Housing Market Must Swallow Bitter Pill To Address Negative Equity

by devteam July 19th, 2012 | Share

A Georgetown law professor is proposingrnthat a Resolution Trust Corporation (RTC) like entity might be the key torngetting the housing market back on track.  rnIn Clearing the Mortgage Market through Principal Reduction:  A Bad Bank for Housing (RTC 2.0) Adam J. Levitinrnconsiders ways in which negative equity problems might be addressed andrnassesses the feasibility of using a “bad bank” entity for pooling andrnstandardized restructuring and resecuritization of underwater mortgages.  This is the first of two MND articlesrnsummarizing the paper which Levitin wrote for The Big Picture, a Wall Street oriented blog.</p

Levitin says that the housing market isrnnot clearing and has not since at least 2008 and possibly 2006.  He defines “clearing” as a climate in whichrnwilling buyers and willing sellers are able to meet on a price.  One reason for this failure is negativernequity which currently affects 27.1 percent of all residential mortgages.  The average negative equity is $65,000,rnconsiderably greater than the average household disposable income of $49,777.  “The depth of negative equity,” Levitin says,rn”is likely to increase as housing prices drop” due to foreclosures and lack ofrnupkeep on properties where homeowners see no upside to further spending.  Negative equity impedes clearing because evenrnwhere buyer and seller are able to meet on a price they often cannot close therndeal because the seller cannot pay the additional $65,000. </p

At the heart of the problem then is thatrnmortgages, unlike houses, are not marked to market but are carried at bookrnvalue.  If they were marked to market</bthey would track home values but a change in accounting is unlikely andrnill-advised so we must look to other ways of clearing the market.  To date there has been only one – foreclosure,rna method that is slow, inefficient and rife with negative externalities onrnneighbors, communities, and local governments. rnForeclosures can also result in over-clearing.  For various reasons the market for distressedrnproperties is thin, bids are heavily discounted, and market prices are drivenrneven lower.</p

Market clearing is not just a housingrnproblem; it is dragging down the whole economy, diminishing household demandrnand casting a liability that is weighing down the financial sector.  Until the market clears financialrninstitutions will continue to have unrecognized losses and will be carryingrnassets at inflated values beyond their loss reserves.   Continued litigation over servicing andrnsecuritization issues present further uncertainties.</p

Levitin said that while not every dollarrnof the $700 billion in negative equity needs to be eliminated, substantialrninroads must be made so any approach to clearing the market must havernsufficient scope, even at the expense of compromising on other factors.  “Without an overriding macro-economic impact goal,rnprincipal reductions will result in little more than charity toward arnpopulation of more-or-less deserving borrowers.”  In addition the problem is not withrnunderwater and defaulted loans – which will eventually clear through foreclosure,rnbut underwater and performing loans, a much vaster universe.</p

Levitin sees five major approaches torndealing with negative equity.  The firstrnis to do nothing based on the idea that doing something is costly and hasrnuncertain benefit; maybe negative equity will go away on its own.  Doing nothing lets financial institutionsrndelay or possibly avoid loss recognition, continue collecting servicing incomernand write off losses against earnings over time.</p

The second strategy is to concentrate onrnmaking mortgages more affordable while keeping principal balances intact.  Mortgage modifications and refinancing arernexamples of this and have been the routes largely followed by financialrninstitutions and the government.</p

The rationale for the affordabilityrnstrategy is two-fold.  First,rnforeclosures for affordability reasons are prevented and second, increasingrnaffordability makes it less likely that homeowners will strategically defaultrnon underwater properties.  Affordability,rnhowever, only clears the market indirectly. rnBy avoiding foreclosures some downward pressure on housing markets isrneliminated but the negative equity may still result in foreclosures or distressrnsales triggered by life-cycle events like death or divorce.</p

The third strategy is voluntaryrnprincipal reduction.  Some of this has occurredrnbut as the exception rather than the rule. rnTheir conservator has expressly forbidden Fannie Mae and Freddie Macrnfrom reducing principal making a large segment of the market simply ineligible.</p

Even among non-GSE mortgages principalrnreduction is rare.  Out of more than arnmillion HAMP permanent modifications only 51,732 (through March 2012) haverninvolved principal reduction and OCC reports that principal reductions accountrnfor only 5 percent of modifications among institutions it regulates.  OCC says reductions are much more likely tornbe undertaken on portfolio loans than on private-label securitized loans; 20.2rnpercent of portfolio loan modifications between 2009-2011 involved principalrnreduction compared to 3.1 percent of private-label securitized loans.</p

