Resolving the Foreclosure Crisis: The City of Los Angeles Principal Reduction Plan
July 15, 2011
Communities throughout Los Angeles are facing a foreclosure crisis as housing values fall and too many homeowners find themselves either in mortgages with payments that increase to levels they cannot pay or falling behind on their payments due to unemployment. This crisis is a drag on the economy as homeowners are forced out of their homes, which are then added to an oversaturated market, with the result that home prices fall even further and major industries like construction struggle along contributing to high unemployment. To stabilize our communities this vicious cycle must be broken.
The unexpected collapse in housing values wrecked the asset position of homeowners, while the recession reduced their incomes: one third of California homeowners with mortgages owe more on the house than the house is worth, 12% of the California labor force is unemployed, and when the measure of unemployment is expanded to include those who are involuntarily working part-time the California unemployment rate rises to 22%. The combined effect of these two forces places many homeowners in an unsustainable situation, because the bank won’t approve a sale of the house as the price doesn’t cover the mortgage debt, and homeowners can’t afford to make their mortgage payments or they can only do so by cutting back on food, health care, and maintenance of the house and their cars. Default, foreclosure and ruined credit looms.
In the worst hit areas, one sixth of all housing units have gone through foreclosure in the past five years. When debt and foreclosure problems are so widespread, they affect the overall economy and will prevent it from growing if they are not addressed. The middle class consumers who count every penny in order to bear their heavy debt burdens can’t afford to consume at a level that will support a vibrant economy. And many foreclosed houses stand empty for months or even years sapping the life out of neighborhoods and local businesses. The foreclosure problem isn’t just a problem for homeowners, but for all of us, and revitalizing our communities will require addressing the crushing burden of housing debt directly.
The Financial Sector’s Windfall Profits Built on the Backs of the Vulnerable
An important issue underlying our current economic difficulties is that modern banking services often facilitate a transfer of resources from those of limited means to the well-to-do, and this phenomenon is equally visible in the mortgage market. To illustrate the problem consider the market for credit cards. There is a group of borrowers, who either because they have difficulty managing their money or because they are hit by a crisis like long-term unemployment or medical issues that make balancing a budget impossible, end up as long-term borrowers paying double digit interest rates on credit card debt that is hardly paid down at all. The wealthy almost certainly comprise a small fraction of these long-term borrowers, since they have the financial reserves to pay the debt off.
Bank CEOs themselves have acknowledged that these long-term borrowers are the individuals who are financing both the profitability of credit card companies and the generous rewards given by credit card companies to wealthy users. Federal Reserve economists have calculated that on average after accounting for rewards, credit card users making less than $50,000 a year pay to use their cards, while credit card users earning more than $150,000 a year receive benefits worth $750 each year through the credit card system.
Thus, in the credit card market, where the banks have vast databases of information on the different types of borrowers, most borrowers do not pay for their access to credit based on the cost of the services that they receive. Instead the fee structure is determined by the ease with which each borrower can use alternate means of payment – with the result that the wealthy, who have many alternatives available, are induced to use the credit card system by offering them “rewards,” while the poor pay usurious fees for access to credit.
Checking account fees prior to regulatory changes in 2009 also appear to have had the effect of transferring resources from the poor to the well-to-do. After the Federal Reserve’s recent restrictions on overdraft fees, banks have been eliminating “free checking.” In the meanwhile, the overdrafts that used to support “free checking” accounts were paid disproportionately by those in low income areas. FDIC data demonstrates that many accounts in low-income areas experienced 20 or more overdrafts in a year at an average annual cost to each account of $1,568. Because the rate of such overdrafts was double the rate in upper-income areas, lower-income areas were paying far more of the costs of our checking account system than the well-to-do.
One would hope that the banks did not intend to develop systems that transfer wealth from the poor to the rich; it is entirely possible that this is just the natural consequence of an under-regulated market in credit. As the poor have fewer alternatives, they are willing to pay more to borrow, whereas the rich are not. After one credit card company offers free services or even reward programs to the well-to-do in order to expand its market share, market forces will mean that all the other companies must follow. The result of unfettered competition is that the wealthy need to be induced to participate in the credit system and the poor pay for it. It is precisely because of the natural evolution of a “free market” in consumer credit that interest rates have been subject to regulation for millennia.
Similar forces are at play in parts of the mortgage market with the result that sometimes it serves to extract funds from the vulnerable to support the windfall profits of the banking system. Because of the banking system’s practice of using one set of consumer’s fees to subsidize the services provided for another set of consumers, there is no reason to believe that any given mortgage was correctly priced to reflect the individual borrower’s probability of default and cost of obtaining the mortgage. On the contrary, just as with credit card accounts, some loans are designed to be more profitable for the bank – even after the likelihood of default is taken into account – than others. Brokers working for subprime lenders like NovaStar Financial were paid thousands of dollars for successfully placing a borrower who qualified for a low-interest rate mortgage in a mortgage at a higher interest rate.
