Compared to what? Part 1, the fix we’re in
“How’s your wife?”
“Compared to what?” Ba-da-bing!
– Henny Youngman one-liner
As the subprime mess continues to unfold, with rate and payment resets looming, Federal and state agencies rushing to offer refinancings or borrower relief, a gradually swelling chorus is advocating loan modifications and restructurings. As I’ve previously posted, securitization has made loan modification more complicated, and a legislative fix might be in the interests of lenders as well as borrowers.
Surprise!
It’s very timely, therefore, to encounter a recent well-written and decently-reasoned scholarly article by Joseph R. Mason, Mortgage Loan Modification: Promises and Pitfalls, that garnered generally favorable commentary by the Economist’s Buttonwood columnist, whose central theses are quite skeptical and cautionary, as revealed by its sub-headings:
The Costs and Benefits of Modification are not Clear
Costs and benefits dead ahead
Since Modification in an Unregulated Environment Caused the Present Difficulties, it does not Make Sense to Encourage More
[The capitalizations in the original section titles lend Professor Mason’s arguments the air of Puritanical tract, don’t you think?]
Why does the good professor apparently advocate the tough-love path of no-modifications — therefore condemning the borrowers to mass foreclosure – and why do I agree with much of his diagnosis yet disagree with the tenor of his prescription?
Partly it’s different experience — both how much of it we’ve had, and what kind.
Professor Mason has a decade on Drexel’s faculty, and before that a long stint at the Office of the Comptroller of the Currency. In other words, his background is academic and regulatory. His paper was published on the Web site of a consulting firm, Criterion Economics:
CRITERION ECONOMICS is a consulting firm in
While I’d be the last to fault someone for publishing his own research on his company’s Web site [That would be calling the kettle black, wouldn’t it? — Ed.], his paper should be read as informed opinion.
Meanwhile, I cut my teeth in affordable housing fixing busted deals thirty years ago – and today my for-profit company does workouts and recapitalizations of large complicated multifamily properties. While big multi and small single are quite different, I do know first hand why some people work out some loans.
“Who are you going to believe, me or your own eyes?”
Thus, while the professor starts from the premise of an academic and regulator, I start from the premise of deal mechanic, opening up the hood and taking out the broken parts.
Let’s see what’s broken here
To understand the difference in our views, and what it implies for resolving the subprime mess, it’s worth delving into the article at some length.
Danger, danger! Multi-part post ahead
Introducing his thesis
Professor Mason starts with a brisk recitation of the unprecedented delinquency and default situation now facing the country:
The current subprime delinquency ratio is about 15% ($180 billion) of outstanding subprime mortgage, a 14-year high. Even if all subprime mortgage loans currently in delinquency do not go into foreclosure [How likely that they’ll all be foreclosed? – Ed.], it is easy to imagine the ratio rising further to create a crisis on a par with the thrift crisis of the late 1980s, which is equal to about $150 billion in inflation-adjusted terms.
Except that the S&L crisis related to potential bank and deposit failure — it was a systemic risk. Borrowers are not banks, and their personal failures, while undoubtedly tragic, do not pose the same systemic risk as would a bank whose depositors lost their savings.
Bank failure: Northern Rock,
Unlike a misleading New York Times article about which I posted some time back, Professor Mason recognizes that the profit in servicing is in healthy loans. Bad loans cost servicers money:
Each delinquency and foreclosure is costly to administer. The cost of a typical foreclosure has been estimated to be about $60,000, or about 20-25% of the loan balance (legal fees alone can cost $4,000), and those costs are expected to be higher in times of home price depreciation. Hence it is logical for lenders to try to avoid foreclosure through loan modification.
Screwing up costs more
He then takes the problem to its next step: who’s going to do all these modifications?
There are three major problems with this strategy.
First, a modification effort of this magnitude is far beyond the existing modification capacity of the industry. Most servicers currently modify less than 1% of their loans, so increasing to 10 or 20% represents growth of 1,000-2,000%.
While a massive increase in workload not only creates a backlog, it risks repeating or exacerbating the original underwriting problems, this is nevertheless a very weak argument. You hire capable people — unemployed underwriters are suddenly available in droves, aren’t they? J — and teach them how to do it. I’ve done it in the multifamily arena.
Hey, we used to originate loans
Second, while modification may be less costly than foreclosure (although this is far from certain), the difference could well be negligible.
This is up to the lenders and loan servicers to judge, isn’t it? As he put it in an email exchange with me (emails in green, article in blue):
Just go in with your eyes open. If 50% of loans re-default and losses are twice as great, there is no net benefit. I am open to being convinced, but I haven’t seen the data and analysis yet.
Fair enough.
Third, the authorities calling for massive modification efforts must realize that ‘Payment deferral will not help people who inflated incomes or recklessly bought properties they could not afford.’
As I’ve previously posted, the first core question in loan modification is, Why are you in trouble? If the answer is, Because I lied about my income, and the loan should never have been made, foreclosure could well be the right way forward.
Since, by some estimates, borrowers inflated their incomes by 50% or more in 70% of loans [!!!!! – Ed.], it could be that few of the loans currently experiencing difficulties can benefit from modifications that would preserve any reasonably economic lending arrangement for borrower and lender alike.
Here’s the crux: if it’s true that two-thirds of borrowers fibbed by half, then modification will fail and all are doomed and modification will fail.
If modifications are given to borrowers that are not well suited for homeownership in the long term, the loan modification only serves to delay the inevitable while keeping the borrower in a (somewhat milder) state of financial distress.
This is the old “don’t throw good money after bad” argument, dressed up in fine clothing.
However, isn’t it a question for those borrowers and lenders? As for the lenders, isn’t protecting the buyers a job for the rating agencies, not the legislators? Even if the rating agencies fell down on the job, is more regulation (and what kind) the cure?
Still, this is anticipatory, criticizing the movie on the basis of its trailer and the article on its executive summary, for the article itself insightfully delves into the loan servicing ecosystem. To understand his perspective, we have to meet some new critters: masters, primaries, and specials.
We’re lenders and we’re here to take care of you
[Continued tomorrow in Part 2.]
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