How to Modify Securitized Mortgages

By James Kwak

Amidst the gallons of ink spilt, here and elsewhere, over the nationalization debate, the AIG collateral payments, and the AIG bonuses, I neglected to comment on the details of the new housing plan, which were released on March 4. When the initial plan was announced in February, I was concerned about the seeming lack of any provision that would enable servicers of securitized mortgages to modify those mortgages without being sued by the investors who bought the securities. (In brief, the problem is that the pooling and servicing agreements (PSAs) that govern those securitizations may not allow loan modifications, or may require the servicer to gain the consent of all of the investors, which is practically impossible.) People who know housing better than I said there was something in there.

If it is, I still can’t find it in the March 4 documents (fact sheet, guidelines, modification guidelines). In any case, an important question is whether the plan will do enough to encourage servicers to modify securitized mortgages, as opposed to mortgages they own. “A New Proposal for Loan Modifications,” a short (13-page) paper by Christopher Mayer, Edward Morrison, and Tomasz Piskorski that will appear in the next issue of the Yale Journal on Regulation, describes the problem clearly and makes three proposals to solve it. (A longer version with appendices is available here.)

The problem, as described in Part 1, is that servicers for securitized mortgages do not have the incentive to maximize the economic value of the mortgages, but rather to maximize their servicing fees and avoid lawsuits from investors, which leads them to foreclose in situations where a servicer that owned the whole mortgage would make a modification. To get around this, they propose three things:

1. Incentive fees to servicers of 10% of all payments made on securitized mortgages, in order to provide them with the incentive to maximize the stream of mortgage payments.
2. Compensation to lenders of second liens, in effect paying them not to hold up a loan modification.
3. New legislation protecting servicers from lawsuits by their investors.

The last proposal raises the issue of the Takings Clause of the Fifth Amendment, “nor shall private property be taken for public use, without just compensation,” which could be interpreted to mean that legislation affecting the rights of investors in mortgage securities is unconstitutional. The authors make an argument, complete with multiple Supreme Court citations, that that interpretation would not be correct in this case. (The Takings Clause is implicated by other policy issues raised by the crisis, such as the recent legislation to impose punitive taxes on bonuses.)

The administration’s housing plan, as far as I can tell, provides a different form of #1 (flat cash incentives for modifications, rather than incentives based on the stream of payments), and some form of #2, but doesn’t directly address #3. (By the way, if you’re interested in the mechanics of how loan payments will be reduced, it’s on pp. 3-8 of these guidelines.)

Comments

[John Lounsbury:]

Excellent article. It just makes me shake my head to see how the complex structure of securitized debt has created disincentives for efficient work-outs. The fact that incentives to maximize return for a system (borrowers, lenders and investors) now must be legislated shows just how ill-conceived the entire process is. Allowed to continue to run without intervention, the current situation would enrich no one but attorneys.

The fact that legislation is now being proposed to mitigate the log-jam is disturbing, not only because the cause of the log-jam should not have been allowed to get out of control, but also because most legislation has unintended consequences. How many more problems will be created to be sorted out later?

Mar 22 02:17 PM