Adam J. Levitin
November 19, 2008
Mr. Chairman, Ranking Member, Members of the Committee:
I am pleased to testify in support of both H.R. 200, the Helping Families Save Their Homes in Bankruptcy Act of 2009, and H.R. 225, the Emergency Homeownership and Equity Protection Act, legislation proposed by Representatives Conyers and Miller that would significantly help ease the nationwide foreclosure crisis and stabilize financial markets.
There are four major points I wish to make in my written testimony:
I. VOLUNTARY PRIVATE MARKET EFFORTS TO ADDRESS THE FORECLOSURE CRISIS HAVE FAILED
A. The Foreclosure Crisis and the Financial Crisis
The United States is in the midst of an unprecedented home foreclosure crisis. At no time since the Great Depression have so many Americans been in jeopardy of losing their homes. Over a million homes entered foreclosure in 20071 and another 1.7 million in the first three quarters of 2008. Over half of a million homes were actually sold in foreclosure or otherwise surrendered to lenders in 2007, and over seven hundred thousand were sold in foreclosure in the first three quarters of 2008 alone. At the end of the third quarter of 2008, one in ten homeowners was either past due or in foreclosure, the highest levels on record.4 Already nearly 20% of homeowners have negative equity in their homes,5 and by the time the housing market stabilizes, 40% of homeowners will have negative equity positions.6 By 2012, Credit Suisse predicts, around 8.1 million homes, or 16% of all residential borrowers could go through foreclosure. 7 In other words one in every nine homeowners—and one in six households who have a mortgage—will lose their home to foreclosure.
The sheer number of foreclosures should be alarming because foreclosures create significant deadweight loss.9 Historically, lenders are estimated to lose 40% - 50% of their investment in a foreclosure situation,10 and in the current market, even greater losses are expected.11 Borrowers lose their homes and are forced to relocate, often to new communities. Foreclosure is an undesirable outcome for borrowers and lenders.
Foreclosures also have major third-party externalities. When families have to move to new homes, community ties are rent asunder. Friendships, religious congregations, schooling, childcare, medical care, transportation, and even employment often depend on geography.12 Homes root people in strong networks of community ties, and foreclosures destroy these key social bonds.
Foreclosures also depress housing and commercial real estate prices throughout entire neighborhoods. There is, on average, a $3,000 property value decline for each of the closest fifty neighbors of a foreclosed property.13 The property value declines caused by foreclosure hurt local businesses and erode state and local government tax bases. Condominium and homeowner associations likewise find their assessment base reduced by foreclosures, leaving the remaining homeowners with higher assessments.
Foreclosed properties also impose significant direct costs on local governments and foster crime.16 A single foreclosure can cost the city of Chicago over $30,000. Moreover, foreclosures have a racially disparate impact because African-Americans invest a higher share of their wealth in their homes18 and are also more likely than financially similar whites to have subprime loans.
The foreclosure crisis has also been at the root of a larger financial crisis. Because most residential mortgages are securitized into widely held securities, unprecedented default rates in the residential mortgage market affect not just mortgage lenders, but capital markets globally. The marketwide impact of defaults on mortgage-backed securities have been amplified by poorly understood and complex derivative products that are bought and sold by financial institutions, which now find themselves insufficiently liquid or undercapitalized. This in turn has led to a global credit crisis as financial institutions have become hesitant to contract not knowing their counterparties’ ultimate solvency.
As long as foreclosures continue at unabated rates, mortgage defaults will continue to rise as foreclosures depress real estate prices, fueling the cycle. Until housing prices stabilize, we will not see stability in the financial system, and housing prices cannot stabilize unless the tide of foreclosures is stemmed. In short, foreclosure is an inefficient outcome that is bad not only for lenders and borrowers, but for society at large.
