Rational Mortgage Restructuring

A Citizen’s Proposal to Facilitate 
Rational Mortgage Restructuring

An Open Letter to:
Timothy Geithner – US Treasury Secretary

Issued & Delivered February 17, 2009

From its inception TARP (the Troubled Asset “Recovery” Program) has actually been an investor “Relief” program.  Responding to a crisis triggered by valuation uncertainty, the process was purportedly intended to stabilize lending markets by getting toxic assets off of banks’ balance sheets, a solution which could only work if the assets were transferred out at prices in excess of their intrinsic value.  Forcing prompt transactions on hard to value, highly illiquid, assets can have only two possible outcomes; either it forces distillation of losses at the current depressed values, accelerating and exacerbating insolvencies, or it transfers losses from the current holder to the buyer – in this case the Treasury and American public – thereby “relieving” investors of the costs of their mistakes.

It should have been focused on mitigating the underlying financial problems while allowing the investor community the flexibility to hold the “toxic assets” long enough to establish and/or realize their fundamental value.

In implementation, the first round of TARP actually was more rational than in conception.  The Treasury allowed Lehman, who was apparently so weak that new funds would have simply been poured into a black hole, to fail, and shifted its attention to infusing preferred capital investments into the stronger banks – assuming that increased liquidity would jump-start the credit markets while providing time for securitization values to stabilize.  It did help increase total liquidity, but unfortunately had far less impact on unfreezing credit markets than expected.

One reason why it did not have the anticipated impact is that the primary attention remains on the trading values of the distressed securities – not the fundamentals of their underlying collateral and loans, and therefore has not significantly changed the valuation of these troubled assets.  A second is that most of the investment community is focused upon how much of the trillion-plus dollars of anticipated future government spending can be siphoned off into their own pockets.  As long as the investment community can expect the government to either step in and absorb more private losses or facilitate the transfer of assets at a discount, private capital will sit on the sidelines and banks will remain reluctant to lend into an accelerating recession and continuing asset valuation declines.

Current discussions re: round two of TARP and its potential alternatives now center around  two options, both still skewed toward shifting private losses to the public coffers;  1) the original concept of government purchase (or guarantee) of “toxic assets”, or  2) forced, mass write-downs of mortgage balances with the government sharing the write-downs.  I believe both of these options are misguided.

The U.S. Government should not be absorbing or guaranteeing investor losses.  It should not be buying or making bad loans.  It should not be deferring foreclosures or propping up inflated real-estate values.  (Remember, the irrational inflation of median home prices vs median income was a key source of the underlying problem and deferring unavoidable foreclosures inflates losses for both lenders and borrowers.)  The Government should not be forcing mass loan write-downs or kick-the-can temporary debt restructurings from its vantage point at 30,000 feet.  It should, however, be facilitating rapid resolution of the fundamental imbalances between collateral values, loan balances, and ability to pay which form the core of the problem.  The problem cannot be fixed by manipulating securitization values, but must be addressed through the under-lying mortgage problems.  The objective should be resolution and mitigation of the underlying mortgage defaults.

PROPOSAL:

The Government should facilitate resolution of underlying mortgage problems by providing a source of cheap mortgage re-financing based on strict underwriting standards.  Fannie, Freddie and the entire Sub-Prime Mortgage Industry did not get into trouble because they loaned money to Bad People.  They got into trouble because they loaned too much money and ignored sound credit practices.  These careless practices generated enormous origination profits but are now inflicting pain upon both investors and borrowers.  The problem was created by the utilization of complex securitizations which disconnected both the originators and the lenders-at-risk from the underlying collateral.  Bailing out holders of these ill-conceived and destructive securitizations is not an appropriate course of action.  Mitigating damages to both borrowers and investors by providing a stable source of refinancing is a far superior approach.

The excesses and errors of past practices must be eliminated.  But until someone steps up to provide a source of refinancing with which to resolve the underlying problems, the crisis will only accelerate.  Homeowners caught up in these problems have had their credit ruined and are currently unable to obtain financing of any kind – even if they have stable incomes which could support debt financing at lower levels.

The Treasury should offer a Government Sponsored Re-Finance Mortgage program of “GSRM” loans, 30 year fixed 4% to 5% mortgages, on sound credit standards – with fixed payments capped at somewhere between 28% and 34% of verified income.  GSRM loans should be made available to any borrower who believes the fair market value of his owner/occupied primary residence is less than the value of its mortgage; loan proceeds to be used to restructure and settle both their pre-existing mortgages and any outstanding high-interest credit card debt – which has typically also been stretched to unsupportable levels.

