Let’s be clear: The heart of the underlying problem now facing Wall Street is the growing number of troubled home mortgages. A bailout plan for Wall Street that does not address the problem mortgages that have led to frozen markets in mortgage-backed securities and their numerous derivatives will ultimately be far less successful—not to mention far less fair to the average homeowner or taxpayer—than one that addresses the problem from the get-go.
Under the plan proposed by U.S. Treasury Secretary Henry Paulson, the Treasury would have very limited ability to gain control of troubled mortgages. Instead, they would buy “troubled assets,” which will be largely residential and commercial mortgage-backed securities and their derivatives held by many financial institutions. Under legislative drafts circulating currently, it also could include any other financial instrument in any sector.
Taking these securities off the books of struggling institutions may stabilize Wall Street for a period of time, which is the prime focus of Treasury. Treasury argues that the broad authority to buy up these troubled assets will have benefits that will trickle down to Main Street in the form of restored liquidity for making mortgages and other credit available. But without control of the mortgages themselves, the plan won’t work.
Under the Paulson plan, Treasury would just be another investor in a pool of loans, stymied by the same conflicts of interest and barriers to loan modifications that have plagued all prior efforts to modify loans to avoid unnecessary foreclosures. While Treasury may try to exhort the servicers to restructure the loans to sustainable levels and prevent foreclosure, they are in no better place to do so under the Paulson plan than under the current voluntary Hope Now Alliance, which Secretary Paulson unveiled with great fanfare but little follow-up earlier this year. Mortgage servicers of the mortgage-backed securities lack financial incentives to help homeowners, fear liability problems if they do so, and face the conflicting interests of various groups of investors that have effectively blocked any serious modification efforts.
This is why the Center for American Progress supports several proposals that return the focus to the underlying cause of the economic spiral: unsustainable mortgages and escalating foreclosures that are dragging down home values, adding to the inflated supply of homes for sale, and sucking wealth from the American economy. These proposals would keep families in their homes, thus also protecting the home equity of their neighbors and communities. Taken together, these proposals would constitute a serious plan for dealing with the root cause of the crisis. Specifically, our plan includes:
The draft version of the legislation under consideration in the House of Representatives today includes judicial modifications for mortgages on primary homes under bankruptcy. While investment properties and second homes have long been able to be adjusted under bankruptcy, current law precludes modification of loans on primary residences. The Center believes that as a matter of fairness, the bankruptcy laws should be modified to allow these modifications to be made. In the context of the current crisis, moreover, we believe providing borrowers with the opportunity to seek relief in Chapter 13 bankruptcy can be an important incentive to bring servicers to negotiate modifications with borrowers at risk of losing their homes.
Treasury purchase of mortgages, loan pools, and servicing rights
This current proposal also takes the perspective that helping homeowners in trouble will have a positive effect on local housing markets and Wall Street, and it can be done quickly at scale. Under the various drafts of the bill now being circulated through Congress, Treasury would have the authority to purchase not only securities tied to residential and commercial mortgages but "any other financial instrument" deemed necessary. In contrast, our plan calls upon Treasury to limit its purchases primarily to mortgages, loan pools, and servicing rights. After acquiring the rights to the mortgages, Treasury would triage them to determine which are current and which are delinquent.
Current loans would be sold to Wall Street in new securities, which could be bought with the liquidity provided by the initial sale, while the delinquent mortgages would be analyzed and restructured to match the borrowers’ capacity to repay. Those that cannot be made to be sustainable would proceed toward foreclosure. But the many additional homes would be prevented from falling into foreclosure. Treasury would then resell the restructured mortgages back to Wall Street with a guaranty and make money on the difference between the steeply discounted purchase price of the non-performing mortgage and the price of the new, sustainable mortgage. This process would keep many borrowers in their homes while providing greater certainty to Wall Street by eliminating troubled securities and replacing them with far less risky ones.
Getting mortgage servicers to participate
In order to encourage participation in the Treasury program, some have suggested banning investor lawsuits or indemnifying mortgages servicers for participating. In both cases, the cost to the government could be substantial. In the first, investors could potentially bring a takings claim for the value of the lost right to sue for breach of their pooling and services agreements, or PSAs, with investors. In the latter, indemnification could make the taxpayers liable for any damages awarded to investors by participating servicers. While neither solution gets directly at the underlying problems in the conflicted structures of PSA contracts and incentives, they do provide some legal breathing room for servicers to begin making modifications.
The Center believes an optimal solution to the issue of servicer participation is a modification of Real Estate Mortgage Investment Conduit laws and an exception for program participants from certain accounting standards. Under CAP’s proposal, REMIC status would be denied to any trust holding these securitized assets whose instruments block sales of mortgages or pools into the program. Similarly, we propose a fix to accounting rule, FAS 140, so participation does not blow up the Qualified Special Purpose Entity, or QSPE, tax status of these trusts.
Under the REMIC fix proposed by CAP, the government is merely changing the tax code, which it does all the time without paying any compensation. While there may be lawsuits, we believe the government would be in a very strong position to win such suits and not have to pay any compensation at all.
Andrew Jakabovics is Associate Director of the Economic Mobility Program at the Center for American Progress. For more detail on our solutions to the financial crisis and our analysis of the problems, please go to the Housing page of our website.