Friday, April 18, 2008

A possible approach to the mortgage mess

(Naked Capitalism) On a post yesterday on how well (or more accurately, how badly) various state efforts to rescue homeowners were faring, reader Richard Kline offered a suggestion.

Note that while I still favor the apparently destined-never-to-see-the-light-of-day idea of permitting bankruptcy judges to write down mortgages to the current market value of the collateral (the rest becomes unsecured), Kline's idea is elegant. One change I'd recommend is to have his markdown from the index vary by either state of MSA.

Hoisted from Kine's comments:
I don't mean to frown any excessive frowns on the issue, but there is simply NO solution to the bad mortgage problems that exist as they are presently constituted. The problems are too diverse; there are too many lenders, and worse diffused standing with respect to the actual mortgates; the volume of property is, well, vast. That's just on the lender side. Borrowers have many and various problems so there is no one-size or even middle-of-the-curve solution to implement. These mortgages need to be, literally, re-negotiated one at a time. But it gets worse: with asset values plunging to well south of the face value of many loans there is no sane way to 'save the loan' as written. You want the lender to eat 40% of the loan? It might be easier for them to walk away---or there may be no 'lender' to walk away, they're dead. For troubled mortgage holders, it's a big blot on their credit, a life-changing event. For lenders, it's often going to be a blot on an x-ray; a life-ending event.

Don't expect a fast resolution to this issue; three years from now, we'll still be unwinding it, in my view. Federal legislation does nothing to solve the problems. 'The guvmint buys all notes?' They don't got that kind of dough.

The government can't solve the problem---but the government just might be able to change the problem. Here is the outline of a coherent solution process; it won't happen, and I'm not going to propose offhand the means to get there, but since this all is a mess, and we'll have some time to kick arouond issues, here is one way to go about it.

Take the market or appraised value of the property as of a set, market top date; oh, March, '07 for an index. Now take 60% of that: this is the new value of the property. Take the loss, and apportion it between mortgage holder and lender based on their equity shares as of today; this means most, but not all of the writedown goes to the lender. Many mortgage holders will end up with negative equity, but at much lower total dollar value; the property is worth less, but by the same token the amount which will have to spend to pay it off and own it clear is much less, too. That's a situation which may keep an owner willing to stay in the property and pay off that smaller negative equity; they take some loss, but they can end up with whole credit and a home, not a bad outcome. Refi the loan into a traditional loan structure. If the owner can't meet that payment, well the loan is dead anyway, we've done all we can. The advantage to the lender is that they now have an asset again, rather than a rotting, unoccupied structure against which they owe taxes after foreclosure costs in a horrible property market without viable mortgage lenders and huge inventory overhangs.

No one forces this solution on either party to a locked up, upside down squat, but it's a package deal, go/no-go, with little or no side dickering over terms: you go to court and say, "We both agree to this change in our pre-existing contract by the terms of the Somebody Help Me Jesus Act of '09," judge raps the gavel, ever'body clap hands, and walk out the door with chins up and best foot forward. Once a mortgage holder at a viable payment is signed on, the lender can sell the package or hold it to term, but the mortgage is a tradable instrument again at known value. This is for first liens only. I have no solution to propose for second and third mortgage situations other than the Darwinian solution: stupidity means your equity dies stillborn without reproducing.

Rather than a total loss-loss, cut cards and do a re-deal, but 'automate' the process with shared pain.

For non-foreclosure situations. Supposing that you were one of the few responsible borrowers who actually got an loan they could afford, no further liens, but now with a 40% decline in value you will be massively underwater. However, you can still afford your payment, so the loan doesn't go into foreclosure, and as things stand _you alone_ are expected to bear the full burden of the loss. You can't refi or sell without paying out the full losss now upfront, either. If you go in to your lender and ask them to write down the principle, and share the loss, you'll hear, We lent X amount; you can pay at y schedule; we expect to recover X amount: no deal.

Well, that's a capital loss, right? It isn't reasonable that you, or anyone get to write off _all_ of that loss against your taxes, but it could be established that for homes sold over thus-and-so years which experienced a loss of value of y% a capital, something well less than half the total loss can be written off against taxes over a period of time; a substantial mitigation even so. If you, the mortgage holder claim the loss, however, the lender has to immediately write down the collateral and with it the loan value, even though over time more than the collateral is worth is going to be paid. On the other hand, if they renegotiate the loan, they (the lender) can claim the capital loss over time.

This is less than ideal. It requires public funds (the capital loss against taxes). It may be hard to find a formula getting the mortgage holder out of the neg eq prison, too. Also structuring the accord so that it was as automatic as possible with as little room for maniupulation by either party would not be easy. The key is that the trigger should be placed in the hands of the one currently taking the loss, the mortgage holder, giving the lender reason to share in the loss. Under no circumstances, though, should the whole value of the asset depreciation be laid off on the US Treasury, though. Something like a third should be the max, with the actual parties to the contract splitting the rest, one way or the other. The time period to qualify for this should be only at the very market top, perhaps '02-'07, still a huge portion of outstanding mortgages, but.

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