A New Proposal for Loan Modifications
by Christopher Mayer, Edward Morrison, and Tomasz Piskorski *
We are witnessing an unprecedented housing and foreclosure crisis, with 2.25 million foreclosures started last year and at least 1.7 million foreclosure starts expected this year. Privately securitized mortgages are at the core of the problem. These mortgages—which were originated without a guarantee from government-sponsored entities—account for more than one-half of foreclosure starts, despite accounting for about fifteen percent of all outstanding mortgages. Servicers of these securitized mortgages make the critical decision of what to do when a mortgage becomes delinquent; choosing to pursue a foreclosure or a modification of the mortgage. Existing research suggests that these servicers opt for foreclosure much more often than private lenders that service their own mortgages. While Fannie Mae, Freddie Mac, the FHA, and private lenders are actively and aggressively pursuing mortgage modifications, servicers of securitized loans are still lagging behind.
Two factors are driving servicers’ reluctance to modify loans when modification makes economic sense. First, servicers are not properly compensated for loan modification. Second, legal constraints prohibit many servicers from pursuing modification. Even when legal constraints are absent, significant litigation risk attends any loan modification.
Securitization investors are undoubtedly aware of these problems, which reduce their returns. But the number of investors is so large—and their interests so divergent—that they are unable to reach consensus in favoring of rewriting securitization agreements and giving servicers greater freedom to modify loans. The typical securitization has as complicated a capital structure as many corporations. No one is surprised when a troubled corporation needs government assistance (via Chapter 11 reorganizations) to rewrite contracts with investors. It is simply too costly and complicated to reach a consensus among investors without government assistance.
We propose a comprehensive solution to this crisis:
We estimate that our plan will prevent nearly one million foreclosures over three years, at a cost of no more than $10.7 billion. It also raises no constitutional concerns, because it builds on well-established Supreme Court case law.
It is important to emphasize that our proposal benefits homeowners as much as it helps servicers and investors. A homeowner is a prime candidate for loan modification when her income is sufficient to make payments that, over time, exceed the foreclosure value of her home. This standard—payments exceeding the home’s foreclosure value—is the same standard applied in proposals to change the Bankruptcy Code.
But proposals to change the Bankruptcy Code are deeply problematic. These proposals would allow homeowners to strip-down mortgages to the current home value and reduce interest rates. These proposals would raise future borrowing costs and could encourage solvent borrowers to miss payments (a form of moral hazard). The financial crisis would be much worse if fifty-two million borrowers, who are now current, attempt to invalidate their mortgages. Equally important, proposals to change the Code could dramatically increase bankruptcy-filing rates. Servicers will prefer mortgage modification in bankruptcy because their expenses are reimbursed in bankruptcy, not outside it. Thus, proposed reforms could push millions of borrowers into bankruptcy, delaying the resolution of the current crisis for years. Finally, bankruptcy reform is a blunt tool: it applies a one-size-fits-all approach to loan modification, and it would impact all mortgages, including the majority of outstanding loans now owned by Fannie Mae and Freddie Mac. The federal government can already encourage effective mortgage modifications through its conservatorship of these organizations, while taxpayers would likely be on the hook for losses to GSE mortgages through the bankruptcy process. Banks are now aggressively modifying their own mortgages.
Another alternative, the FDIC proposal, has many virtues but would have limited success and high costs. This proposal would pay servicers $1,000 for every modified loan, and would have the government share up to fifty percent of losses from unsuccessful modifications. This proposal does nothing to eliminate legal barriers, which would continue to deter modification. Further, the costs to taxpayers would be very large. The government, not investors, would bear the costs of failed modifications.
* Mayer- Senior Vice Dean and Paul Milstein Professor of Real Estate, Columbia Business School; Morrison- Professor of Law, Columbia Law School; Piskorski- Assistant Professor, Columbia Business School. The authors wish to thank Adam Ashcraft, Richard Epstein, Andrew Haughwout, Glenn Hubbard, Thomas Merrill, Gillian Metzger, Henry Monaghan, Karen Pence, Amit Seru, Joseph Tracy, and Vikrant Vig for helpful thoughts and comments and Rembrand Koning, Benjamin Lockwood, Bryan McArdle, Ira Yeung and Michael Tannenbaum for excellent research assistance. The authors alone take responsibility for this proposal and any errors or omissions therein.
Download the PDF for the full proposal: PDF