Posted by Eric Posner:
Paying Loan Servicers to Modify Loans: Mayer, Morrison, and Piskorski reply
http://volokh.com/archives/archive_2009_02_08-2009_02_14.shtml#1234190931
to my [1]comments (in italics) on their [2]proposal:
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).
First, we think you are criticizing TARP, not necessarily our
proposal. TARP could generate ex ante effects of this sort, if you
believe (which we do not) that the government is likely to spend
this kind of money again. Also, we don't need to rely on TARP. Our
original draft relied on an industry tax, but this would likely
cause further damage to the industry when it is already receiving
government help. We settled on TARP funds because we want a plan
that can be implemented quickly and want to limit the waste of
these funds on other proposals such as Hope for Homeowners and the
FDIC plan proposed by Sheila Bair.
Second, loan moratoria would only prolong the current crisis; the
last thing we want to do right now is restrict the supply of
credit.
Third, if you want to restrict lending, we don�t need Chapter 13
reform. Given recent experience, future lenders will be naturally
more cautious in offering credit, with or without changes to
bankruptcy law.
Fourth, our proposal corrects a well-defined market failure
(badly-written servicing contracts) and, by its very nature, is a
temporary intervention. Changes to the bankruptcy code would have
permanent, unintended consequences.
Put differently, while the ex ante effects of our proposal are
highly speculative, the welfare losses from bankruptcy cramdown are
real and documented. 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 $9 billion in TARP funds have a better use.
We computed our Incentive Fee to mimic the fee earned by existing
servicers who are successfully modifying mortgages. Also, please
take a look at our cost-benefit analysis in Appendices 2 and 4 of
our proposal. The empirical assumptions may seem aggressive to you,
but they are fairly conservative and (importantly) were checked by
many market participants.
Our litigation safe harbor should address your risk-aversion
concerns.
Finally, your last point (about better uses of TARP) is a critique
of TARP, not our proposal. If the $9 billion is going to be spent,
how would you spend it? 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.
Your hypothetical doesn�t track our proposal. Under it, a servicer
is incentivized to modify a loan only if modification generates a
greater recovery to investors than foreclosure. Your hypothetical
is just the opposite: it is a case where modification generates a
lower recovery to investors than foreclosure. Your servicer is
acting contrary to investor interest and opening itself to
lawsuits. This servicer would not be protected by our litigation
safe harbor.
Perhaps you are thinking that there will be no lawsuit, because
investors and servicers will split the booty. If that kind of
coordination were possible, we wouldn't have inefficient
foreclosures in the first place. Put differently, your critique is
valid only in a world without coordination failures and transaction
costs. 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.
This critique misunderstands our proposal. Our Incentive Fee does
not depend on whether a loan is modified or not. A servicer
receives an Incentive Fee for _every_ loan being serviced. The Fee
continues to be paid until either (1) our program expires or (2)
the loan goes to foreclosure. So a servicer will never be tempted
to modify a loan when there is no risk of default. That would be a
self-inflicted wound: the servicer would be reducing monthly
payments by the borrower and, as a result, lowering its own
Incentive Fee. Moreover, modification isn�t free. No servicer will
invest up to $1,000 to modify a loan that needs no modification.
Our proposal should be contrasted with the FDIC plan, put forth by
Sheila Bair. That plan offers $1,000 to servicers for every loan
that is modified in a specified way. The FDIC plan, not ours, makes
a �fetish of foreclosure,� because it encourages too many
modifications.
Note also that our plan avoids micromanaging the modification
process. We leave the choice�foreclose, modify a little, modify a
lot, or don�t modify at all�in the hands of the servicer, who is
incentivized to keep loans ongoing and modify only when
modification is better than foreclosure for investors.
In a world where something is going to be done by Congress, we are
trying to find an alternative that does the most good at the lowest
cost. Doing nothing is not an option, at least from the perspective
of Congress, and from our perspective too.
References
1. http://volokh.com/posts/1233788467.shtml
2.
http://www4.gsb.columbia.edu/null?&exclusive=filemgr.download&file_id=53861
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