EconoMonitor

Dan Alpert's Two Cents

Mandatory Mortgage Modifications and the U.S. Constitution

Highlights

  • The Bush administration’s failure to articulate or enact a comprehensive solution to the enormous debt overhang homeowners face is rooted not only in free-market ideology, but also in fundamental constitutional law and case history dating back to the Great Depression.
  • The federal government, through its control of Fannie Mae, Freddie Mac, the Federal Home Loan Banks and the FDIC, already controls and–together with the taxpayer–is fully exposed to the risk of loss on over 60% of the +$11 trillion of residential mortgage loans outstanding.  The government must step up its modification program to a level far more aggressive than that suggested by the Federal Housing Finance Agency this week.  We like the ideas espoused by Sheila Bair of the FDIC with respect to the treatment of government controlled mortgages.
  • Notwithstanding laudable efforts on the part of Ms. Bair and some others, the fact remains that the greatest concentration of troubled loans are trapped in “private-label” securitizations. Over $2 trillion of the most toxic subprime ARMs, Alt-A, Option ARMs and prime/subprime jumbo loans, are controlled by bond indentures administered by trustees and servicers with a strong disincentive to engage in widespread mortgage modifications or forgiveness.
  • The settlement of loans in private securitizations, the source of over 60% of all current loan delinquencies and defaults, is critical to the stabilization of the housing market and the resolution of the present crisis.  Yet government efforts to “jaw-bone” securitization trustees and servicers into taking actions that are not in their economic or legal interests have failed to date and will continue to fail.
  • In our opinion, a loan resolution program that mortgage loan holders (securitization trusts and otherwise) are mandated by law to accept, is the only productive remedy.  Such a solution, however, would face significant obstacles under constitutional law and the extensive case law precedent.  Nevertheless, it is possible to craft a solution that is narrowly tailored to be sustainable within limitations of constitutional property and contract protections.
  • If we fail to be proactive in the mortgage crisis and address the most toxic mortgages, the emergency will drag out to a point where, combined with a severe recession, housing prices will decline well below the level at which they should otherwise find stability. With a mandated solution grounded on constitutionally defensible principles, and a more thorough understanding of the issues by those within government, resolution of this crisis can finally get under way in earnest.  Such a solution is described in this report.

Overview

The Bush administration’s failure to articulate or enact a comprehensive solution to the enormous debt overhang homeowners face is rooted not only in free-market ideology, but also fundamental constitutional law and case history dating back to the Great Depression.  Supreme Court decisions on government-mandated mortgage settlement or modification programs during the 1930s make it enormously complicated to legislate a truly complete solution to the mortgage debt debacle—complicated, but not impossible.

Not only does our present dilemma face a legitimate constitutional obstacle to the ex-post facto changing of laws affecting the making and performance of private contracts such as mortgages (a key pillar in maintaining the right to own and preserve private property), but the Constitution also limits the federal government’s power to take private property–including the substantial impairment of contract interests–without fair and equitable compensation.

These original, widely interpreted and accepted underpinnings of our legal and economic system are now confronted by widely misunderstood and, as yet, under-interpreted forms of financial engineering, none of which could have been contemplated in the 1930s. The unique constitutional expertise necessary to parse through what will and won’t work in possible legislative cures is not generally part of mortgage securitization experts’ repertoire. But thinking “outside the box” in both disciplines is critical to finding a workable solution to our crisis.

Underlying Situation

Here are the unfortunate facts: While the federal government, through the de facto near-nationalization of the GSEs Fannie Mae and Freddie Mac, and the Federal Home Loan Banks (FHLBs), has effective dominion and control over nearly 60% of the $11+ trillion of outstanding U.S. mortgages, most are “prime” mortgages and therefore not directly in the eye of the present storm (although plenty of mortgages previously considered prime are threatened by plunging housing prices). Subprime mortgages of all varieties are overwhelmingly held in so-called private-label securitization pools or by major banking institutions that got stuck with whole loans in their securitization pipelines (and problem loans they had bought out of securitizations to avoid costly cash flow triggers) when the music stopped in the subprime lending business. Another group of troubled loans completely in private hands are the “jumbo” mortgages that exceeded, in size, the GSEs’ qualifying guidelines—even though they may have been regarded as prime—and are in private hands, securitized or otherwise. (Think of these as the McMansion loans that were particularly vulnerable to the housing bubble’s massive price inflation and borrower stretching). Finally, there are subprime and prime loans directly under the control of the government via the FDIC, taken over from banks the agency has seized, whose numbers are relatively small but growing.

