First, a number of comments suggested that I was soft on fraudulent borrowers or too hard on the rating agencies. "Jarhead," for example, admonished that we should "start to sue borrowers." "AMC" doesn't understand why lenders shouldn't be entitled to the full benefit of their contract rights. "Orville R" claims that "nobody, I repeat nobody, for[e]saw [sic] the unprecedented 20% drop in house values." In any case, he suggests, Moody's mistakes were a "non-story" because Moody's ratings simply reflected disagreements among the professionals--in particular the lawyers.
I should be clear that I have no sympathies for any particular type of stakeholder in the mortgage mess. I think no category of participant has a monopoly on cupidity, deceit or incompetence. Thus, I agree that many borrowers who probably knew better (or should have known better) should be held to the bargains they struck. But that's exactly what we're doing. Jarhead's comment that we should sue borrowers ignores the fact that we are: It's called "foreclosure," and the rates of suit are apparently at historic highs.
Home Equity Lenders--LTV Issues
The problem with banks that pull a home equity line when the loan-to-value ratio (LTV) declines is that it may be compounding one mistake with another (thus the title of the post). If AMC had read the underlying article he or she would see that there is no good reason to believe that the new, reduced valuation is any better than the old, inflated one—and there is some reason to believe that it is excessively low.
Thus, the bigger problem is this: In a world of falling real estate prices, what rational lender would ever choose to throw a paying borrower into default? That, of course, is the likely effect of declaring a loan in default solely on LTV grounds. I have to imagine that the mortgages discussed in the New York Times piece—like every competently drafted mortgage—provide that falling below a certain LTV ratio is a default. I am equally sure that in many (perhaps most) cases, the values really have fallen, and the borrowers are in technical default. (incidentally, Orville, Robert Schiller was telling us for a long time that real estate was way over-valued).
But as anyone who has ever had any involvement with the real world of debt in the United States knows, there is a big difference between a "payment" default and a "technical" default. A payment default is what it sounds like: The borrower was supposed to pay at a certain time, and didn’t. A technical default, by contrast, is a violation of any of the many covenants or obligations or promises a borrower might make in the loan agreement--including the promise that the property will remain above a certain value relative to the amount of the loan (LTV). In a well-crafted loan agreement, breach of any obligation--including the LTV ratio--will be (technical) grounds to declare the loan in default.
In my experience as a lawyer, it was almost always possible for a lender to find some technical violation, big or small, to declare a loan in default--if the lender wanted to do so. But the prudent lenders with whom I worked (and even the not-so-prudent ones) all recognized that declaring technical defaults was a risky business, for both economic and legal reasons. Why default a paying customer? Why risk a claim of bad faith or (*gasp*) lender liability?
Here, if the Times story is to be believed, we have lenders doing just this--creating technical defaults at a time when it is simply irrational to do so. It is irrational for them to upset the payment stream they bargained for, if the borrower is current. It is irrational for them to force yet another house onto the auction block. It is simply compounding one mistake with another.
Now, if there are payment defaults, that's a different story. But if there’s a payment default, there’s no need to adjust the LTV. Everybody understands that a lender does—and should—act with haste to protect itself in the presence of a payment default.
Nor, I should add, is it always inappropriate to declare a loan in default when the LTV covenant is tripped. It's there for a good reason--it's an early warning system to the lender. Thus, lenders in many cases may be well advised to call a loan early for LTV or similar technical defaults, if they think it will head off greater trouble in the future.
But usually, the sensible result of calling the loan (especially for a technical default) is negotiation with the borrower over new terms. Here, however, we have good reason to believe that's not occuring at nearly the rate that it should. Mortgage servicers are already stuck in a "traffic jam" of existing defaults which they can't renegotiate. Why on earth should they create new ones?
The Rating Agencies
As for Moody's mistakes: The problem with Moody's (and S&P and Fitch)--the three big rating agencies-- is that they are subject neither to meaningful market competition nor risk of liability. They had little incentive to get it "right"--and it's not clear that that's going to change.
I doubt that liability--as in suing the rating agencies--is likely to produce better ratings in the future. But introducing more competition--something even conservatives should support--could make a big difference. As I understand it--and the evidence is limited--it sounds like the rating agencies suffer from two market failures.
First, and less important, they are effectively an oligopoly. Federal securities laws makes it very difficult for new players to enter the market (although some are trying), yet requires that many bonds have a rating from the big three.
But there is almost certainly competition among the three, so the second and bigger question is: Competition on what? Here, it appears to have been competition to provide ratings--not to provide accurate ones.
That crucial distinction appears to have been driven by the way ratings were purchased. Ordinarily, in any significant transaction, the buyer and seller will do their own analysis of the value of the thing being purchased. A rating is not a valuation, of course, but it sounds like it was important to the buyers, who claim to have been misled into purchasing highly rated, mortgage-backed securities that were "toxic", or at least riskier than their ratings would indicate.
Here, the problem appears to be that the issuers--the sellers of the bonds--were paying for the ratings, even though it was the buyers who relied on them. This appears to have distorted incentives, since the rating agencies all wanted to be paid to give the rating, and so would tend to give high ratings because that was what their customers--the sellers--wanted. In U.S. corporate law, it would be a little like the acquiror of a corporation relying solely on a fairness opinion prepared by the target. It would never happen, because the buyer and seller--and their information professionals (whether rating agencies or appraisers)-- have competing incentives.
The rating agencies now have a pretty bad track record. We know they made serious mistakes in their Enron and Worldcom ratings. They even acknowledge their current mistakes--although they are quick to point the finger at the issuers who packaged the transactions in the first place. They may be right to do so. But that does not excuse their own mistakes.
I should add that, in the same way that I have little sympathy for borrowers who knew or should have known better, I have even less sympathy for hedge fund managers who bought bonds in blithe reliance on (mistaken) ratings. Many of these guys (and perhaps women) apparently pulled down enormous salaries, even as they were using other people’s money (the hedge fund investors’) to purchase bonds that they may not have properly scrutinized because they relied on--you guessed it--mistaken ratings. Being somewhat cynical, I wouldn't be surprised to learn that in some cases these hedge fund managers knew, or should have known, that the bonds they were purchasing were not properly rated. All will come out in the fullness of litigation.
Andrew Cuomo has tried to fix some of this. But until there is meaningful competition and a realignment of price with risk, I have my doubts about the success of these efforts.
In short, I think there is plenty of blame to go around. I generally support contract and markets as institutions. Contract has been the linchpin of the deregulatory experiment commenced in the 1970s. In some cases it has worked; in some cases, it hasn't. Increasingly, it appears that in the case of the mortgage crisis, contract has not done its job, and by itself is unlikely to solve it.