The natural result of a market with this structure is that borrowers who seek loans in areas with less competitive lenders or who do not know how to shop around for a good mortgage rate will find themselves in a loan with an above market rate of return. An “above market rate of return” is financial jargon for a situation where the borrower is paying more than another lender would demand, and the lender is making more than would be possible if all borrowers knew how to shop for loans. It implies that these borrowers are paying the banks more for their home loan than they would in the idealized markets of economic theory.
The subprime mortgage market with its focus on non-traditional borrowers was most similar to the credit card industry. Professor Gary Gorton of the Yale School of Management has extensive consulting experience valuing Wall Street securities, and in 2008 he explained to a conference of the world’s central bankers that:
[In the subprime mortgage market] the decision to default has effectively been transferred from the borrower to the lender. The step-up interest rate forces the borrower to come back to the lender . . . and the lender decides whether to extend another loan or not. Instead of the borrower having an option to default, the lender has an option to extend.
Effectively the subprime mortgage market was built on the principle that borrowers continue to make payments until such time as the lender chooses to take back the house. Just as with the profits in the credit card industry, the whole point of the business model is to impose fees and collect as many payments as possible from borrowers without financial reserves before the borrower goes into default and the lender forecloses on the house.
A typical troubled borrower
Francisco and Marta Sanchez are typical of Los Angeles County’s troubled borrowers. They bought their home in the San Fernando Valley at the peak of the bubble paying $465,000. The Sanchez’ savings of $6,000 were only sufficient to cover the costs of the loan, so they financed $372,000 in a first loan and $93,000 in a second loan. The first loan was an adjustable rate loan where interest only was paid for five years. The second loan was a fixed rate loan at 12% that required a balloon payment of $80,000 in 2021.
Mr. Sanchez works for a large home furnishings company and his hours were cut dramatically in 2008 when the economy entered recession. The Sanchez family was unable to continue making their payments which totaled $3400 initially and rose to $4100 by the end of 2008. While they entered a trial payment program in mid-2009 paying $1900 a month, interest continued to accrue on their loans and by the time they were offered a permanent modification in July 2010, the balance on the two loans totaled more than $550,000. In the meanwhile, the value of their house has fallen below $225,000.
The Sanchez family is committed to keeping their home. Marta started working two jobs and is now trying to maintain her income, while she goes through chemotherapy. The permanent modification lowered the Sanchez’ monthly payment on the first loan to $1820 for five years. The payment will rise to $2250 in 2017 and the loan will be fully paid off in 2041. The Sanchez family is still trying to get their second loan modified: In January 2011 the bank was seeking $800 monthly payments for 10 years and a $63,000 balloon payment in 2021.
Targeting the vulnerable
This example of a subprime loan, where high interest rates make the debt extremely difficult to pay off, is relatively innocuous compared to the worst excesses of the subprime market. The Sanchez loan, like most subprime loans, had a prepayment penalty, but because the Sanchez family never refinanced the loan, they did not have to pay the penalty. Prepayment penalties are usually equal to half a year’s interest on the prepaid amount and increase precisely when the payment on an adjustable rate loan rises. Thus, prepayment penalties make the refinance of a subprime loan extremely expensive for the borrower.
Borrowers with equity in their homes, like the elderly, were targeted by subprime lenders such as Ameriquest. Because the subprime loan was designed to require payments that the borrower could not pay, after the first subprime loan prepayment penalties ensured that the borrower’s equity would be drained in a series of refinances – frequently more than one a year. This process often ended in foreclosure. In a call for more careful regulation of the subprime market, the AARP observed that borrowers over 65 were three times more likely to have a subprime loan than borrowers under 35.
Other vulnerable groups were also targeted. The Federal Reserve found that African Americans were more than twice as likely to receive high cost loans as non-hispanic white borrowers and that little of the difference is explained by borrower characteristics; instead lender characteristics explain most of the difference. The data indicate that the trends are less stark, but similar for Hispanic borrowers. Overall, according to the Federal Reserve’s analysis, if African American communities had had the same distribution of lenders as the non-hispanic white population, then these communities would also have had far fewer high cost loans.
A study of subprime lenders reaches a similar conclusion: Of the loans made by subprime lenders that had gone bankrupt by early 2008, more than 60% went to neighborhoods that were mostly minority, and two-thirds of those loans went to neighborhoods with populations that were at least 80% minority. Thus, certain lenders specialized in subprime loans with unfavorable terms for borrowers and these lenders focused on vulnerable groups like the elderly and minorities.
Problems underlying the current economic malaise: low wages and institutional moral hazard
While society’s most vulnerable have been hardest hit by this crisis, in our current economic environment the average citizen is struggling too. Real wages have stagnated over the past decade, growing even less than they did over the decade that spanned the Great Depression. The recent “recovery” that started officially in the second quarter of 2009 illustrates the problem: Although national income grew over the course of the recovery, 88% of this growth went to corporate profits and only 1% to wages. Such a skewed division of the returns from growth is unprecedented. This reflects an environment where the income earned by a small number of individuals in the financial sector has been growing much faster than the income of all the workers in the non-financial sectors of the economy. There is reason to believe, especially after the recent crisis, that the vast gains in income of the financial sector are founded on implicit and explicit government subsidies, not the extraordinary intelligence, skill and productivity of financial workers.
