Friday, July 11, 2008

Flaws in the FHA Housing Bill

(Naked Capitalism) There is a very good op-ed at the Wall Street Journal today by Adam Levitin, who we have often quoted at the blog Credit Slips. It offers a clear explanation of why the Dodd-Frank housing bill won't accomplish much in the way of borrower relief. Many of our readers will regard that as a good thing.

However, one has to wonder whether the defects of this bill, which got a good deal of media attention, are a bug or a feature. Normally, I would see a cosmetic law to be a bit of political pandering. Yet Frank is no fool (I withhold judgement on Dodd) and borrower advocates have been quick to criticize the limited results produced by the Bush Administration's Hope Now Alliance. It would be naive to think that the same won't happen to this program.

I for one am disappointed at the failure to come up with a solution to the servicer-as-impediment issue. One argument is that borrowers are so underwater they can't be modded into something viable. Indeed, mods to date have a high reported failure rate.

But my contacts who do borrower counseling tell a different story. The mods being granted are too skimpy and do not even remotely reflect how much the servicer could reduce the balance and still come out markedly ahead for the investors versus a foreclosure scenario. And that isn't even allowing for damage to the house by angry former owner or due to neglect via a protracted selling process. Historically, it was almost without exception better to keep a borrower in place if they had any abilit to make payments.

So my beef is that it has been assumed that "we can't interfere with the sanctity of contracts" and find a way to cut the Gordian knot of lack of servicer incentives, staffing, and skill to do mods. Remember, banks are reported to be holding off on foreclosures precisely because they'd rather have a house occupied and maintained, even if the owner can't pay. That plus increasing unsold inventory says the loss severities on unsold REO (and undeclared REO) is almost certain to be higher than what we have seen recently. And very high loss severities (50%+) means there ought to be some economic win-wins for borrowers and investors compared to foreclosure. But no one seems to have drilled further into the data to see under what circumstances breaking contracts by legislative fiat can be justified as a way to protect and assist investors (admittedly hard to do given the local nature of real estate; one might study a selection of locations to generate decision rules from different conditions).

Remember, the root of the objection to fooling with existing contracts is in fact not any sentimentality about them per se but the concern that if mods were done that hurt investors, it would irrevocably damage the mortgage securitzation market. But what if agreements were breached to create outcomes beneficial to investors?

The problem, of course, is class warfare. Even if you figure out that the investors do better by lowering the principal balance rather than taking the losses and expenses of foreclosure, how do you come up with a formula for reallocating the changed cashflows among the various tranches?

Nevertheless, this line of thinking has not been given the study it deserves, particularly as the housing market seems likely to deteriorate even further. If residential real estate values fall by as much as 40% to 50% nationwide, which the most serious pessimists forecast, trust me, we will see force majeure solutions. It would behoove policy wonks to get out in front of this problem.

From the Wall Street Journal:
One year and one million foreclosures into the mortgage crisis, Congress will finally produce a major piece of legislation aimed at alleviating the problem. The Dodd-Frank FHA Bill will authorize the Federal Housing Administration to insure refinanced mortgages, en masse. FHA-guaranteed mortgage terms will supposedly be more manageable for homeowners than their current ones.

Lawmakers can say they've "done something" about the crisis. The only problem is the bill won't work. Contractual and incentive problems in securitized mortgages will defeat the legislation's attempt to provide a significant amount of relief.

First, the bill requires lenders to write down the principal on loans by as much as 15%, and waive prepayment fees before their loans are eligible for FHA-guaranteed refinancing. This would be simple enough in the 1950s mortgage market....Today the majority of residential mortgages are held by securitization trusts...

For securitized loans, there is no "lender" who can write down the principal. Instead, management of the loan is contracted out to a servicer. Frequently, servicers are contractually forbidden from modifying loans or else significantly restricted in their ability to do so. This alone will prevent many mortgages from being eligible for FHA refinancing.

Even when servicers can modify loans, they have no incentive to do so for the FHA program. Servicers incur significant costs (up to $1,600) in modifying a loan. Moreover, servicers' income is mainly based on the amount of principal outstanding in a securitization trust. When a loan leaves the pool because of a refinancing, the servicer ceases to receive revenue from it. Any equity appreciation in the property would be shared by the mortgage holder and the FHA, but not the servicer. In short, servicers have nothing to gain and everything to lose by engaging in the write-downs necessary for the FHA bill to work.

Another obstacle: Many homeowners have second mortgages, and many of these second mortgages are completely "underwater" -- or out of money. The second mortgages are frequently held by different entities than the first mortgages. In order for the refinanced mortgage to be insured by FHA, the second mortgage holder would have to be bought out.

Underwater second mortgagees (and many might be underwater even after a write-down on the first mortgage), have nothing to lose by holding out for a high payout and will block many refinancings. The FHA bill does not fix this problem.

Third, the FHA is not staffed to handle hundreds of thousands of refinancings, and neither are mortgage servicers (if they were willing to cooperate). It will take several months for the FHA program to hit full speed. In the meantime, foreclosures will continue, in the hundreds of thousands. The next Congress, in all likelihood, will have to revisit this problem -- in 2009.

The final critical flaw is that the FHA bill puts taxpayer dollars at risk.

To the extent that lenders are willing and able to do the write-down necessary for the FHA refinancing, they will only do so for loans that they think are worth less than 85 cents on the dollar. Lenders will retain loans with a higher expected recovery rate. This means there is an adverse selection problem for the FHA refinancing. Lenders will only sell the FHA their worst lemons, so the FHA will be overpaying for bum loans.

Lenders' contributions to an FHA loss reserve fund, and a special tax on Fannie Mae and Freddie Mac, are supposed to protect against FHA losses. But no one has a firm idea of how many loans will be refinanced or just what the losses will be on those loans. It's all guesswork, and there's no reason to think that Congress's real estate gamble is going to pan out any better than that of so many investors.

Let's hope Congress gets it right. If not, the taxpayers will be holding the bag, mortgage markets will continue to suffer, and many more families will lose their homes.

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