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Next Steps to Resolve the Mortgage Crisis

SOURCE: AP/Haraz N. Ghanbari

Federal Deposit Insurance Corp. Chairwoman Sheila Bair reviews her notes on Capitol Hill on Sept. 17, 2008. The FDIC has led the way in seeking to end the housing crisis, and Treasury could contract with the FDIC in restructuring efforts.

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There is bipartisan agreement today that stemming home foreclosures and restructuring troubled mortgages would slow the downward spiral harming financial institutions and the real American economy. The federal government possesses a range of tools to take action, but what’s missing is a way to persuade the mortgage servicers who control most of these loans on behalf of investors in mortgage-backed securities to restructure the loans themselves or sell the loans to the Department of the Treasury at a discount so these loans can be refinanced.

To date, Treasury’s efforts have failed. Owing a duty to countless investors with conflicting interests, servicers are paralyzed by fear of liability, restrictive tax and accounting rules, and the wrong financial incentives. What’s more, contracts typically bar servicers from selling underlying mortgage loans out of the loan pools that make up mortgage-backed securities. Instead, servicers are foreclosing at alarming rates, dragging down our economy with them.

We need new legislation to unlock the securitization trusts that govern mortgage-backed securities so that servicers have the authority they need to sell loans to Treasury at a steep discount. Treasury can then restructure them, include a shared equity feature to protect taxpayers, issue new federal guarantees on the restructured loans, and sell them back into the market—helping homeowners and restoring liquidity and stability to our markets.

Until Congress acts, however, Treasury can get the ball rolling today with the existing tools it must wield to slow foreclosures. Here’s how:

Guarantee home mortgages in exchange for real restructuring. Treasury can offer to guarantee troubled loans held by servicers in portfolios or trusts if they make principal write-downs to bring loan-to-value and debt-to-income ratios in line with prudent underwriting. The guarantee on restructured loans would provide a new tool for servicers to act in the investors’ best interests in modifying troubled loans.

Pay servicers to restructure loans. Servicers get paid by the securitization trusts for the extra work of foreclosing on homes but generally get little or nothing for successful loan modifications. Treasury could pay servicers to make loan modifications that meet Treasury loan-to-value and debt-to-income guidelines.

Let the Federal Deposit Insurance Corporation act now. The FDIC has led the way in seeking to end the housing crisis, and has demonstrated its expertise in loan restructuring when acting as receiver of failed banks. Treasury could contract with FDIC to run loan guarantee and restructuring efforts now.

Enlist Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac should be engaged systematically to refinance troubled mortgages according to standard criteria and should transparently report on their efforts on loans held in portfolio or in securitization trusts.

Bolster the Federal Housing Administration. The administration should dramatically increase the staffing, administrative, and technical support necessary to ensure FHA can play a strong role alongside Fannie Mae and Freddie Mac, the Federal Home Loan Banks, Treasury, and the FDIC in restructuring troubled loans.

New legislation for broad-scale mortgage restructuring

In addition to these immediate steps, Congress needs to pass legislation to unlock securitization trusts and take other key steps to encourage the broad restructuring of troubled mortgages. Since January of last year, the Center for American Progress has been arguing for the creation of a modern-day Home Owners Loan Corporation, which helped American homeowners out of the Great Depression. That can work today, but to do so we need to provide mortgage servicers with the legal means and incentives to sell mortgage loans to Treasury out of the securitized pools and loan portfolios so that the loans can be restructured.

Congress added provisions to the October financial rescue bill to require Treasury to use its new authority under the legislation to exhort servicers toward more loan restructurings, but we need to free servicers from the conflicting requirements and give them an incentive to sell mortgages to Treasury for refinancing and foreclosure avoidance. Here’s how it would work.

Preserve tax benefits. Servicers managing pools of loans for investors are generally barred by contract from selling the underlying mortgage loans, but the trust agreements also generally provide that servicers must amend the agreements if doing so would be helpful or necessary to stay in compliance with tax rules under the Real Estate Mortgage Investment Conduit statute and related laws. REMIC provides important benefits for these securitization trusts and their investors. We propose to modify the REMIC rules to ensure that servicers have the authority and incentive to sell the mortgages to Treasury.

Legislation would provide that REMIC benefits would be denied going forward if the securitization’s contract provisions have the effect of barring servicers from selling or restructuring loans under Treasury’s programs. Servicers would have a legal obligation to their investors to modify the agreements to stay in compliance. Servicers could then sell loans to Treasury for restructuring. Participation in the Treasury program would remain voluntary, but the key legal impediments to participation would be removed.

Indemnify servicers. Legislation could provide a narrowly tailored indemnification for servicers who reasonably pursue loan modifications or sales under Treasury programs.

Provide legal certainty under accounting standards. Because selling home mortgage loans to Treasury would advance important public interests and not conflict with the underlying purposes of the Financial Accounting Standards Board’s Statement 140, which provides accounting rules governing qualified special purpose entities such as certain mortgage-backed securitization trusts. FASB should modify Statement 140 to provide servicers with further legal comfort in broadly modifying and selling mortgage loans under Treasury’s mortgage restructuring programs.

Authorize judicial modifications in bankruptcy.Legislation should provide bankruptcy judges with the authority to modify home mortgages under circumstances in which the homeowner’s income is insufficient to cover mortgage payments. Mortgage loans could be reduced to the current value of the property.

Pause foreclosures. While the administration is putting these systems in place, it could seek a pause in foreclosures in order to provide time for the programs to work.

It will be crucial over the next three months for our government to tackle the housing crisis so that the many measures already taken to alleviate the global financial crisis can take hold. Taking steps that federal agencies are already authorized to make under existing law to restructure troubled mortgages, followed by swift congressional action to unlock mortgage securitizations and permit broad-scale restructuring, would enable the federal government to get at the root cause of the financial crisis swiftly and surely.

Michael S. Barr is a Senior Fellow at the Center for American Progress. For more information on the Center’s proposals to tackle the home mortgage crisis please go to the Housing page of our website.

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