How the Fannie and Freddie Could, But Won’t, Cut the Housing Gordian Knot

The ongoing, still unresolved issue of the mortgage mess is that irresponsible, unaccountable, self-serving “agents” called servicers manage foreclosures and mortgage modifications. Pretty much anyone who has looked at the problem argues that mortgage modifications to viable borrowers would lead to lower losses to investors and less damage to the housing markets than the Mellonite “Liquidate real estate” program in place now.

The reason we seem unable to get off this destructive path is servicers are paid to foreclose, and not to modify, hence they have set themselves up pretty much only to foreclose. And even with bribes like HAMP 2.0 (and increasingly, threats, like pending legislation in California and other states that puts more teeth in the requirement that a servicer negotiate with a stressed borrower), servicers really can’t be bothered. Part of it is their existing software platforms are held together with bubble gum and rubber bands; the other part is that they’d have to create new infrastructure, with very different staffing and management approaches than in their existing businesses. I’ve had “special servicers,” the boutiques that are set up to do high-touch servicing, tell me that it takes five times the staff levels of regular servicers to handle mods, and they think their business has scale limits (as in once a special servicer gets too large, it has to start increasing the standardization of its operations, which undermines doing mods well).

So it appears servicers need more pressure applied to them to make them offer mods to borrowers. Adam Levitin has come up with a new idea that could be implemented readily, at least for Fannie and Freddie borrowers:

Under current bankruptcy law, a Chapter 13 plan may be confirmed only if secured creditors receive their collateral, receive the value of their collateral, or consent to the plan. The legislative proposals for cramdown all sought to enable involuntary modification of mortgages; cramdown was to be the stick that would encourage voluntary modifications.

But we could have voluntary cramdown under existing law and this could be done on a large scale staring immediately. Specifically, FHFA could require the GSEs to adopt a policy of consenting to Chapter 13 plans that have cramdown. (FHA/VA/Ginnie Mae could adopt a parallel policy for government insured loans.) Such a policy would address the two major objections that have been raised to principal reduction by the GSEs: the much dreaded (and overstated, imho) moral hazard problem and the second lien free-rider problem.

There is actually a bit of an operational issue, which may not be trivial. Levitin noted in an earlier post that:

The GSEs claim that when a loan defaults, the property is automatically transferred to the servicer, so that the servicer can foreclose in its own name (and Fannie and Freddie’s names never appear, which would be bad for P.R.). It’s not clear how this automatic transfer actually works–I don’t know of any legal mechanism that blesses it, but maybe it can be brought into the scope of UCC Article 9 (other than in South Carolina).

I’m going to address this matter in a separate post, but this does raise the question of who is actually the foreclosing party and how the GSEs compel them to play ball (since the whole problem to date has been reluctance to discipline servicers). But we’ll assume this issue can be finessed. He also pointed out that unsecured creditors might throw a spanner in the works.

But the real point of cramdown, or a cramdown variant threat, is to force servicers and second lien holders, who foot drag and obstruct, respectively, to cooperate. If Levitin’s scheme is perceived to have good odds of working, and better yet, survives any initial challenges, it would make a huge difference. It would provide a means for getting principal mods, which a newly released study shows have lower redefault rates than other types of mods.

But Levitin points his finger at the real problem, Ed DeMarco at the FHFA and Shaun Donovan at HUD, without acknowledging that the Administration IS the problem. Now, admittedly, DeMarco is now difficult to dislodge. If he were removed, he’d be replaced initially by another acting director, chosen from his deputies, who are all of similar views to him, and he has staunchly refused to consider principal mods. A permanent director would be subject to Seante approval, and the Republicans, who quite like DeMarco, would fight anyone more borrower-friendly being put in his place. They already did so with Obama nominee Joseph Smith, whose nomination was approved by the Senate Banking Committee but blocked from reaching a Senate vote, and the bone of contention was that Smith was perceived by Republicans as being willing to do principal mods.

But it also happens that the Administration is well served having DeMarco in place as a house stooge. That way, the failure of Obama policies can be pinned on FHFA intransigence rather than a series of half-hearted remedies: HAMP, HARP, HAMP 2.0, and of course, the bank gimmie branded as a mortgage “settlement”. So Levitin’s clever approach is a reminder that there are lots of potential remedies to the housing mess. The problem is that any that solution that will do lasting good would reveal the near or actual insolvency of the four biggest US banks by forcing them to write down their second liens. Since that’s what both parties are determined to avoid, zombification, continued abuse of borrowers, and posturing will continue to be the order of the day.