B. Loss Mitigation Options on Defaulted Loans
Foreclosure, of course, is never mandatory. It is only one possibility among a set of loss mitigation options for a lender confronted with a defaulted loan. A lender always has the option of forbearing or of modifying the terms of a non-performing loan so that it can perform under less onerous terms.20 Indeed, so long as the losses from a modification would be less than those from foreclosure, modification is the efficient economic outcome for a non-performing loan. Given the sizeable losses lenders incur in foreclosure, one would expect lenders to be making significant modifications to loans, including reduction of principal and interest
Yet, to date, there have been relatively few voluntary, private modifications of non-performing loans. As Chart 2 shows, the workouts performed by the HOPE Now Alliance have failed to keep pace with foreclosures. Chart 3 presents a similar picture for a select group of national banks and federal thrifts that comprise around 60% of the total servicing portfolios nationwide. Moreover, as both Charts 2 and 3 show, most of the workouts have been repayment plans, in which the arrearage is simply reamortized into the remaining term of the loan or tacked on at the end, thereby increasing or at best holding steady the borrower’s monthly payments. While repayment plans are sensible solutions to temporary disruptions in the borrower’s cash flow, they are wholly inadequate responses to the key problems of the current mortgage market—payment reset shock and negative equity. Payment reset shock from an adjustable rate mortgage or negative amortization trigger in an option-ARM can only be addressed by modifications that freeze or lower monthly payments, which requires a reduction in the interest rate or principal of the loan. Likewise, negative equity positions can only be corrected through principal write-downs.
Even among the modifications, the vast majority fail to reduce monthly payments, making them near worthless.23 As the State Foreclosure Prevention Working Group has noted,
The failure of existing loan modification programs is not surprising—most loan modifications do not change monthly payments or even increase monthly payments. Less than 20% of voluntary loss mitigation efforts rarely reduce monthly mortgage payments according to a study by Professor Alan White of Valparaiso University Law School.25 Likewise, the Center for Responsible lending estimates that under 20% of HOPE Now loan modifications result in lower monthly payments.
Unrealistic modifications have been a problem not just for the subprime loans examined by the State Foreclosure Prevention Working Group, but also for the predominantly non-subprime loans held in Fannie Mae’s portfolio or securitized by Fannie Mae, the vast majority of loan workouts have been through Fannie’s “HomeSaver Loan” program, which involves making defaulted homeowners a new unsecured loan for up to $15,000 to cover the deficiency on their mortgage loan. The HomeSaver program thus increases financially distressed homeowners’ debt burdens while masking non-performing loans. At best, HomeSaver is a bridge-loan program that buys time until a modification can be done, but given that Fannie Mae is carrying the HomeSaver Loans on its books at about 2% of their face value,27 it clearly expects near universal default and no recovery on these loans.
The federal government’s foreclosure prevention programs have even more dismal results. The FHA’s FHASecure program, which was intended to let borrowers with non-FHA adjustable rate and interest-only mortgages refinance into fixed-rate FHA loans has only helped has only helped a few thousand delinquent homeowners,28 not the 240,000 predicted.29 Likewise, the HOPE for Homeowners program, established by Congress in July 2008 to permit FHA insurance of refinanced distressed mortgages, and predicted to help 400,000 homeowners, had as of mid-December 2008 attracted only 312 applications,30 and not actually refinanced any mortgages,31 in part because of its reliance on private market cooperation to do voluntary principal write-downs.
Similarly, the Streamlined Loan Modification Program (SMP) adopted by the GSEs (in conservatorship) is set up to fail.33 The SMP does not require any modifications, but instead merely sets a target for modified loan payments (principal, interest, taxes, insurance) to be no more than 38% of gross monthly income (front-end DTI). Putting aside whether it makes sense to do modifications based only on front-end DTI, ignoring back-end DTI (total monthly debt payments to gross monthly income), the SMP’s front-end DTI target is grossly inadequate and has already been rejected as resulting in unsustainable loan modifications by leading elements of the mortgage servicing industry have already abandoned as resulting in unsustainable modifications. Litton Loan Servicing, a Goldman Sachs affiliate, uses 31% front-end DTI as its initial target,34 FDIC has proposed a general modification program using a 31% front-end DTI target,35 and Bank of America/Countrywide’s settlement with the state Attorneys General requires use of a 25%-34% front-end DTI standard.36 The GSEs’ own initial underwriting guidelines suggest a maximum 25%-28% front-end DTI.37 If the GSEs do not believe that 38% DTI is prudent underwriting for a loan to begin with, it is not clear why they would use 38% DTI as a modification target, especially as most loans already have a front-end DTI of less than 38%.38 Only around 10-15% of prime loans and alt-A and 25-30% of subprime loans are already above this threshold.39 SMP consists largely of suggesting a standard so low that most troubled loans already comply with it.
