Duncan Black: The Securitization of Mortgages and Ronald Coase's Revenge

Atrios writes:

Eschaton: Who Do You Negotiate With? The other part of the housing/mortgage meltdown is coming out - when your loans are bundled up and resold there's no one to negotiate with.

In 2003, Dianne Brimmage refinanced the mortgage on her home in Alton, Ill., to consolidate her car and medical bills. Now, struggling with a much higher interest rate and in foreclosure, she wants to modify the terms of the loan.

Lenders have often agreed to such steps in the past because it was in everyone’s interest to avoid foreclosure costs and possibly greater losses. But that was back when local banks held the loans and the bankers knew the homeowners, as well as the value of the properties.

Ms. Brimmage got her loan through a mortgage broker, just the first link in a financial merry-go-round. The mortgage itself was pooled with others and sold to investors — insurance companies, mutual funds and pension funds. A different company processes her loan payments. Yet another company represents the investors as the trustee.

She has gotten nowhere with any of the parties, despite her lawyer’s belief that fraud was involved in the mortgage. Like many other Americans, Ms. Brimmage is a homeowner stuck in foreclosure limbo, at risk of losing the home she has lived in since 1998.

...

“Securitization led to this explosion of bad loans, and now it is harder to unwind and modify them even where it is in the best interests of both the borrower and the investors,” Kurt Eggert, an associate professor at the Chapman University School of Law in Orange, Calif., said in an interview. “The thing that caused the problem is making it harder to solve the problem.”

Comments

[anne]

http://economistsview.typepad.com/economistsview/2007/08/foreclosures-a-.html

August 6, 2007

Foreclosures: A Call to Action
Edited by Mark Thoma

Paul Krugman has a recommendation for policymakers:

Money Talks: In today's Times, Gretchen Morgenson has a frightening piece about the troubles facing many homeowners, headlined "Mortgage Maze May Increase Foreclosures." ...[T]his isn't just a sad story. It's a call to action.

If a homeowner is fundamentally unable to pay his or debt, there's not much that can be done to avoid foreclosure. What's happening now, however, is that many borrowers who would in the past have been able to work out a mutually beneficial deal with their bank, restructuring the terms of their loan so as to avoid foreclosure, are now stuck. Their mortgage has been "securitized" — sold off to third parties, then pooled with many other mortgages and repackaged into various component parts. And because of the complexity of the securitization, there's nobody for the homeowner to deal with.

Regulators, and the Federal Reserve in particular, need to step in and serve as coordinators, ensuring that deals do get made when possible.

This wouldn't be at all unprecedented. The Fed and the Treasury stepped in to coordinate lenders to Latin American countries in the 1980s, acting to prevent a rush for the exits that would have led to widespread defaults. An emergency loan to Brazil in 2002 gave that country a chance to work its way out of a potential financial crisis. If we can rescue third-world economies, why can't we rescue American homeowners?

I hope that people at the Fed are working on this. If not, Congress should hold hearings and prod them into action.

[anne]

http://www.nytimes.com/2007/08/06/business/06home.html

August 6, 2007

Mortgage Maze May Increase Foreclosures
By GRETCHEN MORGENSON

In 2003, Dianne Brimmage refinanced the mortgage on her home in Alton, Ill., to consolidate her car and medical bills. Now, struggling with a much higher interest rate and in foreclosure, she wants to modify the terms of the loan.

Lenders have often agreed to such steps in the past because it was in everyone's interest to avoid foreclosure costs and possibly greater losses. But that was back when local banks held the loans and the bankers knew the homeowners, as well as the value of the properties.

Ms. Brimmage got her loan through a mortgage broker, just the first link in a financial merry-go-round. The mortgage itself was pooled with others and sold to investors — insurance companies, mutual funds and pension funds. A different company processes her loan payments. Yet another company represents the investors as the trustee.

She has gotten nowhere with any of the parties, despite her lawyer's belief that fraud was involved in the mortgage. Like many other Americans, Ms. Brimmage is a homeowner stuck in foreclosure limbo, at risk of losing the home she has lived in since 1998.

As the housing market weakens and interest rates on adjustable mortgages rise, more and more borrowers are falling behind. Almost 14 percent of subprime borrowers were delinquent in the first quarter of 2007. Investors, fearful that these problems will hurt the overall economy, have retreated from the stock and bond markets, creating major sell-offs.

And the very innovation that made mortgages so easily available — an assembly line process known on Wall Street as securitization — is creating an obstacle for troubled borrowers. As they try to restructure their loans, they are often thwarted, lawyers say, by strict protections put in place for investors who bought the mortgage pools.

This impasse could exacerbate the housing slump, pushing more homeowners into foreclosure. That would lead to a bigger glut of properties for sale, depressing home prices further.

"Securitization led to this explosion of bad loans, and now it is harder to unwind and modify them even where it is in the best interests of both the borrower and the investors," Kurt Eggert, an associate professor at the Chapman University School of Law in Orange, Calif., said in an interview. "The thing that caused the problem is making it harder to solve the problem."

