First hurdle cleared in allowing judges to modify home loans; Levitin’s explanation of problems with securitization revisited

March 7th, 2009 by Mike Hinshaw

New legislation aimed at the major roadblock to helping distressed homeowners passed the House March 5, when the Helping Families Save Their Homes Act of 2009 was approved via a vote of 234-191. If it gets Senate approval, bankruptcy judges will gain the power to modify terms of loans for some homeowners–an ability already in place for commercial property and nonessentials such as vacation homes, yachts and snowmobiles.

Support for the measure in the Senate is unknown, with various news sources citing low regard among Senate GOP leaders as well as a few Democrats, while others indicate the necessary votes may already be lined up. For example, an AP story on the NPR Web site says of the bill, “It faces a tough road in the Senate, where Republicans and some Democrats oppose the idea.”

But a Marketwatch account, while acknowledging that Senate support “is unclear,” also reports that “Senate Majority leader Harry Reid, D-Nevada, said he believes he has the votes to confirm passage. The measure will likely require the support of a few GOP Senators. A spokeswoman for Sen. Mel Martinez, R-Fla., said he is considering the legislation. Like many other states, Florida has an unusually large number of troubled homeowners and foreclosures.”

Detractors label bankruptcy judges’ loan-modification abilities as “cram-down powers,” and Fox news just flat out opines that although the bill “is officially dubbed the ‘Helping Families Save Their Home Act,’ [it]. . . is known as the ‘cram down’ bill because it enables judges to reduce or cram down the size of the mortgage.”

Oddly enough, no one refers to the mortgage industry’s having had “cram-down powers” of its own, despite years of pressing ill-advised, securitized loan packages down the throats of unwary, unsophisticated home buyers.

One of the better explanations of the problems with the type of securitization that fueled the economic crisis is at the Harvard Law online site, as noted in this previous post. As thoroughly researched as it is illuminating, Levitin’s paper should be a must-read for all senators, as well as mortagage-industry critics, responsible media, confused taxpayers–and, of course, anyone considering bankruptcy protection or facing foreclosure.

Levitin’s initial premise addresses the primary question that millions have pondered: Why in the world has the private lending industry failed so miserably in any effort to resolve the crisis?

He explains that the type of mortgage lending many U.S. homeowners remember does not exist anymore, not in any sense of prevalance.  For the most part, the days when a homeowner would have a relationship with the lender are long gone. Once upon a time, the norm was more like this: “When a single lender owns a loan, it will modify the loan in order to keep it performing as long as the modified loan minus transaction costs performs at a level above what would be realized in net in foreclosure.”

Hence, “If lenders lose 50% in foreclosure, why aren’t they reducing interest rates and writing down principal balances and stretching out amortizations to make the loan perform at 51% of current net present value?”

Indeed, why not?

Well, it turns out that “for most mortgages, there are no longer ‘lenders’ of which to speak. Most mortgage loans are no longer owned by a single entity; instead they are securitized, so that thousands of investors have a fractional interest in a pool of loans. The vast majority (over 80%) of residential mortgages are securitized.”

Now, securitization in and of itself is no boogey-man–nothing sinister about it. The “government sponsored entities” (GSEs) Fannie Mae and Freddie Mac used securitization for years without helping trigger a global economic meltdown. And, says Levitin, although “the GSE underwriting standards were not statutory, they were subject to federal regulatory oversight and significant political pressure that indirectly ensured that securitization did not produce reckless lending. Because the GSEs often took on the credit risk on the loans they securitized, they served as gatekeepers for the mortgage market and did not purchase ‘subprime’ or ‘exotic” loans.’ ”

Lack of regulation also plays a crucial role, one that must be emphasized. Levitin points out that not only did Fannie/Freddie insist on strict underwriting standards but also “they ruthlessly pursued recourse against originators for any loans that turned out to be non-conforming.”