While the government is, practically speaking, the largest U.S. mortgage lender (and today involved in more than 80% of all new loans), its ability to modify payments and reduce ultimate principal obligations on the sizable majority of the most severely troubled mortgages is nil as a matter of law to date. And so, the Federal Housing Finance Administration (FHFA) and other executive branches, through and including the FHFA’s announcement this week, have resorted to “jawboning” the portion of the mortgage industry over which they have no effective control. This moral suasion has had industry “cooperation” through special-sounding, congressionally appealing programs like Hope for Homeowners and HOPE NOW. As well-meaning as such programs are, the industry involvement therein has generally amounted to making sure the government does not unduly interfere with the private prerogatives and contract rights of mortgage banks and servicers. The programs themselves haven’t had—and have no ability to generate—a meaningful impact on the crisis.

One bright light, in terms of government action, has been the wise efforts of the FDIC, under indefatigable Chairperson Sheila Bair, to aggressively modify loans under its direct control. While Ms. Bair’s program has been far more effective than anything the government has pursued to date, it is necessarily limited to mortgages under the government’s control. And while she has been arguing to expand her program to privately held loans, the best the FDIC has been able to come up with, according to press reports, is the suggestion that the government guarantee lenders, in whole or in part, against such losses. One doesn’t need to be a free-market ideologue to see this would mean bailing out all the folks who invested in the foolish loans contained in the subprime and jumbo securitization pools, among others. On that score, in his press conference this week, Treasury Secretary Paulson issued a political “thanks, but no thanks” to Ms. Bair.

Addressing the Problem:

Government Controlled Mortgages vs. Privately Held Mortgages

The government can do much more than FHFA suggested this week to restructure loans under its control in the GSEs (the remaining 20% shareholder interest in Fannie and Freddie must also be immediately nationalized to eliminate legal challenges from outside shareholders), or via the FHLBs and FDIC. The feds must be willing to take the hit on defaulted and/or underwater loans, either restructuring them directly, or preferably monetizing them at fair prices to parties that will acquire them, reset payments to affordable levels and offer principal reduction over time in exchange for borrower performance (full disclosure: our firm is in that business). This must occur with deliberate haste as foreclosures mount and home prices continue to fall. The government needs to insist that regulated banking institutions (in exchange for the capital infusions they will continue to require under TARP) do likewise, as the sale for cash of $1 of already marked-down, non-performing assets will be $1 less the government needs to inject into banks.

The problem of the private-label securitizations holding more than $2 trillion of our nation’s most troubled loans, and other loans in private hands, will not be addressed by any of the foregoing—but nevertheless must be tackled with equal vigor. The law, tested on similar issues during the Great Depression, simply does not permit fiat legislation mandating the same type of modifications described above. And the unique attributes of securitizations make it extremely unlikely that anything but a mandated solution will have any effect.

Residential mortgage-backed securitization pools are groups of mortgage loans that have been bundled to issue debt interests in multiple classes, reflecting varying seniority and levels of payment risk. In making reference to securitizations, the business media often refer to securitized mortgages as “sliced and diced mortgages.” In fact, this is a bit of misnomer. The mortgages in securitized pools are happily whole—floating in the pool attended by a trustee, on behalf of the securities’ holders, and a mortgage loan servicer, retained by the trustee to collect payments and deal with defaults and delinquencies. It is the regular cash flow from the mortgage payments (and mortgage maturity, prepayment and foreclosure proceeds) that is sliced, diced and paid to the various classes of securities in accordance with a fixed priority.

Now, here’s the rub: Any really appropriate action securitization trustees and servicers take to modify loan payments or, heaven forbid, actually write down mortgages’ principal to the market values of the homes securing them, will result in one or more classes of the securities being severely impaired or entirely wiped out. Because the governing documents of securitizations never contemplated what would happen in an environment where home prices fall dramatically, there is no road map servicers can rely on to prove they “did the right thing,” and any major moves could expose them to massive lawsuits alleging they acted too hastily or without prudence. As a result, servicers and the trustees to whom they report have a profound disincentive to act, even with the government flapping its gums about the need to do so.

