Newsflash: the system has been failing homeowners, and the rest of the market, for some time.
This is a placeholder for some ideas I want to develop further. Obsidian Wings catches something I've noticed in this debate too: "In any event, I noticed commenters at every blog giving a ritual statement that 'of course I don't have any pity for people who are defaulting on their mortgages' before they get down to the business of apportioning blame." If there's anything our elite can agree on, it is beating on the so-called 'losers' who are getting kicked out of their homes.
I think this is a backwards way of looking at what is going on with the foreclosure crisis. The way we deal with mortgages in this country is a brand new phenomenon, one that only dates back 15 years or so, and it is a failed system. It's like a car in an accident that wasn't tested, but instead of the airbag not deploying the car has exploded. That a record numbers of homeowners are delinquent and defaulting is the sign of a sick system, and efforts to 'purge' delinquencies out doesn't get at what has gone wrong.
The real debate for me is: why are we having so many foreclosures? Think of the iconic example of a local housing bubble, Texas in the 1980s. Here's how bad the foreclosure rate got:
That was after a pretty vicious oil and housing bubble popped around 1986, and we don't see anywhere near as many foreclosures as we do now (the number has gone up throughout 2009 and 2010).
Because the first rule of mortgage lending is you don't foreclose. And the second rule of mortgage lending is you don't foreclose. For all the talk about how principal modifications will harm other economic parties, it's the other way around. Imagine a house is worth $200,000, but the mortgage is worth $300,000. The homeowner can't make the payments at $300,000 but can at $250,000. If the homeowner's principal isn't written down, the bank seizes the house and sells it at... $200,000. And that assumes they don't lose 30+%, as is common for a foreclosure sale. This loss will raise the cost of capital for everyone else. Why is it breaking down this way?
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One reason is that there isn't anyone standing in the center acting as the fiduciary. We only have to look at the structure of the servicers to see this. Designed to do automated, scalable and streamlined work, they are being asked to do work that is time and energy intensive. Then comes the incentive structure wherein it's less profitable for loans to be current and functioning. Built into this business model is the fact that delinquent loans will balance out the lack of profit from fewer mortgages being started (what they called a counter-cyclical diversification strategy). This is what people like Amar Bhide are pointing out about local knowledge; issuing loans can harness economies of scale. Servicing loans can harness economies of scale. Managing loans that are delinquent and in need of modification is time and knowledge intensive.
The second is the structure of multiple liens. It was no accident that this structure makes it incredibly difficult to modify and deal with a mortgage crisis. If you go back and read the arguments put out by a conservative think tank like the American Enterprise Institute, arguments like Charles W. Calomiris and Joseph R. Mason's High Loan-to-Value Mortgage Lending: Problem or Cure? (which we discussed here), the idea that leveraging up and using your home as a credit card with multiple different entities having multiple different claims, junior claims that senior claims might not even know about, would lock you into having to be a more responsible party and also save you some pennies on that housing credit card. Calomiris:
Misplaced concerns about the riskiness of HLTV lending and the destabilizing effects of reloading and churning have led some in Congress to advocate altering personal bankruptcy law to allow cram-down -- or bifurcation -- of mortgage debt exceeding 100 percent of home value. Under such a scenario a borrower filing under Chapter 13 would avoid foreclosure. Mortgage lenders would retain senior claims on the borrower up to the amount of the fair market value of the underlying property at the time of bankruptcy. The HLTV loan would thus be second in line as a claim on borrower wealth up to a maximum of the value of the mortgaged property. The amount of the HLTV loan greater than the value of the underlying property at the time of bankruptcy would be treated as unsecured debt and placed on an equal footing in the bankruptcy process with other unsecured debt... Cram-down would essentially eliminate that special bargaining power of the HLTV lender.
So AEI thought it should be incredibly difficult to modify a failing mortgage so that homeowners could save a tenth of a percent on their house credit card. It's worth noting that the "special bargaining power" is designed to eliminate modifications, or the simple Pareto-improving agreements between a senior debt-holding bank and a lender. As we noted before, it would be insane to allow this kind of structure to go on in the corporate bond market.
Another way to think of this more general idea is that if we seal someone inside a car and take out the airbags and seatbelts, they'll be the best driver ever. I had an economics professor back in business school who was proud of the fact that he never wore a bicycling helmet, even after he broke his collarbone in an accident, because he found some half-assed research saying that cars drive closer to people with bike helmets on.
This bizarre idea, known as risk homeostasis in the economic ideology, is useful as a thought exercise, but a dangerous way to run a mortgage system. And this is the system that we are dealing with. Because it ignores the fact that sometimes a gigantic truck of global imbalances and a systemically large housing bubble and financial crash will be racing the opposite way, right in your direction.
Last bit of real talk: there's no point in making a partial payment on a mortgage from the standpoint of keeping the mortgage current. If your mortgage payment is $1,000, and you pay $900, you aren't any more current for it. Is there an instrument we can use to see if people are trying to stay current and make some sort of payment? Here's one from Mr. David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, at a House committee on "Second Liens and Other Barriers to Principal Reduction as an Effective Foreclosure Mitigation Program":
It is important not to confuse payment priority with lien priority. In almost all scenarios, second lien holders have rights equal to a first lien holder with respect to a borrower’s cash flow. The same is true with respect to other secured or unsecured debt, such as credit cards or car loans. Generally, consumers can decide how they want to manage their monthly payments. In fact, almost 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. It is only at liquidation or property disposition that first lien investors have priority.
So what you see is a lot of people, over half, who have stopped paying the first lien are trying to make some sort of payment. (In a way that strikes me as a weird conflict of interest if it's consistent across all servicers. Talk about bad financial literacy.) If there's ever been evidence that rather than trying to leech out a vacation, there are a large number of people trying to get current on their loans, trying to pay something to stay in their homes, it's this number proving that people are paying the smaller junior lien first. Why can't the system meet them halfway?
Mike Konczal is a Fellow at the Roosevelt Institute.