February 1, 2011

Can Bankruptcy Courts Limit Homeowner and Investor Losses?

Testimony before the U.S. Senate Judiciary Committee
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One of the objectives of government loan modification programs is home preservation. Home preservation is achieved when loan modifications are used to keep borrowers in their home. The desire to keep borrowers in their home must make economic sense to both the investor and servicer.

There is a movement to provide homeowner relief by allowing bankruptcy courts to force the borrower and servicer to into attempting to mediate a solution. The servicer would be required to make a good faith effort at offering a loan modification; whether good faith requires the servicer to be willing to modify the loan may be an open question under this legislation.

We already have HAMP and individual lender/servicer programs in place; do we really want yet another variation of HAMP (through bankruptcy courts)? While legislation mandating mediation between the parties sounds benign, there are several serious problems with this approach to the loan modification problem.

First, having a mandatory mediation assumes that a borrower would be better-off in their home as an owner than as a renter. Given the prevalence of negative equity and the large supply of vacant and rentable property in the country, it is highly likely that many borrowers would be better off renting. Homeownership is expensive and not for everyone since it has always been a risky investment. Just based on tax reasons, many households are in a very low marginal tax rate already; hence, the interest and property tax deduction is thrown away or valued at a low rate. Renting is more efficient in terms of taxation. When you combine the tax disincentives with the risk of homeownership, borrowers would often be better-off renting and getting a fresh start.

As Raphael Bostic, HUD’s Assistant Secretary for Policy Development and Research, stated in a recent Washington Post interview,

"In previous eras, we haven't seen people question whether homeownership was the right decision. It was just assumed that's where you want to go. You're not going to hear us say that."

Second, a mandatory mediation adds additional costs and delays to the process, a process that is already severely strained. The average time to liquidation of a house averages 17 months already (costing the investor/lender lost interest and asset value declines). If bankruptcy becomes more appealing to borrowers because of the mandatory mediation, we would expect rather onerous delays in moving borrowers to foreclosure. Furthermore, the mandatory modification may result in borrowers bypassing HAMP (or lender/servicer programs) and go directly into bankruptcy.

Third, Fannie Mae and Freddie Mac, the mortgage giants, have expansive data bases and models regarding the likelihood of a borrower surviving with a loan modification. If Fannie Mae and Freddie Mac are having trouble with serious delinquencies and foreclosures, what are the odds that a bankruptcy court can intervene with a sensible loan modification solution that Fannie/Freddie couldn’t direct its servicers to accomplish?

Fourth, any requirement of mediation between a borrower and the servicer must be made explicit when the mortgage loan is originated and the securities are created. As of now, there is no understanding by borrowers or investors that mandatory mediation in bankruptcy is required, or that it is even possible. This represents another “surprise” to investors and other market participants which is almost always viewed negatively. Creating more surprises may further decrease interest in mortgage-market investment, resulting in less available mortgage credit and higher interest rates.

Finally, while mediation may result in more loan modifications being made, we know that the failure rate on loan modifications is about 50%. And this could be higher if house prices continue to be soft and unemployment doesn’t improve. Stated differently, if the standards for getting a loan modification are lowered, the more likely it is that the failure rate for loan modifications would increase.

In summary, the housing market needs to recover and persistent attempts at delaying foreclosure (whether through mediation or moratorium) only adds additional uncertainty to the housing market and slows any recovery.

I suggest that lenders/servicers continue their efforts to offer sensible loan modification programs. Mediation in Chapter 13 could cannibalize HAMP and private market attempts at loan modifications. And we need to reconsider that policy of keeping borrowers in their homes if it does not make economic sense to any of the parties involved.

Thank you for your willingness to let me share my thoughts with you.