A Targeted and Constitutionally Sustainable Solution

With our decades-long experience in structured finance, we have developed a mortgage crisis plan—The Freedom Recovery Plan (www.westwoodcapital.com/freedomrecovery)—that has received some attention in the media. The plan was developed with an eye toward implementing a program that would be mandatory for lenders and servicers, granting them full performance on the mortgages they hold in the form of structured “deed-in-lieu” settlements between electing borrowers (owner occupants only, no investor properties) and mortgagees. The plan incorporates a lease-back of the surrendered home to the previous owner for a period of four to six years, and a right to reacquire the home at fair market value once the present crisis subsides and the former homeowner has an opportunity to regain financial health by the end of the lease term. The plan eliminates the onerous costs and disruptions of adversarial foreclosure and creates an after-market for homes subject to what we have termed “Recovery Leases.”

Of critical importance, the plan we have proposed is designed to address what we view as the most controversial issue of this crisis: the need to mandate changes to distressed loans among the more than $2 trillion of highly toxic mortgages currently beyond the government’s reach (as well, of course, as those within it). We believe, especially after considering the Depression-era precedents, this plan is defensible from a constitutional standpoint, as the only impairment of mortgagees’ rights being suggested under the plan is the requirement to lease the repossessed home for a relatively short period, for which the mortgagee is being fairly compensated on a fair market analysis that we believe would withstand claims of a government “taking.” It is also our belief that the plan is narrowly tailored to address the current public need.  The body of law regarding rent stabilization and control regulations also provides useful precedent on government-imposed use limitations on existing housing.

To date, we have seen no other legally sustainable plans effectively mandating the modification or settlement of troubled loans held by private-label mortgage securitizations, in a manner that will keep people in their homes.   Some proposals we have seen may result in marginal relief, but harbor either potential constitutional pitfalls or largely involve bailing out investors in severely impaired mortgages so as to enable the feds to get control of such loans.

Conclusion

One fact is very clear: If we fail to be proactive in the mortgage crisis and address the most toxic mortgages trapped in trusts and elsewhere, the emergency will drag out to a point where, combined with a severe recession, housing prices will decline well below the level at which they should otherwise find stability. With a mandated solution grounded on constitutionally defensible principles, and a more thorough understanding of the issues by those within government (although we’ve had very useful conversations recently with some very committed people in Treasury and Congress), resolution of this crisis can finally get under way in earnest. Our structured debt industry used legal and financial principles (the latter, faulty) to engineer this crisis, with the view that nothing is impossible. The industry was dead wrong in its economic assumptions—but nothing is impossible with careful structural consideration.

11 Responses to “Mandatory Mortgage Modifications and the U.S. Constitution”

GuestNovember 18th, 2008 at 10:32 am

Excellent comprehensive post. I hope Mr. Alpert has a direct line to the new administration. This plan would be a deal changer if implemented in a timely fashion. My fear is that it seems that the powers at be seem content to put out fires, rather than create pro active strategies such as this.

JohnRyskampNovember 18th, 2008 at 12:41 pm

This is just ridiculous and shows the cloddish dunderheadedness of our Constitutional “scholars.” The problem now is that these financial instruments have been sliced into so many parts that you can’t find the “owner” in order to impose this scheme.Funny, this clown wants this program for owner-occupied residences only. Gee, sounds like he thinks housing is important. Oh really? Important enough to raise its level of scrutiny above Lindsey v. Normet? See? I know the law too, you dolt, and I know you are a police state monkey.And if housing is so important, what about rental housing? Not a word about this.This is a fat, self-satisfied pig writing his little self-satisfied nostrums for a world which does not exist. Clown!Hey clown, want a REAL education? Just read my book, The Eminent Domain Revolt.