Creating difficulties is the complex design of mortgage securities.

Some homeowners have problems simply identifying who holds their mortgages. Others find the companies that handle their loan payments, known as servicers, are unresponsive, partly because modifying loans cuts into profits.

Even if circumstances suggest fraud when a loan was made, lawyers say, the various parties protect each other by refusing to produce documents.

Compounding the problem is a law stating that when a loan is passed to another party, that entity cannot be held liable for problems.

"I don't think there is anything in the entire securitization process that is at all focused on the borrower's interest," said Kirsten Keefe, executive director of Americans for Fairness in Lending. "Everything they do is, 'How are we going to make a profit, and how are we going to secure ourselves against risk?' "

The idea of pooling loans and selling them to investors dates back to 1970, but the practice has exploded in recent years. At the end of last year, $6.5 trillion of securitized mortgage debt was outstanding....

[anne]

The problem that Paul Krugman is worried about and that Gretchen Morgenson has worried about for months while being periodically ridiculed is the distancing of owners of mortgage debt from homeowners. Even investors who have understood the difficulties that homeowners would experience when home price increases slowed or reversed, and who properly invested in anticipation, still do not appear to fully or even comfortably understand where the ownership of mortgage loans is situated.

[anne]

Though I do not expect a lowering of short term interest rates just now, even if the Federal Reserve were to soon lower rates for an extended period, as from 1991 on, I would expect the help in terms of economic growth to be limited because the problem with mortgage debt is not a banking problem. Banks do not seem to be much exposed to problematic mortgage debt, but then what institution are so exposed? Pension funds? I wonder, but do not know.

[Hal]

"Banks do not seem to be much exposed to problematic mortgage debt, but then what institution are so exposed? Pension funds? I wonder, but do not know."

I think the PBofChina is vastly exposed, among others. A lot of the "toxic waste" was purchased by China, so some say. And of course numerous hedge funds, fast closing their doors, as a result.

[anne]

"I think the PBofChina is vastly exposed...."

Not so. But, much more is just not clear.

Pension funds, almost surely; selected hedge funds, surely; mutual funds, likely; the Bank of Japan, I wonder.

[Barry]

And again, it's really, really valuable to have the power to stop a process. Being a chokepoint is valuable.

[Matt]

Loans aggregated and moved to the right on the X spectrum acquire a phase shift between asset and liability, classical bubble creation.

Hedge fund managers, like aristocrats of old, want their asset value assurred by the market, even though the liabilities have been shifted forward in time.

It goes back to the problems with our handling of the yield curve. We deal with a yield curve that is a folded over vesion of the double sided yield curve. What we are asking the Fed to do is to unfold that portion and realign asset and liability.

We need a mathematically correct version of economic yield.

[save_the_rustbelt]

Out here in the rustbelt we are about four years ahead on the foreclosure boom.

My son spent one summer mothballing empty foreclosed homes, because the bank had no prospect of selling them, even at giveaway pricing (of course our unemployment and bankruptcy rates played a role in that problem).

Gee, how come all those really smart people did not see this coming? I'm a half-witted bookeeper and saw this storm building.

Perhaps Cambridge MA and Bereley CA are not the best places to observe reality.

[howard]

save_the_rustbelt, i'm not sure "smart" people didn't see this coming. after all, you knew (and i knew) (and lots of other people knew) that people were being granted mortgages who shouldn't have been.

so the investment banks that securitized the loans knew it too.

they just wanted to book the sale, not carry out due diligence.

[rich]

The problem may be that mortgages written so as to maximize liquidity of rmbs by making change of terms impossible are now an impediment to post-distress rmbs liquidity--everybody has to go through default and foreclosure.

Perhaps federal legislation along two lines would help: (1) legal immunity for the trustee of a rmbs trust who agrees to workouts within certain good faith parameters, and (2) a temporary subsidy to trustees for successful workouts (e.g. a percentage of the difference between the impact on the rmbs of a default vs. writedown from workout). This would be in lieu of making the trustee look for funding for this operation from far-flung investors.

If there are a significant number of homeowners who could stay homeowners with adjustments that are realistic given the cost of capital, I think swift action to create incentives for the renegotiation process is worth the time and money.

[Gabriel Nichols]

From http://www.bloomberg.com/apps/news?pid=20601087&sid=awRQv0XawGk0&refer=home

"Bear Stearns shares rose $1.19 or 1% to $115.00 at 10:32 a.m. in New York Stock Exchange composite trading. Yesterday they fell to their lowest level since 2005 before rallying on speculation the government may limit losses in mortgage lending. "

Here we have the real problem. For the last four decades it has been the policy of the US government, in the interest of economic stability, to protect the financial industry from the consequences of their own poor decisions. If it wasn't S&Ls it was LTCM or IMF loans that make sure foreign creditors are paid while domestic services are cut. No wonder banks are still advertising 3 year interest-only ARMs to subprime borrowers as a way to "increase your cash flow" As long as the large banks are protected from their own idiocy they will have no incentive to clean up their act and actually pay attention to who they lend to. Add in the securitization and it seems the only people in danger of taking a real loss are the poor schlubs who believed the mortgage broker when told that this was a good idea. Funny how that works.