Extraordinary government support of the financial sector started in 1984 with the bailout of the first “too big to fail” bank’s creditors. Since then, the Federal Reserve has intervened to protect the investment banks during the stock market crash of 1987 and again in 1998 when a major hedge fund collapsed. Furthermore, the Federal Reserve created the expectation that there was a “Greenspan put” or that financial sector could rely on the Federal Reserve to intervene whenever its profitability was threatened by the likely failure of a large firm. There is, thus, strong evidence that the Emergency Economic Stabilization Act of 2008 was just the culmination of recent trends in government support of the financial industry.
This government support of finance has created a problem of moral hazard, where the financial industry has no incentive to avoid macro-economic instability, because it relies on government intervention and bailouts to protect it from the massive losses associated with that instability. Thus, even though the financial sector plays an important role in the macro-economy, the financial sector we have focuses only on its short run profitability and leaves macroeconomic stability as a problem to be solved by the Federal Reserve and Department of the Treasury.
Institutional Moral Hazard and the Subprime Mortgage Market
In this environment, it is not surprising that perverse market forces aggravated the worst properties of the subprime loan market. From 2004 through the first half of 2007, subprime mortgages comprised more than 25% of the collateral underlying the global issuance of an investment product that claimed to offer relatively high returns to investors called a collateralized debt obligation or CDO. The important role played by subprime mortgages in the CDO market created a strong market demand for subprime mortgages with the result that brokers were offered premia by the banks for originating new subprime loans. This perverse market incentive led brokers to put borrowers who qualified for lower cost loans into subprime loans and, in some cases, to give loans to people who were not qualified to borrow at all. Thus, the dynamics of the subprime loan market were driven, not by borrowers’ demand for subprime loans, but by Wall Street’s funneling of a vast supply of investor funds into the subprime mortgage market. Over a period of five years starting in 2002 subprime mortgages grew from 7 to 20% of mortgage market originations. As commentators noted at the time: the tail was wagging the dog.
Another way that perverse market forces aggravated the worst properties of the subprime loan market can be seen in the failure of the large banks that were packaging subprime loans into securities to monitor the behavior of the subprime lenders that were originating the loans. The subprime lenders had a legal obligation to buy back any loans that went into default within a few months of origination. These lenders were not, however, putting aside reserves sufficient to cover their obligations on these loans and most of them filed for bankruptcy early in the financial crisis.
New Century Financial Corporation was a typical subprime lender; its business practices were clearly not geared to long run success, but to the maximization of bonuses and current compensation. After paying out wages, stock options and bonuses that enriched the firm’s executives, New Century didn’t retain enough funds to honor its loan repurchase obligations and filed for bankruptcy on April 2, 2007. David Kenneally, the firm’s controller, was sanctioned by the SEC in 2010 for changing New Century’s method of accounting for these obligations in the year before the onset of the subprime crisis.
Of course, these are the same subprime lenders who targeted vulnerable groups like the elderly and minorities. Since most of these lenders have declared bankruptcy, even if a lawsuit could have elicited sufficient evidence to prove a case of discriminatory lending, these lenders no longer have assets with which to make good on a settlement or judgment. As a consequence of the structure of the subprime loan industry, our largest banks were able to profit from the questionable and unmonitored practices of fly-by-night mortgage lenders.
Current Policy Continues to Coddle the Banks
Even though institutional moral hazard contributed to our largest banks indifference to the practices of subprime mortgage lenders, current policy continues to foster moral hazard by protecting the banks from the consequences of their actions. Notably, although the federal government’s Home Affordable Modification Program (HAMP) offers low cost loans to borrowers, it also has some of the properties of a sub-prime loan. One of the Troubled Asset Relief Program (TARP)’s goals was to preserve homeownership and protect home values, and the Department of the Treasury put HAMP in place in order to implement these goals. It is not clear, however, that the details of the program were designed to achieve either of its goals. The program requires a current monthly payment that is at the limit of a borrower’s ability pay. Even so, in many cases these monthly payments are not fixed over time. In order to be able to make the monthly payment on the loan many borrowers will find that their income needs to increase by 33% over a period of eight years. Of course, those borrowers whose income does not increase on this optimistic schedule will once again be faced with default and the possibility that the bank takes the house.
In addition, because the standard HAMP program does not reduce the principal owed by borrowers on their loans, many HAMP modifications require the borrower to make a balloon payment in excess of $100,000. These balloon payments are also likely to cause problems for some borrowers and may lead to default and foreclosure in the future.
In an environment where banks ignore the macro-economic consequences of their actions and argue that it is their duty to their shareholders or investors to extract as much money as possible from susceptible borrowers, homeowner advocates find it difficult to convince banks to offer sustainable mortgage modifications even to those borrowers whose income would qualify them for a 40 year fixed rate mortgage in the amount of the market value of their home – if it weren’t for an outstanding mortgage balance that is 150% of the value of their home.
The disadvantages faced by borrowers are exacerbated by the fact that gross incompetence on the part of banks servicing mortgages is subject to no discipline whatsoever. Regulators respond to documented violations of state and federal law with consent orders – effectively demanding only that the banks promise not to break the law again.
