Posted by Eric Posner: Paying Loan Servicers to Modify Loans. http://volokh.com/archives/archive_2009_02_01-2009_02_07.shtml#1233788467
That is the proposal of Christopher Mayer, Edward Morrison, and Tomasz Piskorski, contained in this [1]paper, which has received attention from Congress. The proposal addresses one of the major difficulties posed by the current financial/economic crisis: millions of homeowners with negative equity have a strong incentive to walk away from their homes, leading to foreclosure, which predictably reduces the value of the homes by as much as fifty percent. In the old days, the bank and the homeowner would renegotiate the loans because the bank does better if the homeowner pays off a smaller debt based on something above the foreclosure value, and the homeowner does better if he or she pays less than the payments under the original loan agreement (through lower interest payments, or deferral of payments, or whatever). Today, loan servicers act as agents for thousands of mortgage-backed security holders, who have conflicting interests to the extent that their claims have different levels of seniority. Some readers of my earlier [2]post disputed these assumptions, but the Mayer et al. paper cites the latest academic literature that confirms them. According to Mayer et al., loan servicers have weak incentives to renegotiate the loans. A loan modification costs between $750 and $1000. Foreclosure costs the loan servicer nothing; it is reimbursed for foreclosure-related expenses under the contract. However, the servicer does continue to receive its fee (typically, 0.25 percent of the balance per year) if it can maintain or renegotiate the loan. A numerical example shows that under (presumably) reasonable assumptions, servicers will often foreclose rather than renegotiate even though renegotiation is in the bondholders� interests. Because they are numerous and dispersed, bondholders cannot, as a practical matter, renegotiate with the loan servicer and pay it to renegotiate when it would otherwise prefer not to. The proposal has two parts. Like other proposals, including bills in Congress, Mayer et al. would give loan servicers a good-faith defense against suits brought by bondholders. The more distinctive part of the proposal is the use of TARP money to compensate loan servicers for the cost of renegotiation. The government would pay loan servicers an amount equal to ten percent of mortgage payments up to $60 per month, plus an additional amount if the borrower prepays. Only certain types of loans would qualify: privately securitized non-jumbo mortgages. The fees on jumbo mortgages are high enough to compensate servicers for the costs and risks of loan modification. The proposal can be contrasted with the FDIC proposal, under which the government pays servicers $1,000 for a loan modification that survives for at least six months, and shares fifty percent of the loss if default occurs. The main difference between the two proposals is that the FDIC proposes a flat fee with some protection on the downside, while Mayer et al. give the servicer a share of the upside. That helps align the servicer�s incentives with the bondholders� interests. If the bondholders gain, the servicer gains. By contrast, under the FDIC plan, the servicer could in principle gain by agreeing to loan modifications that ultimately fail. Mayer et al. also argue that their proposal is superior to bankruptcy strip-down proposals, which would lead to endless litigation rather than a quick end to the housing/financial/economic crisis. A few concerns about the Mayer et al. proposal (and readers are invited to give their reactions as well): 1. If it has ex ante effects (that is, creditors expect that in any future financial crisis, the government will do the same), then it will help reinflate a credit and housing bubble. Loan servicers, creditors, and homeowners can divide ex ante the future government bounty. By contrast, loan moratoria, Chapter 13 reform, and the like, should reduce the incentive to extend credit (for better or worse). Think of the way agricultural subsidies are capitalized into the cost of farmland: there is a one-time transfer of wealth, and then a permanent surplus of crops which are pure waste. 2. Mayer et al. criticize the bankruptcy reform proposals for being crude, but their approach is crude as well. Why ten percent capped at $60 per month? Why not lower or higher? The proposal rests on pretty aggressive empirical assumptions about such things as the risk aversion of loan servicers and the likelihood that beneficiaries of renegotiated loans will default. And then there is the question of whether the estimated $10 billion in TARP funds have a better use. 3. Servicers will have an incentive to renegotiate loans even in cases where the homeowner should lose the house. In some places, the foreclosure value of the house will not necessarily be much lower than the market value�for example, in healthy neighborhoods where a homeowner defaults not because housing prices have plummeted but because the homeowner suffers a permanent loss in income. Here, the house should be foreclosed and resold. Instead, the servicer will renegotiate the loan down to a level the homeowner can afford, thanks to the subsidy from the taxpayer. The proposal makes a fetish of foreclosure: we don�t want to avoid all foreclosures; we want to reduce the incidence of inefficient foreclosure that results in the loss of home value. 4. Servicers will have an incentive to renegotiate loans even in cases where the homeowner would be able to avoid default without a loan renegotiation. Consider people with low or even negative equity who nonetheless want to stay where they are and possess the wherewithal to make loan payments. The loan servicer would be willing offer the homeowner better terms in return for a loan renegotiation that would enable the loan servicer to claim TARP funds. Perhaps, this behavior would be considered bad faith, creating a risk of litigation by MBS holders. But the loan servicer might be able to avoid the litigation by adjusting the loan only minimally�it would still be entitled to the TARP funds and the MBS holders might think that the cost of litigation exceeds the gain from any remedy. References 1. http://www4.gsb.columbia.edu/null?&exclusive=filemgr.download&file_id=53861 2. http://volokh.com/posts/1232638414.shtml
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