barriers to large-scale modification efforts, lest judges do it for them.
The opposition to this provision is overdone. Unfortunately, this is the only section of the plan that I expect to have a significant impact on homeowners.
Bill Berliner is a consultant based in Southern California. His web site is www.berlinerconsulting.net.
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