Applicants seeking to re-finance under this program would offer a loan repurchase proposal to their existing mortgage holder with said offer subject to either prompt acceptance or a prompt, orderly and consensual foreclosure sale at absolute auction.  Proceeds from the GSRM could be supplemented by the homeowner either with equity or debt, but any supplemental debt must be subordinated to the GSRM with cash interest not to exceed 5% and no principal repayments until the GSRM is repaid in full.  Proceeds from the GSRM and any supplemental re-financing must be used to retire all outstanding mortgage liens and any outstanding credit card debt.  (There is no point in restructuring a mortgage without restructuring any high interest consumer debt held by the borrower at the same time.)

If the Mortgagee declines the GSRM repurchase offer and opts for a foreclosure auction, the existing homeowner shall have the right to use the GSRM and qualified supplemental financing to bid at the auction.

If the Mortgagee accepts the GSRM backed refinance offer or the existing homeowner prevails at the auction and retires the loan at a discount, Mortgagee shall be granted a secured interest in one-half of any equity appreciation realized by the homeowner upon eventual resale of the home.  If the Mortgagee opts to decline the GSRM offer and a party other than the original homeowner prevails at auction, then the Mortgagee shall waive its right to pursue any deficiencies against the original borrower (absent fraud on the part of the borrower).  To the extent a Mortgagee may have been induced by and relied upon borrower assets other than the home as justification for granting the loan, a Mortgagee appeal process should probably be instituted to allow Mortgage holders to petition against incurring inappropriate forced write-downs.

It should be noted that a potential obstacle to this proposal is that many securitization agreements make it difficult to identify the “mortgagee” or find anyone with authority to “accept” a restructuring or discount repurchase offer.   Reluctance or lack of authority on the part of mortgage servicers to act on behalf of mortgagees is one of the reasons recent proposals aimed at facilitating mortgage restructurings have thus far failed to gain much traction.  One benefit of this GSRM proposal is that it puts control of the process clearly in the hands of the homeowner.  If a homeowner can trigger a foreclosure sale by setting forth a GSRM backed minimum bid – it establishes a fast track to a fair market value restructuring.

I anticipate the primary outcry against a proposal of this nature will be a fear that it will depress rather than support real estate values.  Regretfully, all I can say is – it’s painful and unfortunate, but unavoidable.  The fundamental problem has been artificial inflation of real estate values.  Government policies erred in placing the goal of home ownership above that of affordable housing and were complicit in driving the unsustainable inflation of real estate values.  A reduction in both the cost of purchase and the carrying costs of home mortgages would provide a societal benefit.  Over-heating the economy by leaving real estate prices out of reported inflation numbers and encouraging consumers to borrow against artificial “equity” in their homes has proven to be an unsustainable model for growth.  The benefits of lower costs of living should provide some compensation for the decline of this fictional home equity.  If it is coupled with and constrained by sound credit practices, the availability of affordable mortgage borrowing will guide market valuations to a fair equilibrium.

A second complaint could be concern that this program invites the discounted refinancing of mortgages that would and should otherwise continue to perform.  I don’t believe it will.  Few homeowners will willingly put their homes at risk by submitting them to an absolute auction and cede the rights to 50% of any future appreciation, unless they are truly already at risk and significantly underwater.

The third outcry would likely be its costs and inflationary impact.  Here I have two replies.  First, the inflationary impact of making good loans is certainly far less than that of absorbing other people’s losses.  Second, I would strongly urge that Government backed mortgage assets be held in trust as property of the social security fund.  The liabilities are already there.  We just pretend that they’re not.  I concede the government will indeed print money to fund the program.  But it will receive assets in return, and the liabilities that are the real source of inflationary pressure already exist in the social security obligations, we will simply be moving them onto the Treasury’s balance sheet.

Every dollar of mortgage debt repaid will create new liquidity in the financial markets.  If the Treasury writes $300 billion dollars in sound credit-worthy GSRM loans, it will not only resolve the underlying mortgage problems for the related borrowers and illuminate the valuation uncertainties for the corresponding securitizations, it will infuse $300 billion back into circulation – all of which will need to be reinvested, and some of which will find its way back into treasury notes, helping to finance the program.  Therefore, I believe that the positive benefits of a program like this would be greater, and the net inflationary pressure would be less, than under any other alternative funding mechanism.

The primary downside I see is that it will certainly disappoint those members of the investment community who are salivating over the prospect of converting substantial portions of the anticipated government deficits directly into their private profits.

To the best of my knowledge, very little of what I have set forward above has received any public discussion or consideration.  I would welcome a dialogue or discussion on the concepts set forth.

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As perspective – the author of the proceeding proposal has spent most of his life being studiously a-political.  He has provided turnaround and crisis management consulting services to middle market companies for over thirty years, including the workout of a large mortgage portfolio in the 1980’s, and is co-author of “Crafting Solutions for Troubled Businesses”, published by BeardBooks.

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