OK, so what happened? What changed? It traces back to 1990…

“Starting in the 1990s, however, a private-label mortgage securitization market developed that did not adhere to Fannie/Freddie underwriting guidelines and was not subject to federal regulatory oversight or political pressure,” explains Levitin, in footnote 15. “This private-label market securitized almost entirely loans that did not conform to Fannie/Freddie standards. Because non-conforming mortgages were riskier, they offered higher yields, which attracted investors. These transactions lacked the recourse element that existed in Fannie/Freddie deals because the securitization trusts and their investors lacked the resources to examine individual loans they purchased for conformance with the pool’s requirements, much less to pursue legal recourse. As a result, the originators of the loans for private-label securitizations did not retain any credit risk on them, either as a de jure or a de facto matter. Therefore, because they received flat rate payments for all the loans they originated, they were strongly incentivized to originate as many loans as possible. As a result, underwriting standards plummeted. Moreover, mortgage broker incentives often encouraged them to steer consumers to higher cost, non-conforming products.”

Here’s the takeaway: Without proper regulation, the mortgage industry was free to allow loan originators to:

* peddle loans that were risky to both investors and homeowners
* without being exposed to credit risk, either by matter of law or industry practice.

Another twist in the convoluted plot involves the actual structure of the deal, that is, who owns what–and which party actually has any responsibility.

Levitin offers a bare bones model for example. “A financial institution owns a pool of loans that it either made itself or purchased. Rather than hold these loans (and the credit risk) on its books, it sells the pool of loans to a specially created entity, typically a trust. The trust pays for the loans by issuing bonds. Because the bonds are collateralized (backed) by the pool of loans held by the trust, they are called mortgage-backed securities (MBS).”

Notice the entry of a “trust” as a player. This has enormous consequences for the homeowner.

“The securitization trust is just a shell to hold the loans and put them beyond the reach of the financial institution’s creditors. Therefore, a third-party called a servicer must be brought in to manage the loans. The servicer is supposed to manage the loans for the benefit of the MBS holders. (There is also a trustee, but its duties are expressly limited to ministerial functions, so the servicer is largely unsupervised.) The trust’s contract with the servicer is part of the indenture that creates the MBS, so under the Trust Indenture Act of 1939, to alter the contract requires at least a majority of the MBS holders, and if the alteration affects the MBS investors’ cashflow, 100% consent is needed.”

If you’re mired in this process along with millions of others, you will probably recognize “the servicer” as the company that actually sends your statements. Likely, you have found they’re difficult if not to impossible to deal with. At any rate, the point is the servicer is probably not the owner of your note. If you’ve tried to negotiate new terms with the servicer, you very well may have been told that they just can’t do that. There’s a reason–the trust. What may have started out, back in ’39, as a way to stimulate investment has morphed into a barrier keeping homeowners from being able to deal with the actual owner(s) of the note.

Bottom line? The servicer risks being sued by the owner(s) of your note.

And it gets worse…

Levitin explains it this way: “And in many cases, foreclosure is often more profitable to servicers than loan modification. Servicers receive fixed-rate compensation for a limited duration when a loan is modified, but get unmonitored costplus compensation in foreclosure. Therefore servicers are incentivized to foreclose rather than modify loans, even if modification is in the best interest of the MBS holders and the homeowners.”

That’s why passage of the new bill is so important. Alternatives might include restructuring the Trust Indenture Act or the federal governement’s seizure of mortgages. But given critics’ current howling about “commies,” “undeserving homeowners” and “redistribution of wealth,” just imagine the firestorm that would erupt if either of those options were pursued–not to mention further delay and even more cost.

The House passed its version after much wrangling and deal making, incuding compromises effected by the so-called  “New Democratic Coalition,” described by Marketwatch as  “the 67 members of the centrist [group who]  voted to support the measure after a series of provisions they introduced were included into the overall bill.”

One concession, hammered out with Citigroup, would allow bankruptcy judges to modify only those mortgages that were effective before enactment of the bill.

Other restrictions, according to Marketwatch, include “a measure that would create some additional uniformity when it comes to what kind of modification bankruptcy judges agree to. One other provision requires judges to use Federal Housing Administration appraisal guidelines to consider the property’s ‘fair value.’ Also, judges would have to require borrowers to pay a uniform amount each month, rather than varied amounts.

Also, struggling homeowners would need to certify that they actually have talked to their loan servicer to see if a modification can be made instead of bankruptcy. The borrower would need to provide the servicer with their tax return, for example. . .”

Given that no legislation is perfect and none will please everybody, this act promises to introduce at least some relief while also bringing some order to the mess besides simply dumping millions more homes on the market. If you’d like to write your senator, here’s an easy link to get started.

[Note: Footnotes from Levitin excerpts are not included here.]