All voluntary foreclosure mitigation efforts to date have failed, as have federally- sponsored efforts, which have been reliant on private market cooperation. As the State Foreclosure Prevention Working Group has noted, “[n]early eight out of ten seriously delinquent homeowners are not on track for any loss mitigation outcome,” and “[n]ew efforts to prevent foreclosures are on the decline, despite a temporary increase in loan modifications through the [second quarter] of 2008.
II. BANKRUPTCY MODIFICATION IS THE ONLY WAY TO ADDRESS THE OBSTACLES TO MORTGAGE MODIFICATION CREATED BY SECURITIZATION
A major factor complicating private, voluntary loan modification efforts is securitization. The vast majority, somewhere upwards of 80%, of residential mortgages are securitized. Understanding securitization is key to understanding why private, voluntary efforts at mortgage modification will inevitably fail and why bankruptcy modification presents the only sure method of preventing preventable foreclosures.
Securitization transactions are technical, complex deals, but the core of the transaction is fairly simple. A financial institution owns a pool of mortgage loans, which it either made itself or purchased. Rather than hold these mortgage loans (and the credit risk) on its own books, it sells them to a specially created entity, typically a trust (SPV). The trust pays for the mortgage loans by issuing bonds. The bonds are collateralized (backed) by the loans now owned by the trust. These bonds are so-called mortgage-backed securities (MBS).
Because the trust is just a shell to hold the loans and put them beyond the reach of the financial institution’s creditors, a third-party must be brought in to manage the loans. This third-party is called a servicer. The servicer is supposed to manage the loans for the benefit of the MBS holders. The servicer performs the day-to-day tasks related to the mortgages owned by the SPV, such as collecting payments, handling paperwork, foreclosing, and selling foreclosed properties. These servicers are the entities that actually consider loan modification requests. Confusingly, the servicer is often, but not always, a corporate affiliate of originator; most of the major servicers are subsidiaries of bank holding companies: Countrywide Home Loans (Bank of America); CitiMortgage and CitiFinancial (Citigroup); Select Portfolio Servicing (Credit Suisse); Litton Loan Servicing LP (Goldman Sachs); Chase Home Finance and EMC Mortgage (JPMorgan Chase); Wilshire Credit (Merrill Lynch); Wells Fargo Home Mortgage and Homeq Servicing (Wells Fargo).
Securitization creates numerous obstacles to voluntary loan modifications, but they may be reduced to three broad categories: contractual, practical, and economic.41
A. Securitization Creates Contractual Limitations on Private Mortgage Modification
Securitization creates contractual limitations on private mortgage modification. These limitations cannot be bypassed except through bankruptcy modification or a taking of MBS holders’ property rights.
Servicers carry out their duties according to what is specified in their contract with the SPV. This contract is known as a “pooling and servicing agreement” or PSA. Although the decision to modify mortgages held by an SPV rests with the servicer, and servicers are instructed to manage loans as if for their own account, PSAs often place restrictions on servicers’ ability to modify mortgages. Almost all PSAs restrict modifications to loans that are in default or where default is imminent or reasonably foreseeable in order to protect the SPV’s pass-thru REMIC tax and off-balance sheet accounting status.
PSAs often further restrict modifications: sometimes the modification is forbidden outright, sometimes only certain types of modifications are permitted, and sometimes the total number of loans that can be modified is capped (typically at 5% of the pool). Additionally, servicers are frequently required to purchase any loans they modify at the face value outstanding (or even with a premium). This functions as an anti-modification provision.