In this environment, even HAMP is struggling. A recent GAO study of HAMP indicates that 76% of borrowers have had a negative or very negative experience with the program. Of borrowers who contacted housing counselors 56% had problems with servicers losing their documentation, 54% found that three-month-trial periods were lasting more than three months, 42% felt that they had been wrongfully denied a modification, and 37% had difficulty contacting the servicer. Counselors reported that when servicers denied borrowers a modification because their payment was already below the threshold level of income, 53% of these denials resulted from incorrect calculations of income, such as a failure to convert bi-weekly income figures into annual figures correctly or the inclusion of the income of individuals who were not co-signers on the loan.
Escaping the Vicious Cycle: Principal Reductions are Necessary
The collapse in housing values wrecked the asset positions of both homeowners and banks. Unfortunately current federal policies focus on restoring the banks to health and do nothing to restore the financial position of homeowners. When California’s middle class consumers face heavy debt burdens, they can’t afford to consume at a level that will support a vibrant economy. And those homeowners who are employed, but still struggling to pay their mortgages find that when they turn to the banks for help, the banks are happy to continue to accept modified payments, but will almost never reduce their mortgage debt. These policies impede the revitalization of our communities, as a large fraction of the population must spend their resources paying down debt and can’t afford to support local restaurants and businesses.
By contrast, in the business world, when a major asset securing a loan falls significantly in value, the principle that the borrower has the right to renegotiate the loan is so fundamental to the operation of our economic system that “cram down” is written into the bankruptcy code. Usually a lender will come to the table when the borrower simply threatens to declare bankruptcy. The economic policy underlying the cram down principle is clear and compelling: foreclosing on an asset can never bring in more money than its current market value, so giving a lender an asset worth the market value of the property ensures that the lender gets the full benefit of the secured loan, and keeping property owners in their current location avoids imposing the costs of moving on the owners and the costs of reselling or renting out the property on the lender. Thus, the cram down principle is economically efficient and guarantees that there are gains for both the lender and the borrower.
The cram down principle also guarantees an appropriate balance of power between lender and borrower: The borrower almost certainly does not want to declare bankruptcy and the lender has some culpability due to the failure to recognize that the asset would be worth too little relative to the loan. The principle also helps to protect the economy from speculative bubbles, as it gives lenders a strong incentive to lend cautiously and for less than the full value of the asset when the economy is booming.
The housing market is so dysfunctional today in part because the natural restraints on lending were not present: when the Bankruptcy Code was rewritten, the banking lobby successfully introduced one exception to the cram down principle, principal residences. This exception treats individuals asymmetrically and effectively makes them second-class citizens in their own country: Francisco Sanchez is at risk of having his pension written down, but doesn’t have the same protection as a corporation when the value of his most important asset plummets. This exception also means that, as the housing market struggles to recover from the bubble, borrowers face an unequal negotiating structure that often forces them to choose between leaving their homes and struggling to pay more than double what they’re worth.
The community-wide consequences of current housing law should, however, be of greatest concern. After a housing bubble, the economy without cram down for houses must choose between a massive and costly reallocation of homes and the drag created by a substantial population with massive debt and no spending capacity. In practice, we risk experiencing the worst of both possibilities: many homeowners will spend years trying to keep their homes before they succumb under their debt load, lose their homes and perpetuate this vicious cycle.
The main argument against principal reductions for homeowners is that the moral hazard created by writing loans down to their actual value to the lenders will mean that homeowners who are capable of making payments may opt to default. For this argument to have substance, however, its proponents must first explain why the moral hazard created by protecting Bank of America from immediate realization of the consequences of its faulty underwriting procedures is outweighed by the moral hazard of reducing the debt burden of Francisco Sanchez, and why the moral hazard of writing down United Airlines’ corporate debts to lenders and pensioners is not more damaging to the economy than that of writing down the average homeowner‘s mortgage debt.
In our current situation, the vast number of homeowners whose mortgages are worth more than the value of their homes means that there are macroeconomic consequences to policy decisions affecting mortgages, just as there are macroeconomic consequences to putting large firms like United Airlines and Lehman Brothers investment bank through bankruptcy. Because of the macroeconomic role played by homeowners in the current crisis, writing off debt and giving a large segment of the population a fresh start supports the growth of the economy as a whole. In short, principal writedowns on unsustainable mortgages are essential, if we are to stabilize our communities and the economy around them.
Towards a Solution: Principal Reduction
Over the last year Treasury has started to support loan modifications that include principal reduction. In June 2010, a Principal Reduction Alternative (PRA) was added to HAMP, and over the past year Treasury has allocated $420 million in TARP funds to the California Housing Finance Agency (CalHFA) to support mortgage principal reduction.
These programs, however, benefit banks more than homeowners. Principle reduction under HAMP is entirely voluntary: HAMP-PRA requires only that servicers perform a calculation to establish whether or not principal reduction would be more advantageous to the owner of the loan than a standard HAMP modification, and the latest Servicer Performance Report issued by Treasury does not have data on the number of principal reductions under HAMP. CalHFA’s Principal Reduction Program both overpays banks for the principal writedown and does not impose a cap on the degree to which homeowners owe more than their properties are worth. When homeowners remain deeply underwater on their modified mortgages, they are far more likely to default on the modified loan. Thus, plans like CalHFA’s are more likely to perpetuate than to resolve the foreclosure crisis.
