$700 billion question: fate of bad loans

Debate rages around Treasury plan

By Matt Carter, Monday, September 22, 2008.
Inman News

The Bush administration's plan to allow the Treasury Department to buy up to $700 billion in troubled mortgage-related assets could help thaw the credit crunch by helping big financial firms move bad loans off their books.

But critics of the plan want the government to provide more protections for taxpayers and help for individuals struggling with their mortgage payments -- goals that may be inherently contradictory.

The battle that's shaping up in Congress over the plan isn't expected to derail it, but the debate over its particulars could complicate or delay its implementation, as lawmakers must authorize the issuance of the Treasury securities that would finance it.

While the plan put forward by Treasury Secretary Henry Paulson on Saturday seems simple enough on its face, the details of how it is implemented could have profound implications for the hardest-hit housing markets and the plan's ultimate cost to taxpayers.

Once taxpayers are in charge of these assets, will troubled borrowers be more likely to get loan modifications or workouts to keep them in their homes? If the government becomes the owner of hundreds of thousands of foreclosed homes, will it sell them quickly at fire-sale prices to investors, or more gradually over time to earn a better return?

While there is general agreement that the government must take action to keep the financial system functioning, the question then becomes: What happens next?

"You save the banking system, now what are you going to do with all this distressed property?" said Dennis Hedlund, president and founder of the mortgage market forecasting firm iEmergent.
As detailed by Paulson, the plan envisions that the mortgage-related assets Treasury buys would be managed by private managers "to meet program objectives."

If the government creates aggressive objectives to keep people in their homes -- by forgiving some of the principal on their loans, for instance -- "that could very quickly solve a lot of problems" in housing markets where prices continue to fall, Hedlund said. But that approach would mean larger losses up front, and perhaps a bigger bill for taxpayers in the long run.

"If the government does more modest workouts and hopes home values sort of correct themselves, there's a danger home prices would continue to fall, and this could really stretch out," Hedlund said. "It's really a question of how fast do you want to get it over with? The faster you want to get it over with, the more the government will foot the bill, so there will be political pressure not to do that."

Hedlund said a less aggressive approach at preserving home ownership could have a "devastating" impact on 50 to 60 urban areas, and rural communities with large numbers of moderate-income homeowners.

"My opinion is that the recovery back to normal lending patterns and purchase trends easily could be five years," Hedlund said. "This thing could go on forever, especially if nothing happens to (check the decline in) home prices."

In an e-mail to clients, K&L Gates attorney Larry Platt noted that Treasury has not spelled out any requirement to seek to preserve home ownership or otherwise deal with foreclosures and loss mitigation, "which is one of the biggest criticisms leveled at the plan by the Democrats. That doesn't mean that Treasury will not implement an ambitious loan modification program; it just means that (as proposed Saturday) Treasury does not have to do so."

During the savings and loan crisis, the Resolution Trust Corp. disposed of assets over a period of four years, said Donald Kelly, a spokesman for real estate valuation company Zaio Inc.
Kelly said commentators are suggesting that the Treasury would buy troubled assets at a discount, but with the design of managing them with a possibility of a positive return for the government down the road.

"There is a real sense of urgency, in the financial markets, within the administration, and in Congress," Kelly said in an e-mail. "One thing is clear: Decisive action must be taken and taken soon. Postponing a solution will only cause additional instability. From what I have seen, FHA and the secondary market players are ready to continue operations now, but to some extent it is conditional as everyone awaits the details of the financial stability package."
Many securities are being valued at pennies on the dollar due to the very high leverage ratio and illiquidity of some mortgage-backed securities, National Association of Realtors President Richard Gaylord said in a statement.

"Unrealistically low valuations are paralyzing the balance sheets of financial institutions and have hindered liquidity flow," Gaylord said, urging Congress to take action to "stabilize financial markets to allow rational valuation of assets, expedite refinancing and relief efforts for homeowners, and ... reestablish a level of confidence in the housing credit markets."