AnonymousNovember 18th, 2008 at 8:18 pm

America has decided to let everyone live at the lowest common denominator. If your idealistic world of living in your Mcmansion is now crumbling around you then it is most assuredly your fault. We are at a point where the more successful or the more wise decisions you make, the more you are required to help those who are lazy and make poor decisions. Bailing out the reckless homeowners is just another example of encouraging those who make poor decisions and milk the system to do so at the expense of us who are responsible and do what is right, and fair. America is saying that if you have screwed up we’re going to help you out and let you off the hook. Better yet, the worse the decision, the more you benefit!This obsession by our leaders to keep homeowners in their home will mark the end of whatever is left in this country resembling prudence and morality. I support saving all homeowners not just the irresponsible 3 million living in Mcmansions.Congress and Sheila Bair’s obsession with this spend-only bailout rewards the reckless and punishes the prudent. Consider the lesson it imparts to promote bailouts to the reckless. City by city, neighborhood by neighborhood, people who live beneath their means and manage money carefully will see more careless neighbors supported by federal decree. And what about the 30 percent of this nation who were smart enough to rent? Or how about the large percentage of us who gave plenty of warnings to these same people the government now wants to redistribute my taxes to so they can stay in a house twice the size the home I live in. The backlash to the 700 B bailout package was not only because of the bailout of wall street but also the bailout of the reckless homeowners and their relentless ATM / HELOC spending. As it is now these people can live in their home for over a year rent free while they find a home they should have been living in from the start.We are becoming a nation of people who feel it is not only okay but justified to cheat, lie, and swindle each other and the rest of the population. Personal responsibility is discouraged by the government and the mainstream media. Our nation is eating ourselves from within just to keep a facade of prosperity. Hope is being replaced by anger and desperation. Welcome to the new dawn.

GuestNovember 18th, 2008 at 9:15 pm

Not mentioning humongous moral hazards other people spoke about, this is a suggestion for government to come and force some new deal that Sheila Bair and Daniel Alpert or Nancy Pelosi and Barney Frank happen to like at the moment onto parties of a private contract. It will ruin not just public market financing of homes and securitisation in the future, but endangers trust in US business laws in general by any investor or business.Less important point is that similarly to great HOPE project, it wouldn’t work for many reasons. Basically, who is going to take care of the property when you make homeowners become renters? Noone, when things like that were done, collateral quickly halved in value — renters don’t care about homes. Borrowers whose loans were modified redefaulted in 50-60% cases historically. This rate of redefault is just average, it is much higher for large LTV loans and other bad loans author wants to tackle so heroically. This experience was in the healthy raising home market without a year of overhang of home inventory and foreclosures. This was also done not for subprime borrowers and overextended McManson owners, but for conforming loan borrowers.This looks stupid, costly, useless, potentially dangerous. This just might cut it for the US government.

Bruce KrausNovember 18th, 2008 at 9:51 pm

Control of mortgage pools is indeed key to the vital National Housing Workout, and gaining that control involves understanding which tranches of securities have the voting rights, and gaining control over them. As I wrote here http://www.pionline.com/apps/pbcs.dll/article?AID=/20081013/PRINTSUB/310139983 some time ago, the Treasury should lever its TARP clout to add the votes of the institutions it’s assisting to its own, which will go a long way to accomplishing the needed restructuring without running afoul of the “takings” clause of the US Constitution. Every institution receiving assistance should give the Treasury a proxy over its voting of all mortgage securities it owns to approve restructurings of the kinds banks are approving for mortgages they own directly. The proxy should run with the security, and should also apply to mortgage securities the institution acquires later.

AnonymousNovember 19th, 2008 at 10:10 am

I am a landlord (18yrs), lied to, no pays,vacancy without reason.Now in a negative situation. I am notlazy, also 30yrs at my factory. I am an American investor! When times are good, it’s good.IT’s now, not worth the fight anymore.Surrender is the only way.Is there a light at the end of the tunnel? How bright is it?Our great country is being bled out to places like China.In 20yrs what’s left.I’ll survive.

GuestJanuary 15th, 2009 at 8:42 am

Just another “feel good, let everyone win” fuzzy math scenario. I know the author realizes the Big Brother implications this nightmare scenario would bring, but it makes me wonder why he would bother to think it, let alone print it. God forbid someone from Obama’s admin or the Congress would read it and give it a thought. All of us need to be clear about this. We are in this mess now BECAUSE government has been in the lending process. This only exacerbates the problem and encourages government control over our lives. Government SHOULD NOT BE involved in lending. Period. End of story. Not their job. It’s not even Constitutional.We are in a terrible mess. More government control / participation is not the answer.

AnonymousMarch 2nd, 2009 at 12:59 pm

It is estimated that it could benefit 3 to 4 million homeowners from the new modification procedures. So how do you qualify for the Mortgage Modification? Check the website http://mortgagemodificationprogram.blogspot.comto see if you qualify. I was in trouble I am glad I did check it before I talk to my mortgage company and it worked – John Mayer, California

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