The City of Los Angeles has adopted a Principal Reduction Plan that was developed with the support of One L.A. and Neighborhood Legal Services of Los Angeles County. This plan will benefit homeowners, while at the same time ensuring that banks and mortgage investors receive the fair value of their loans and that the program will help as many homeowners as possible.
Because the resources available to support mortgage principal reductions are limited, a building block of the City of Los Angeles Principal Reduction Plan is that the lender should be paid only enough to ensure that the loan modification is worth as much as foreclosing on the property. This results in a payment of about fifteen cents for every dollar of principal reduction and allows the Plan to help many more homeowners per dollar of funding than the CalHFA Program.
Even as the City’s Principal Reduction Plan helps more homeowners, it also guarantees that each homeowner has less debt after the modification than the CalHFA Program. The Plan sets a maximum for total mortgage debt after the modification at 125% of the property’s current value; CalHFA does not. As defaults are highly correlated with the degree to which mortgages are underwater, modifications under the City of Los Angeles Plan are also more likely to be successful over the long-run than CalHFA modifications.
Conclusion
The City of Los Angeles with the support of One L.A. and Neighborhood Legal Services of Los Angeles County has designed a principal reduction plan for mortgages and is committed to moving this plan forward in the City of L.A. This plan treats banks fairly, not favorably. By doing so, it maximizes the value of the funds invested in it so that it can reach many more homeowners than alternate plans and results in modifications that are more likely to succeed.
The foreclosure crisis has been dragging on for more than three years now and will continue to wreck havoc with our communities if it is not addressed effectively. Because federal government policy is focused on protecting the banks from the consequences of their poor lending practices, an alternative plan designed to stabilize our communities is needed. The City of Los Angeles Principal Reduction Plan was developed to meet this need.
Endnotes
[1] CoreLogic Press Release (March 8, 2011), available at http://www.corelogic.com/uploadedFiles/Pages/About_Us/ResearchTrends/CL_Q4_2010_Negative_Equity_FINAL.pdf; State of California Employment Development Department Press Release (May 20, 2011), available at http://www.edd.ca.gov/About_EDD/pdf/urate201105.pdf; Bureau of Labor Statistics, Local Area Unemployment Statistics, Alternative Measures of Labor Underutilization for States, Second Quarter of 2010 through First Quarter of 2011 Averages, http://www.bls.gov/lau/stalt.htm (last visited June 9, 2011).
[1] Id. at 9. Note that the data is actually tabulated by MSA, not county.
[1] See Lowell Bergman & Oriana Zill de Granados, The Card Game: Transcript, (2009), http://www.pbs.org/wgbh/pages/frontline/creditcards/etc/script.html Comments of Shailesh Mehta, former CEO of Providian Financial: “in a strange way, the banks were charging borrowers higher interest rates in order to give the wealthy people a break -- in a strange way, if you look at it, because the people who have money were paying in full, and they were getting the break at the expense of the people who couldn't pay in full.” And “We were making a billion dollars a year … In profit before tax.”
[1] Scott Shuh et al., Who Gains and Who Loses from Credit Card Payments? Theory and Calibrations 3 (Federal Reserve Bank of Boston Public Policy Discussion Paper No. 10-03, 2010), available at http://www.bos.frb.org/economic/ppdp/2010/ppdp1003.pdf. While the Credit Card Act of 2009 may reduce the size of this transfer, research indicates the less sophisticated and less wealthy borrowers will continue to bear the costs of the system. See Joshua M. Frank, Dodging Reform: As Some Credit Card Abuses Are Outlawed, New Ones Proliferate (Center for Responsible Lending, 2009), available at http://www.responsiblelending.org/credit-cards/research-analysis/CRL-Dodging-Reform-Report-12-10-09.pdf
[1] Board of Governors of the Federal Reserve System Press Release (Nov. 12, 2009), available at http://www.federalreserve.gov/newsevents/press/bcreg/20091112a.htm.
[1] Robin Sidel & Dan Fitzpatrick, End is Seen to Free Checking, Wall Street Journal, June 16, 2010, http://online.wsj.com/article/SB10001424052748703513604575311093932315142.html (last viewed June 2, 2011); Karen Blumenthal, Why Checking Fees Keep Going Up, Wall Street Journal, Dec. 4, 2010, http://online.wsj.com/article/SB10001424052748703865004575648603199758586.html (last viewed June 2, 2011).
[1] Fed’l Deposit Ins. Corp., FDIC Study of Bank Overdraft Programs 76-77 (2008), available at http://www.fdic.gov/bank/analytical/overdraft/FDIC138_Report_FinalTOC.pdf [hereinafter FDIC Study]. See also Mike Konczal, The So-Called Death of “Free” Checking, Rortybomb Blog (June 18, 2010), http://rortybomb.wordpress.com/2010/06/18/the-so-called-death-of-free-checking/.