No one has a firm sense of the frequency of contractual limitations to modification for residential MBS (RMBS). A small and unrepresentative sampling by Credit Suisse indicates that almost 40% of RMBS PSAs have limitations on loan modification beyond a near universal requirement that the a loan be in default or imminently defaulting before it may be modified.43 The Credit Suisse study, however, did not track all types of modification restrictions, such as face-value repurchase provisions, so the true number of restrictive PSAs is likely higher. Nonetheless, there are still a large number of homeowners whose mortgages are held by securitization trusts with restrictive PSAs. This includes both private-label securitizations and GSE securitizations; some Fannie Mae securitizations, for example, prohibit any reductions in either principal or interest rates.
It is virtually impossible to change the terms of a restrictive PSA in order to allow the servicer greater freedom to engage in modifications. The PSA is part of the indenture under which the MBS are issued. Under the Trust Indenture Act of 1939,45 the consent of 100% of the MBS holders is needed in order to alter the PSA in a manner that would affects the MBS’ cashflow, as any change to the PSA’s modification rules would.
Practically speaking, it is impossible to gather up 100% of any MBS issue. There can be thousands of MBS certificates from a single pool and these certificate holders might be dispersed world-wide. The problem is exacerbated by collateralized mortgage obligations (CMOs), second mortgages, and mortgage insurance. MBS issued by an SPV are typically tranched—divided into different payment priority tiers, each of which will have a different dividend rate and a different credit rating. Because the riskier tranches are not investment grade, they cannot be sold to entities like pension plans and mutual funds. Therefore, they are often resecuritized into what are known as CMOs. A CMO is a securitization in which the assets backing the securities are themselves mortgage-backed securities rather than the underlying mortgages. CMOs are themselves then tranched, and the senior tranches can receive investment grade ratings, making it possible to sell them to major institutional investors. The non-investment grade components of CMOs can themselves be resecuritized once again into what are known as CMO2s. This process can be repeated, of course, an endless number of times.
The upshot of this financial alchemy is that to control 100% of an MBS issuance in order to alter a PSA in any way that would affect cash flows, one would also have to own 100% of multiple CMOs to alter the CMOs’ PSAs and of multiple CMO2s to alter the CMO2s’ PSAs. Given that there were 6,815 private-label securitizations from 2001 thru 2007, not counting many more agency securitizations, and then numerous resecuritizations and re-resecuritizations, the scope of the obstacle to voluntary modification of PSAs to permit greater servicer discretion is considerable.
The impossibility of modifying PSAs to permit modification on a wide scale is further complicated because many homeowners have more than one mortgage. Even if the mortgages are from the same lender, they are often securitized separately. If a homeowner is in default on two or three mortgages it is not enough to reassemble the MBS pieces to permit a modification of one of the mortgages. Modification of the senior mortgage alone only helps the junior mortgage holders, not the homeowner. In order for a loan modification to be effective for the first mortgage, it is necessary to also modify the junior mortgages, which means going through the same process. This process is complicated because senior lenders frequently do not know about the existence of the junior lien on the property.
A further complication comes from insurance. An SPV’s income can exceed the coupons it must pay certificate holders. The residual value of the SPV after the certificate holders are paid is called the Net Interest Margin (NIM). The NIM is typically resecuritized separately into an NIM security (NIMS), and the NIMS is insured by a financial institution. This NIMS insurer holds a position similar to an equity holder for the SPV. The NIMS insurer’s consent is thus typically required both for modifications to PSAs and modifications to the underlying mortgages beyond limited thresholds. NIMS insurers’ financial positions are very similar to out-of-the-money junior mortgagees—they are unlikely to cooperate absent a payout because they have nothing to lose.
Thus, the contractual structure of securitization creates insurmountable obstacles to voluntary, private modifications of distressed and defaulted mortgages, even if that would be the most efficient outcome.