Among the reasons for the scarcity are arnlack of capacity on the part of servicers, communication problems betweenrnborrower and servicer, legal constraints because of pooling and servicing agreements,rnthe constantly shifting requirements of the HAMP program, complication fromrnsecond liens, and the desire to delay or avoid loss recognition.  Principal reductions, if done en masse couldrnraise capital adequacy issues for some lenders. rnOther constraints are a reduction in servicing income via a reduction inrnprincipal volume and what Levitin describes as a free-riding problem.  Any one lender or servicer has loans that arernso geographically dispersed that large scale reductions would be unlikely tornunfreeze the market enough to offset the costs of a single lender whilernbenefiting many who do not participate.   Only with several large servicers acting inrnconcert would any one of them achieve sufficient benefits. </p

The final factor that impedes voluntary principalrnreductions is moral hazard, namely that reducing principal on defaulted loansrncould encourage borrowers who are paying as agreed to default to obtain thernsame benefit.  Levitin said it is notrnclear how much this concern has actually prevented reductions and how much is arnrhetorical device to shift attention away from some of the other factors.</p

Even though low, the numbers of principalrnreductions still overstate their impact. rnWhile principal may be forgiven, Letivin said that borrowers are almostrnnever put into positive equity because that would enable refinancing and thernloss of income to the servicer. In short, voluntary principal reductions arernrare and of questionable impact in terms of reducing defaults and while therernare several options to improving them such as more generous incentive paymentsrnto servicers (something which subsequently has happened), or if politicalrnpressure should reverse the decision and allow the GSEs to participate in thernHAMP principal reduction program, it isn’t clear if these would producernreductions of the number and amount to help clear the market.</p

Short sales would have a similar effectrnon clearing the market as principal reduction but the event sequencingrndifferences are important.  In a shortrnsale the principal forgiveness occurs only when a short sale is in processrnwhereas a modification can occur at any time. rnIf lenders are slow or stingy in dealing with a short sale offer it canrnchill future transactions.</p

Several factors mitigate against shortrnsales.  First such a sale forces thernlender to immediately recognize loss even if it is not certain that loss wouldrnultimately occur without the sale. rnSecond, lenders are concerned about collusion between buyer and sellerrnand third, the presence of a second lien on the property makes a short sale (asrnwell as voluntary principal reduction) “a non-starter.”</p

Finally, to the method Letivin isrnespousing for clearing the market, involuntary principal reductions.  He sees two major approaches to these.  The first is a bankruptcy “cramdown” in whichrna judge can unilaterally reduce the principal balance to more closely match thernactual value of the home.  Whilerncramdowns are permitted for second or vacation homes, they are currentlyrnprohibited for primary residences and a change would require Congressionalrnaction.  Cramdown is appealing in that itrndeals with negative equity, offers impartial judicial valuation, addressesrnmoral hazard concerns by requiring bankruptcy and its costs, and could bernlimited by a cut-off date.  It alsornoffers a judicial airing of all claims and defenses to the mortgage and createsrnincentives for voluntary principal reductions in the face of bankruptcy.  It has, however, been politically charged andrnCongress appears to have little appetite to revisit the subject.</p

The second method is through therngovernment’s eminent domain “taking power.” rnThis would, in theory, allow the federal government to “take” allrnunderwater mortgages by paying their owners the market value of the mortgagesrnwhich might not match the property value but would be much closer than thernunpaid mortgage balance.  Eminent domainrnrequires “just compensation” for the taking and mortgagees could alwaysrnlitigate over whether the compensation was just but that would not impinge onrnthe government’s ability to take the property only the cost of doing so.  Having taken the mortgages, the governmentrncould then reduce the principal balances to that “just” price and either managernthe restructured mortgages itself or resecuritize them with or without arnguarantee.  </p

While a “takings” approach isrntheoretically possible (and is under serious discussion by two localrngovernments in California) it would be an unprecedented use of a power whichrnhas traditionally been used for physical rather than financial assets.  Therefore there is some question about itsrnConstitutionality.</p

Constitutional or not, it would havernproblems not the least of which is its cost. rnIt would also impose a huge operational burden on the government andrnwould, most importantly, entail significant political risk.  Eminent domain is never popular and its usernin such a context might be extremely unpopular politically.</p

Finally there is the option ofrnnegotiated principal reductions.  Thesernwould be semi-voluntary with the reductions done by mortgagees but in the facernof litigation or in response to pressure from regulators.  Negotiation would be with the regulator orrnlitigant rather than with individual homeowners.</p

There are two variants to this.  The reductions could be achieved as part of arnlitigation settlement, possibly following suit by state attorneys generalrnagainst large financial institutions including the GSEs.  Alternatively the federal government could forcernparticipation in principal reductions by leveraging the ability to do FHArnlending or do business with the GSEs. rnSimilarly Treasury could make its continued support of the GSEsrncontingent on both the GSEs and its customers participating.  Levitin said his point is not to name thernlevers that government might use in accomplishing this, merely to point outrnthat there are levers if there is political will.</p

In a second article we will summarizernthe transactional framework that Letivin suggests for structuring a massive principalrnreduction effort. 

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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