[1] See FDIC, supra note 20, at 77.
[1] For a discussion of the ways in which brokered loans can function to subsidize the loans of some borrowers, see: Doris “Tanta” Dungey, CRL: Brokered Loans Cost (Some People) More, Calculated Risk Blog (Apr. 9, 2008), http://www.calculatedriskblog.com/2008/04/crl-brokered-loans-cost-some-people.html.
[1] The practice of giving mortgage brokers a bonus, known as a yield spread premium, for putting borrowers into a loan at a higher interest rate than the one for which they qualified has been roundly criticized in the press. See Gretchen Morgenson & Julie Creswell, Borrowing Trouble, New York Times, Apr. 1, 2007, http://query.nytimes.com/gst/fullpage.html?res=9F01EEDB1130F932A35757C0A9619C8B63&pagewanted=all (last viewed June 16, 2011); E. Scott Reckard and Marc Lifsher, 2 States Probe Countrywide Home Loans, Los Angeles Times, Dec. 14, 2007, http://articles.latimes.com/2007/dec/14/business/fi-countrywide14 (last viewed June 16, 2011). An Urban Institute Study of mortgage closing costs found that yield spread premia were very costly for borrowers. Susan E. Woodward, A Study of Closing Costs for FHA Mortgages 59 (May 2008) available at http://www.urban.org/UploadedPDF/411682_fha_mortgages.pdf. See also R.B. Avery et al., The 2006 HMDA Data, Federal Reserve Bulletin, Dec. 2007, at A95, available at http://www.federalreserve.gov/pubs/bulletin/2007/pdf/hmda06final.pdf, and, for a detailed discussion of broker pricing: Doris “Tanta” Dungey, Risk Based Pricing for UberNerds, Calculated Risk Blog (Sept. 16, 2007), http://www.calculatedriskblog.com/2007/09/risk-based-pricing-for-ubernerds.html.
[1] Gary Gorton, The Panic of 2007 at 17 (Paper prepared for the Federal Reserve Bank of Kansas City, Jackson Hole Conference, 2008) available at http://www.kansascityfed.org/publicat/sympos/2008/gorton.08.04.08.pdf
[1] Debbie G. Bostein et al., Borrowers in Higher Minority Areas More Likely to Receive Prepayment Penalties on Subprime Loans 5, Jan. 2005, available at http://www.responsiblelending.org/mortgage-lending/research-analysis/rr004-PPP_Minority_Neighborhoods-0105.pdf. According to the mortgage industry, prepayment penalties serve to compensate the lender for low initial rates offered to the borrower. Typically, however, the borrowers who take these loans have imperfect credit and are paying a high interest rate overall, so it is extremely difficult to verify the claim that that they have received a benefit in the form of a lower interest rate.
[1] Id. at 3.
[1] Susan Kelleher and Justin Mayo, Homeowners in debt, seniors prime targets of riskiest loans, Seattle Times, Dec. 3 2007 available at http://seattletimes.nwsource.com/html/localnews/2004049184_predatorylending03m.html.
[1] Nearly all of Ameriquest’s loans went to people who already owned homes. Id.
[1] AARP Public Policy Institute, FYI: The Subprime Market: Wealth Building or Wealth Stripping for Older Persons 2 (June 2007) available at http://assets.aarp.org/rgcenter/consume/m_6_mortgage.pdf.
[1] R.B. Avery et al., The 2006 HMDA Data, Federal Reserve Bulletin, Dec. 2007, at A95-96, available at http://www.federalreserve.gov/pubs/bulletin/2007/pdf/hmda06final.pdf.
[1] Id.
[1] Id.
[1] California Reinvestment Coalition et al., Paying More for the American Dream 5, March 2008, available at http://www.calreinvest.org/system/assets/125.pdf
[1] JED GRAHAM, 10-Year Real Wage Gains Worse Than During Depression, INVESTOR'S BUSINESS DAILY June 2, 2011 available at http://www.investors.com/NewsAndAnalysis/Article/573982/201106020800/10-Year-Real-Wage-Growth-Worse-Than-During-Depression.aspx cited in Wage Growth Over Past Ten Years Worse Than During Great Depression, Doug Mataconis · Friday, June 3, 2011 Outside the Beltway Blog.
[1] Andrew Sum et al. The “Jobless and Wageless” Recovery from the Great Recession of 2007-2009: The Magnitude and Sources of Economic Growth Through 2011 I and Their Impacts on Workers, Profits, and Stock Values, Center for Labor Market Studies Northeastern University Boston, Massachusetts May 2011 available at http://www.clms.neu.edu/publication/documents/Revised_Corporate_Report_May_27th.pdf pp. 19-20.
[1] Id at 20-21.
[1] Justin Fox, Pay Wall Street Less? Hell Yes, Time Magazine, Feb 19, 2009 available at http://www.time.com/time/magazine/article/0,9171,1880637,00.html; Simon Johnson, The Quiet Coup, The Atlantic, May 2009 available at http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/.
[1] Id.
