Servicing Mortgages (Part 1): Underwater Homeowners, Banks and Social Trust

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Steve Waldman of Interfluidity has an interview up at mortgage calculator where he discusses, among many other things, his statement: “I think that the moral thing for most borrowers to do, under present circumstances, is to default on loans when it is in their financial interest to do so.” You should check it out.

There’s a lot of arguments for “strategic defaults” which we will leave to the side for right now. The counter-argument is that lending has an element of “social trust” norms build into it, a trust that isn’t easy to replicate and once broken it is very difficult to rebuild. The small, difficult to quantify but ever present, elements of these norms are what form the glue of many of our credit markets. Lenders trust borrowers, and borrowers can trust lenders, and this takes the rough edges off the credit market.

Recap: we have a problem where many homeowners, maybe one out of four, are underwater, which means they owe more than their home is worth. Many others, with 18% underemployment and loan resets, are having trouble making their monthly payments. Being underwater is very correlated with defaulting on a loan, and foreclosures destroy value for the house itself and has an externality destroying value for neighbors.

Meanwhile there’s also an agency problem that has exploded: as we discussed last summer, mortgage backed securities were never designed to handle large numbers of write-downs; as the inventor Lewis Ranieri warned for years, nobody has a fiduciary responsibility to make sure principal gets written down in mortgage backed securities. For normal mortgages at a regular bank you writedown before your foreclosure; but none of the gee-whiz financial engineers stopped to think how you’d do that in a mortgage backed security.

Because of all these problems, the Obama administration decided to start a program called the federal Home Affordable Modification Program (HAMP) last year. Long story short, we subsidize banks who make adjustments to the amount people pay per month. Obama is doing this do this because of the externality of waves of foreclosures, the threat of abandoned neighborhoods and to “nudge” the servicer of the loan, who have a twisted incentive to get paid through fees as things get worse for investors, to do the right thing.

Underwater and Social Trust

I think we can quantify this trust thing a little bit. Let’s get into the meat of a new report issued by the State Foreclosure Prevention Working Group: Analysis of Mortgage Servicing Performance (pdf) (h/t Shahien Nasiripour for the pointer).

Remember there are two problems: too much of a loan principal that is underwater, and too high of a payment. Most agree that the first is the bigger problem for both parties, but the second is easier to modify, politically, from the point of view of the government. Now people (including myself) thought it would be great if banks would decrease the principal of the loans they are modifying in addition to the payment, which would reduce the risks of default and help get mortgage prices to adjust quicker, but they could instead just leave them the same. That’s their choice. But given that the borrower is going out of their way to try and make the payments, it would be a nice social trust kind of thing to reduce the principal slightly instead of leaving it the same, right?

So what has happened? From Analysis of Mortgage Servicing Performance, more than 70% of the modifications resulted in an increase in the loan balance. Not staying the same, and certainly not decreasing, but piling on more principal for the loan ():

I’ve seen a lot of bad things during this financial crisis, but this is the most disgusting thing I’ve seen so far. At a time when one out of four homeowners are underwater, banks are using a mortgage modification program to pile on more debt on these loans. They do this even though it’s well known there's a correlation between the level of being underwater and default.

How? From the report:

Servicers routinely capitalize delinquent interest, corporate advances, escrow advances and attorney fees and other foreclosure-related fees and expenses into the loan balance when completing a loan modification.

So fees allow them to make it look like they are doing their clients a favor, while all they are really doing is running them in a big circle.

(If any risk quants or people who work in this area want to contact me, I can keep it completely off the record, but wtf? Is this a statistical juking? This has to increase the redefault risk, but is there a way that this makes the numbers in the medium term look better on expected values? Is this the servicers going completely rogue? Or is this simply profit maximization as sociopathic behavior? One can’t simply “nudge” a sociopath….)

And for the social trust argument, these are not random people. These are people who, instead of walking away from their responsibilities, are burning time, money and energy to credibly signal to the bank: “I’m in over my head with this mortgage but I want to do right by it because it’s an obligation I made to you. Instead of simply walking away or trying to short sell, is there any way we can work this out so I can still pay you whatever I can? I gave you my word and that means something to me.” And the bank uses their signal that they want to do the right thing to fuck these borrowers the hardest, piling on as much debt as possible on these guys as they can get away with. The borrowers are trying to come up from the pool to get a breath of air, and the bank grabs them by the head and pushes them as far underwater as they can get them. And we are subsidizing this.

Though I shouldn’t be too surprised. I mentioned before when it came to the walking-away problem simple game theory tells us, “If you are convinced that the other party will cooperate with you no matter what (i.e. never walk away), that’s when you fuck them over the hardest (or more politely, that’s when you ‘don’t co-operate’). It’s only through the threat of non-cooperation that you can actually secure cooperation.” So the people who really want to meet their obligations are the ones you screw with as much principal as possible, and the ones who threaten to walk away are the ones you have to take seriously. If we had mortgage cramdowns, everyone would suddenly be someone the banks would have to take seriously in these situation, instead of a mark who still believes in things other than profit maximization…

(Part Two here)