The Prudent Solution: Scaled Principal Write-Downs
The most effective means of averting mortgage delinquency, default, and foreclosure—and the associated economic costs—is principal reduction. As even creditors recognize, debt loss must be formally recognized in a manner that bears some intelligible relation to home equity loss. Moreover, for much underwater mortgage debt, write-downs raise value—a benefit borne out by the frequency with which portfolio loan holders write down debt (Olick 2012; Goodman et al. 2012; Ritholtz 2012; Goodman 2012).
Write-downs are not easily carried out in all cases, however. Much depends on whether the targeted loans are held in bank portfolios or by private-label securitization trusts. In the portfolio case, write-downs occur at significant and still growing rates (Goodman et al. 2012; Goodman 2012; Streitfeld 2011). Bank officers know that underwater loans foreclose at high rates, with the result that expected values fall needlessly short of face values; hence, they find it financially rational to write down these loans. In so doing, they benefit not only themselves, but also their debtors and the communities in which they reside. In this case, the interests of all parties converge.
Securitized mortgage loans, however, pose a problem. While it would be no less rational or beneficial to write these loans down, certain structural features of the loans—features that now act as market failures—prevent the rational thing from being done. The upshot is deadweight loss—loss whose recoupment and equitable distribution is one object of the plan sketched below.
Structural Impediments to Write-Downs
What are these structural impediments? A host of classic collective action problems, reinforced by dysfunctional contract provisions, stand in the way of the optimal solution (Hockett 2012a, 2012b; Shiller 2012). For one thing, there is a last-mover advantage where write-downs are concerned, owing to the benefits (positive externalities) that accrue to the creditors on later loans when principal is reduced on earlier loans. This problem afflicts portfolio loans too, of course, and probably therefore keeps modification rates lower than optimal even among banks. But in the case of privately securitized loans, it is reinforced by additional challenges.
Most decisive among the additional challenges is that so many of the pooling and servicing agreements governing the private securitization of loans—agreements drafted during the bubble years when few foresaw a marketwide housing price bust, and many rushed either to push or to purchase an innovative product—require supermajority voting among mortgage-backed securities (MBS) holders before loans can be modified or sold out of trusts. And these bondholders, geographically dispersed and unknown to one another, cannot collectively bargain with borrowers or buyers on workouts or prices.
Moreover, the agreements governing the loans prevent trustees and loan servicers, who are duty-bound to act on behalf of the bondholders and thus could in theory address their collective action problems, from modifying or selling off loans in the requisite numbers (Hockett 2012a, 2012b).5 Finally, the agreements typically stipulate compensation arrangements that make it more profitable for servicers to oversee lengthy foreclosure proceedings than to seek modification. In sum, then, these contracts now virtually ensure that mortgage loans will default, harming all interested parties.
Additional complications arise from the fact that many underwater homes are subject to second liens that secure home equity lines of credit or closed-end second mortgages. First lienholders benefit little from loan modifications unless second lienholders modify too; hence, they are rationally reluctant to modify on their own. But second lienholders feel less pressure to modify because borrowers, strapped by post-bust liquidity needs for which home equity lines constitute precious sources of credit, are apt to make payments on them first—a reversal of the legal order of creditor priorities (Goodman 2012).6 In addition, the second lienholders quite often are banks—the same banks that service the first-lien-secured loans. That poses a conflict of interest where firsts prefer that seconds modify too in order to optimize the benefits that modification brings to firsts, further obstructing agreement among borrowers and creditors.
Other constraints—including inapplicable bankruptcy laws and Internal Revenue Code and Trust Indenture Act uncertainties—impede the kind of collective action that would benefit both debtors and creditors (Hockett 2012a, 2012b). But the foregoing discussion suffices to indicate how formidable the obstacles to principal write-downs can be, particularly for loans held in private-label securitization trusts.
Bypassing the Impediments through Collective Agency
Solving a collective action problem requires a collective agent. Of course, that is what PLS trustees and servicers in theory are. But as we have seen, these agents are often hand-tied or conflicted. Who, then, will act for the creditors and, in so doing, for homeowners and spillover victims of local foreclosure and the continuing weakness in the U.S. mortgage market?
As it happens, governments are also collective agents. They are likewise the sole entities authorized to sidestep the contract rigidities of the pooling and servicing agreements that stand in the way of broad write-downs for PLS loans. But which government should take up this mantle—federal, state, or local?
In 2008-09, this author and two others separately advocated federal action under eminent domain—the power of governments to take private property for public use (Hockett 2009; Jackson 2008; Willis 2008). In 2010, two higher-profile advocates, including one member of Congress, added their names to the call (Miller 2010; Kuttner 2010). But thus far no action of this sort has been taken, even though other actions have brought some help.
The federal government’s flagship Home Affordable Mortgage Program (HAMP), for example, has accomplished much, but it is not designed to deal with underwater or “negative equity” mortgages. For their part, the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac have been steered clear of write-downs by their regulator and current conservator, the Federal Housing Finance Agency (Appelbaum 2012). Finally, Congress has twice now attempted but failed to get mortgaged homes into the Bankruptcy Code, thus leaving no means for bankruptcy judges to employ their equitable powers to salvage value among mortgagors and mortgagees as they routinely do among other debtors and creditors.7
The consequences of our failure thus far to focus on principal reduction can be seen in more numbers: Since 2007, little more than 1 percent of underwater home loans have seen write-downs. Fewer than half of these write-downs have brought loans above water. Meanwhile, only 2.7 million loans have been modified in any way by their servicers, while 40 percent of these modifications have reduced monthly payments by less than 10 percent.8
This weak response is surprising in light of the abundant evidence, derived from the portfolio loan case, that sizable write-downs save sizable value (Olick 2012; Goodman et al. 2012; Ritholtz 2012; Goodman 2012). And it is surprising too given the compelling evidence, found in the GSEs’ filings with the Securities and Exchange Commission, that unmodified underwater PLS loans will default at high rates: For 2006 vintage loans, for example, 71 percent of sub-primes, 70 percent of option adjustable-rate mortgages, 58 percent of variable-rate loans, and a surprising 40 percent of traditional fixed-rate loans have defaulted.9
The State/Municipal Eminent Domain Plan
If it is not to be federal instrumentalities or PLS trustees and servicers, then, the collective agents best able to address the structural problems that arise with the pooling and servicing
agreements on privately securitized loans are st ate and municipal governments. These governments (a) face the brunt of mass foreclosure and its consequences more directly than the federal government in any event, and (b) have constitutional authority to address these exigencies.10 Let us first consider how the subfederal units of government can act, then elaborate briefly on their suitability for these roles.
Using their traditional eminent domain powers—a legal authority enshrined in our state and federal constitutions for precisely such exigencies as the foreclosure crisis presents—states or their sub-units can compulsorily purchase underwater loans from private-label securitization trusts at fair value, dealing directly with trustees and sidestepping all contract rigidities. They can then write down the loans, reducing default risk and raising expected values in the process.
If need be, eminent domain authority can also be used to take second-lien-secured loans at fair value, or even the liens that secure them, while leaving the notes with their holders—effectively converting the latter to unsecured consumer debt. That prospect can bring recalcitrant second lienholders to the table with firsts—particularly if, as suggested below, they also are offered some fraction of the surplus recouped through the write-downs.