[Matthew Saroff]

We have had 25 years of bailouts for investors, starting with the S&L bailout, and this sort of reckless investment instrument has grown since then.

Alan Greenspan has been in all the bailouts. He thinks that investors are near to God, and wage earners deserve nothing, as befits an acolyte of Ayn Rand.

That being said, I'd like to see Mr. Delong's analysis, I read Atrios anyway, and I'd like to see a post on your take on the Greenspan legacy.

[Paul J. Reber]

My first thought when I saw this was that there's an opportunity for a financial entrepeneur to sweep in and buy up these about-to-foreclose loans at dramatically reduced rates in order to renegotiate a better settlement.

What's such a mortgage valued at? If the property cannot be easily sold, not much, I'd think. The illiquid basis of the house could still serve as useful collateral (revalued properly). There's a labor cost to finding the properties, revaluing and renegotiating the mortgages. But it seems as if there is some money loose in here for an innovator -- if she can get the credit necessary to do this.

It'd be nice if the gap here was filled. It would simplify the unwinding for the big investors (although they'd still lose lots of money due to prior bad decisions). It'd save some houses for some homeowners and create properly secure mortgages for both them and the banks.

If this isn't happening already, I'd guess at 2 hurdles. First, it might be hard to get credit to tackle this problem after the big losses in subprime even if you had a reasonable business plan. Second, the financiers with the reputation and ability to pull this off may already be making a lot more money working the big market shifts following the crash.

[JonF]

Re: The other part of the housing/mortgage meltdown is coming out - when your loans are bundled up and resold there's no one to negotiate with.

This is not true (I work in the industry). In most cases the loan servicer (the company that collects the payments) has the authority to negotiate. And indeed, I have seen this situation occur in a number of cases. The deciding factor is if the servicer feels that the borrower has a chance of getting caught up. In some cases the borrower may be in such bad straits or so far behind that the servicer will simply refuse any renegotiation of terms as likely to be hopeless.

[Janon]

What JonF said. The NY Times article is devoid of information -- it offers no evidence to support the claim that the borrowers' problem is the inaccessibility of the servicer. Contractual restrictions on loan modifications (which only apply to a minority of loans) have had no impact on the problem. The issue is whether the borrower really can get caught up. For some actual information on how mortgage servicing works, see
http://calculatedrisk.blogspot.com/2007/02/tanta-mortgage-servicing-for-ubernerds.html.
Then see recent posts on the same site for a reality-based view of the problems in subprime.

[Janon]

Tiny URL version of link: http://tinyurl.com/38yb89

[christofay]

This is a Greenspan and government friendly web-site. What we are seeing is the downside of Greenspan's accommodative to Republicans' election prospects in 2002 (we deserve this, we won the mid-terms, let's spend without fears) and Bush's re-election chances in 2004 policy. Keeping the Fed rate low to stimulate consumption was the policy (buy a Ford mega-truck) that was supported on this blog. Greenspan himself did a thorough cheerleading event in early 2004 to show innovative spirit with the mortgages. Along with much of the Fed govt, the Fed Reserve was politicalized, that was the point of the anonymous quotes about Greenspan short changing Bush's Pa in 1991-1992 by not being accommodative.

Now this topic is a sotto voce attempt to play the Greenspan put, Fed interference in the markets. It's a chance to show that government can work by bailing out the Titanic though the Fed is the iceberg in the water of the deflating bubble.

I'd rather see a bail-in first. Let the Big 4 + Bear Sterns return the fruits of the seven fat years, didn't they just all get record breaking bonuses in 2006? Now 2007 we're waiting to see how much of the finance system can collapse. Greenspan can make a vow of collecting no govt bennies, turn over whatever $150,000 a speech fortune he has, and teach business at the Univ of Southeastern Iowa for the rest of his life.

Sorry to get all Ho Chi Minh, but grown-up observers of the finance system were writing about this from the get-go, Grant's Interest Rate Observer please for starters.

[christofay]

The biomass, the tax paying middle class of the American public, can take the hit either of two ways or both.

There can be a Fed rate reduction now which will jack up inflation. Early in the Bush years $0.82 bought a euro, now it's $1.37 or so.

Or we can bail out the finance system which is letting the people who didn't play pay for the mistakes of those who did.

We'll get hit with both in time probably.

I don't believe the Fed's success over the last two decades was the Great Greenspan Moderation. The Fed did well moderating the rate of change in a subset of statistics that it targeted. The cost of living for the biomass increased the entire time.

We need a banker like Volckner not Greenspan-lite Bernanke who along with the Viceroy of Goldbrick Sacks at Finance have been yapping the last year, "we got the situation under control."