Some Democrats and consumer groups see the Paulson plan as an opportunity to push through new restrictions on lenders and help for borrowers that didn't make it into HR 3221 -- the sweeping housing bill signed into law on July 30 -- or other recent housing legislation.

The Center for Responsible Lending, for example, has renewed a push for Congress to allow bankruptcy judges to rewrite the terms of troubled borrowers' mortgages -- an idea that has the support of presidential candidate Barack Obama. The lending industry has opposed granting judges such power, saying it would worsen the credit crunch by undermining investors' confidence in mortgage-backed securities.

The center maintains that judicial modifications -- derided as "cramdowns" by industry critics -- would save 600,000 homes from foreclosure, while the Paulson plan to buy mortgage-related assets would save none.

"Only by preventing the 6.5 million foreclosures expected in the next few years -- and the $356 billion drop in surrounding property values that will result for an additional 46 million families -- will the economy begin to recover," the center said in a statement.

Rep. Henry A. Waxman, the California Democrat who chairs the House Committee on Oversight and Government Reform, expressed "serious reservations" about the Paulson plan in a statement, saying it "appears designed to maximize returns for Wall Street and minimize protections for the taxpayer."

The Mortgage Bankers Association said resurrecting bankruptcy cramdowns would be "wholly unproductive" and "runs counter to the bipartisan efforts to restore liquidity to the global capital markets." The issue is irrelevant, the group said in a statement, because once the Treasury buys distressed mortgages, it can write down loan balances itself, without Congress giving bankruptcy judges that authority.

Senate Banking Committee Chairman Chris Dodd, D-Conn., today released Democrats' proposed changes to the Treasury plan, which include granting bankruptcy judges the power to modify mortgages.

"After a year of efforts to get servicers and lenders to modify loans, the industry's voluntary HOPE Now program has fallen far short of what is needed," Dodd said in a statement posted on the Banking Committee's Web site.

Dodd's proposal would allow the Treasury Department to buy a wide range of troubled assets but would require it to hand over mortgage loans and mortgage-backed securities to the Federal Deposit Insurance Corp. (FDIC) for management.

The FDIC, Dodd said, "has shown a commitment to modifying mortgages both to ensure long-term affordability and to protect the taxpayer. The FDIC estimate performing loans are worth about 87 percent of their face value, while nonperforming loans are worth only about 36 percent of par. "Modifying loans to ensure affordability increases the value of the loans," Dodd said.

Democrats will also push for looser criteria for the Federal Housing Administration's HOPE for Homeowners loan guarantee program, which was authorized at $300 billion in HR 3221
Supporters of the Paulson plan say that without quick government intervention, the financial system is in danger of collapse. Keeping investment dollars flowing into mortgage lending will eventually help slow the decline in home prices in some markets, they say.

In a statement, President Bush acknowledged there will be differences over some details of the plan, "and we will have to work through them. That is an understandable part of the policy-making process. But it would not be understandable if members of Congress sought to use this emergency legislation to pass unrelated provisions, or to insist on provisions that would undermine the effectiveness of the plan."

As Congress kicks off a week of debate -- Dodd's Senate Banking Committee will hear from Paulson and Federal Reserve Chairman Ben Bernanke Tuesday, and the House Financial Services Committee has scheduled a hearing for Wednesday -- lawmakers will also be looking for clarification on details of the plan that are, for the moment, unclear.

In his e-mail to clients, Washington, D.C.-based K&L Gates attorney Platt outlined some important issues still to be resolved, such as what assets Treasury would be authorized to buy.
The Treasury Department has defined "mortgage-related assets" as "residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages" originated or issued on or before Sept. 17.

Platt said Treasury appears to be preparing to buy loans regardless of priority of the lien or the purpose of the loan -- meaning investor loans would be eligible. While it doesn't look like credit default swaps or other "synthetic instruments" tied to performance of mortgage pools would be included in the plan, "the phrase 'related to' could encompass a wide array of instruments that bear some indirect relationship to mortgage loans," Platt said. "We'll have to see."