Possibly no aspect of the financial crisis touches individual Americans as deeply as the threat of losing a home to foreclosure. Undeniably, we are witnessing an unprecedented housing crisis, with 2.25 million foreclosures started last year and at least 1.7 million foreclosure starts expected this year. A number of remedies have been touted in Washington, but most do not focus on the core of the problem — privately securitized mortgages.
These mortgages — which were originated without a guarantee from government-sponsored entities — account for more than half of foreclosure starts, despite accounting for only about 15 percent of all outstanding mortgages.
Servicers of these privately securitized mortgages make the critical decision of what to do when a mortgage becomes delinquent: choosing to pursue a foreclosure or a modification of the mortgage. Existing research suggests that these servicers opt for foreclosure much more often than private lenders that service their own mortgages. Meanwhile, Fannie Mae, Freddie Mac, the FHA and private lenders are aggressively pursuing mortgage modifications.
Two factors are driving servicers’ reluctance to modify loans, even when doing so makes economic sense: servicers are not properly compensated for modifying loans, and legal constraints deter many servicers from pursuing modification.
Securitization investors are aware of these factors, because they reduce their returns. But the number of investors is so large — and their interests so divergent — that they are unable to reach consensus in favor of rewriting securitization agreements and giving servicers greater freedom to modify loans. The typical securitization contract has as complicated a capital structure as many corporations. No one is surprised when a troubled corporation needs government assistance, through Chapter 11 reorganization, to rewrite contracts with investors; it is simply too costly and complicated to reach a consensus among investors without government assistance.
A homeowner is a prime candidate for loan modification when his or her income is sufficient to make payments that, over time, exceed the foreclosure value of a home. This standard — payments exceeding the home’s foreclosure value — is the same standard applied in proposals to change Chapter 13 Bankruptcy Code, one option being floated in Washington.
But proposals to change the Bankruptcy Code are deeply problematic. These proposals would allow homeowners to strip down mortgages to the current home value, would reduce interest rates, would raise future borrowing costs and could encourage solvent borrowers to miss payments. The financial crisis would be much worse if 51 million borrowers who are now current attempt to invalidate their mortgages.
Equally important, proposals to change the Bankruptcy Code could dramatically increase bankruptcy-filing rates. Servicers will prefer mortgage modification in bankruptcy because their expenses are reimbursed in bankruptcy, not outside it. Thus, proposed reforms could push millions of borrowers into bankruptcy, delaying resolution of the current crisis for years.
Bankruptcy reform is a blunt tool: it applies a one-size-fits-all approach to loan modification, and it would impact all mortgages, including the majority of outstanding loans now owned by Fannie Mae and Freddie Mac. The federal government already can encourage effective mortgage modifications through its conservatorship of these organizations, while taxpayers would likely be on the hook for losses to government-sponsored enterprise mortgages through the bankruptcy process.
Another alternative, the FDIC proposal, has some virtues but would have limited success and high costs. This proposal would pay servicers $1,000 for every modified loan, and would have the government share up to 50 percent of losses from unsuccessful modifications. This proposal does nothing to eliminate legal barriers, which would continue to inhibit modification. Further, the cost to taxpayers would be very large. The government, not investors, would bear the cost of failed modifications.
We propose a comprehensive solution to this crisis that would benefit servicers and investors and help homeowners. We propose a two-pronged approach: compensate servicers that modify mortgages while removing legal constraints that inhibit modification.
Servicing contracts makes little economic sense in the current crisis. No one anticipated the extent of the crisis, and servicers are poorly compensated as a result. Also, servicers have too few incentives to pursue loan modification instead of foreclosure. Most securitization agreements compensate servicers for costs incurred during the foreclosure process but not for expenses associated with loan modification. Even when modification is successful under these circumstances, it typically does not generate sufficient fees to cover the cost of modification. Consequently, servicers often choose to foreclose, even when modification makes good economic sense for borrowers and investors. We propose that, using funds from the Treasury’s Troubled Assets Relief Program (TARP), the federal government increase the fees that servicers receive for continuing a mortgage and avoiding foreclosure, thereby aligning servicers’ incentives with the interests of borrowers and investors.
Our proposal would pay servicers a monthly Incentive Fee equal to ten percent of all mortgage payments made by a borrower, with the fee for each mortgage capped at $60 per month. If a borrower prepays the mortgage, the servicer receives a one-time payment equal to twelve times the previous month’s Incentive Fee, rewarding servicers that accept short sales. Because servicers receive payment only for successful modifications that don’t re-default, our proposal rewards servicers for keeping future payments as high as possible without putting homeowners in a position that makes them vulnerable to re-default after modification.
Second, servicers face explicit and implicit legal barriers to modifying mortgages successfully. Some pooling and servicing agreements (PSAs) place explicit limits on loan modifications. In other cases, vague provisions in PSAs, and the consequent threat of lawsuits, serve to limit servicers’ ability to modify loans successfully.
Our proposal calls for the federal government to enact legislation that modifies existing securitization contracts. The legislation should eliminate explicit limits on modification and create a safe harbor from litigation that protects reasonable, good-faith modification that raises returns to investors.
Other proposals do not address both barriers that servicers face. Our proposal would cost taxpayers considerably less money than other programs under consideration, with no requirement to provide costly loan guarantees. Losses for bad loans remain with private investors rather than taxpayers. It raises no constitutional concerns, because it builds on well-established Supreme Court case law.
We estimate that our plan will prevent nearly one million foreclosures over three years, at a cost of no more than $10.7 billion — high, but a small price to pay to help shore up the housing market and, vitally, preserve homeownership.
Christopher J. Mayer is the Paul Milstein Professor of Real Estate in the Finance and Economics Division and senior vice dean at Columbia Business School.
Edward R. Morrison is Professor of Law at Columbia Law School.
Tomasz Piskorski is assistant professor of finance and economics at Columbia Business School.
This month, Professor Mayer has testified before the House Financial Services Committee and House Judiciary Committee in support of legislation under consideration by the House of Representatives to reform the TARP, which incorporates parts of this proposal.
To read more and to download the full proposal, visit the Housing Crisis resource page of the School’s Paul Milstein Center for Real Estate. The page also includes information on Professor Mayer’s related plan, developed with Dean Glenn Hubbard, to stabilize the housing market.