[1] The bailout of Continental Illinois’ creditors is discussed in FDIC, Continental Illinois and 'Too Big to Fail', in History of the Eighties — Lessons for the Future 235, 244 (1997) available at
http://www.fdic.gov/bank/historical/history/235_258.pdf.
[1] For the 1987 rescue of the investment banks see Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets, MIT Press 2006 at 2-4; Mark Carlson, A Brief History of the 1987 Stock Market Crash with a
Discussion of the Federal Reserve Response, Federal Reserve Board Finance and Economics Discussion Series 2007-13 at 19-20 (Nov. 2006) available at http://www.federalreserve.gov/Pubs/feds/2007/200713/200713pap.pdf; for the 1998 Long Term Capital Management intervention see The Financial Economists Roundtable Statement
On Long-Term Capital Management and the Report of the President’s Working Group on Financial Markets
October 6, 1999 available at http://fic.wharton.upenn.edu/fic/policypage/fer1999.pdf.
[1] See Nouriel Roubini and Stephen Mihm, Crisis Economics, p. 75.
[1] A CDO is an investment product that owns a package of assets and distributes the returns on those assets to different classes of investors in the CDO: the equity investors get the highest returns, but bear the risk of all defaults until their investment is wiped out; the mezzanine investors get moderately high returns and bear the losses after the equity investors are wiped out; the senior investors get the lowest return and bear losses only after all other investors have lost their money. CDOs initially packaged corporate bonds, but after the dotcom bust in the early ‘00s, the junk bonds that had been packaged into these CDOs performed poorly, as did the CDOs, and financiers needed to find another source of collateral in order to sell CDOs. Low interest rates led to a mortgage refinance boom, so just as financiers were looking for an asset to package, there were a vast number of new mortgages available for packaging.
The data on CDO issuance is available from SIFMA at www.sifma.org/uploadedFiles/.../SF-Global-CDO-Issuance-SIFMA.xls. A Moody’s March 2007 Structured Finance report indicates that 45 to 49% of the collateral in structured finance CDOs was subprime RMBS from 2004 to 2006. Park, The Impact of Subprime Residential Mortgage-Backed Securities on Moody's-Rated Structured Finance CDOs: A Preliminary Review 2 (March 23, 2007). Standard & Poors data indicates that this figure can be extended to 2007. Basel Committee on Banking Supervision Joint Forum, Credit Risk Transfer: Developments from 2005 to 2007 50 (April 2008) available at http://www.bis.org/publ/joint18.pdf. Multiplying the fraction of subprime RMBS collateral in SF CDOs times the fraction of SF CDOs in total CDO issuance leads to the conclusion that 24 to 29% of CDO collateral was subprime RMBS from 2004 to first half 2007.
[1] See supra n. 22.
[1] U.S. Dep’t of Housing and Urban Development, Regulatory Impact Analysis and Initial Regulatory Flexibility Analysis: FR-5180-F-02 at 2-97 (2008) available at http://www.hud.gov/offices/hsg/ramh/res/impactanalysis.pdf.
[1] See, e.g., Doris “Tanta” Dungey, MBS For UberNerds II: REMICs, Dogs, Tails, and Class Warfare, Calculated Risk Blog (Apr. 20, 2007), http://www.calculatedriskblog.com/2007/04/mbs-for-ubernerds-ii-remics-dogs-tails.html.
[1] For a list of closed subprime lenders see Worth Civils & Mark Gongloff, Subprime Shakeout: Lenders that Have Closed Shop, Been Acquired or Stopped Loans, Wall Street Journal Online, http://online.wsj.com/public/resources/documents/info-subprimeloans0706-sort.html (last visited: May 31, 2011).
[1] David Cho, Pressure at Mortgage Firm Led To Mass Approval of Bad Loans, Washington Post, May 7, 2007 available at http://www.washingtonpost.com/wp-dyn/content/article/2007/05/06/AR2007050601402.html
[1] On the profits extracted from the industry by executives see Gretchen Morgenson, Lenders Who Sold and Left, New York Times, Feb. 3, 2008, http://www.nytimes.com/2008/02/03/business/03gret.html.
[1] In re Kenneally, SEC Administrative Proceeding, File No. 3-14040, Sept. 10, 2010 page 2-3, available at http://www.sec.gov/litigation/admin/2010/34-62888.pdf .
[1] In the Dep’t of Treasury, Supp. Directive 10-09, Making Home Affordable Program: Handbook for Servicers of Non-GSE Mortgages 65 et seq., version 3.0 (Dec. 2, 2010) available at https://www.hmpadmin.com/portal/programs/docs/hamp_servicer/mhahandbook_30.pdf (hereinafter MHA Handbook) this is called the “target monthly mortgage payment ratio.”
[1] See MHA Handbook at 66. When the interest rate rises from 2% to 5% a 33% increase in payments results.
[1] See Letter from Community Organizations to Ben Bernanke et al. (April 6, 2011) available at http://www.responsiblelending.org/mortgage-lending/policy-legislation/regulators/Regulators-Servicing-Consent-Orders-4-6-11.pdf.
[1] U.S. Gov’t Accountability Office, GAO-11-367R , Troubled Asset Relief Program: Results of Housing Counselors Survey on Borrowers’ Experiences with the Home Affordable Modification Program 5 (2011), available at http://www.gao.gov/new.items/d11367r.pdf. Note that this is reported by housing counselors so there may be an issue of selection bias; there does not, however, appear to be any more general survey of homeowners seeking modification that could provide evidence relating to the direction of the bias.
[1] Id. at 4.
[1] Id. at 7-8.
[1] See 11 U.S.C.A. § 1129(b); H.R. Rep. No. 95-595 at 413-14 (1978). Union employees of a firm that declares bankruptcy know a lot about the renegotiation of contract terms that takes place in bankruptcy as they have seen their pensions stripped to a fraction of the amount for which they contracted. See, e.g., Can You Afford to Retire? (PBS Frontline 2006), available at http://www.pbs.org/wgbh/pages/frontline/retirement/.
[1] As the Mortgage Bankers Association has argued repeatedly, if mortgages were subject to cram down, banks would offer fewer loans – at the peak of the bubble this would have been a service to all our communities. See Stop the Bankruptcy Cramdown Resource Center, Mortgage Bankers Association Website, http://www.mortgagebankers.org/StopTheCramDown (last viewed May 31, 2011).
[1] See 11 U.S.C.A. § 1322(b)(2); Grubbs v. Houston First Am. Savings Ass’n, 730 F.2d 236, 245-46 & n. 13 (5th Cir. 1984).
Organized opposition to cramdown for homeowners continues to this day. See Ryan Grim, Cramdown Vote: Banks Bought Senators on the Cheap, (Apr. 30, 2009), http://www.huffingtonpost.com/2009/04/30/cramdown-vote-banks-bough_n_193674.html (viewed: May 25, 2011); Ryan Grim, Dick Durbin: Banks Frankly Own the Place, (Apr. 29, 2009), http://www.huffingtonpost.com/2009/04/29/dick-durbin-banks-frankly_n_193010.html (viewed: May 25, 2011; Stop the Bankruptcy Cramdown Resource Center, http://www.mortgagebankers.org/StopTheCramDown (viewed: May 25, 2011); Kevin Drawbaugh, U.S. House Rejects Mortgage Cramdown Measure, (Dec. 11, 2009), http://www.reuters.com/article/2009/12/11/us-financial-regulation-house-cramdown-idUSTRE5BA3CN20091211 (viewed: May 25, 2011).
[1] See Laurie Goodman et al., The Case for Principal Reductions, Amherst Mortgage Insight, Mar 24, 2011, for a detailed analysis of the mortgage default data, concluding: “the risk of not making principal reduction modifications is far greater than the moral hazard in a principal reduction program. If no further action is taken, and home prices continue to deteriorate, more ‘always performing’ borrowers will be underwater, increasing the rates at which these loans transition to default, further increasing delinquencies and shadow inventory, and causing continued declines in home prices, and in turn exacerbating the negative equity cycle.” Id. at 11.
[1] See, e.g., Jared Bernstein, Shoulds versus Coulds, On the Economy Blog (May 30, 2011), http://jaredbernsteinblog.com/shoulds-versus-coulds/.
[1] Over 28% of homeowners with mortgages owe more than their homes are worth. Press Release from Zillow, Inc. (May 9, 2011), available at http://zillow.mediaroom.com/index.php?s=159&item=228.
[1] Since 1938 and the Great Depression bankruptcy laws, in recognition of the need to give debtors a fresh start, “favor reorganization over liquidation.” David S. Kennedy & R. Spencer Clift, III, An Historical Analysis of Insolvency Laws and Their Impact on the Role, Power, and Jurisdiction of Today’s United States Bankruptcy Court and Its Judicial Officers, 9 J. Bankr. L. & Prac. 165, 176 (2000).
[1] Dep’t of Treasury, Supp. Directive 10-05, Home Affordable Modification Program – Modification of Loans with Principle Reduction Alternative, (2010) available at https://www.hmpadmin.com/portal/programs/docs/hamp_servicer/sd1009.pdf.
[1] MHA Handbook at 67.
[1] Id.
[1] Dep’t of the Treasury, Making Home Affordable Program: Servicer Performance Report Through January 2011, (2011) available at http://www.treasury.gov/initiatives/financial-stability/results/MHA-Reports/Documents/Jan_2011_MHA_Report_FINAL.PDF.
[1] HFA Proposal Submission from CalHFA to the U.S. Dep’t of the Treasury at 5 (Apr. 16, 2010) (on file with author). The CalHFA programs seeks only a 100% match by the lender, thus guaranteeing that the lender is paid at least 50 cents for every dollar of principal reduction. Net Present Value calculations indicate, however, that the principal on many homes is worth much less. See the One L.A. Plan, discussed below, for a more detailed analysis. The CalHFA program also requires that “the current first mortgage loan-to-value (LTV), after principal reduction, does not fall below 120%;” this means that it is a requirement of the program that the borrower continue to be seriously underwater on the mortgage.
[1] Laurie Goodman et al., The Case for Principal Reductions 2, Amherst Mortgage Insight, Mar 24, 2011
[1] Id.
