Subprime Mortgage Crisis in California and the Nation: Broader Changes Needed from Industry and Policymakers

The push towards more systematic modifications has been led by Federal Deposit Insurance Corporation Chair Sheila Bair who has called on mortgage lenders, servicers and investors to voluntarily rewrite the millions of the nation’s subprime loans that are poised to reset to levels borrowers cannot afford to repay. [Sheila C. Bair, “Fix Rates to Save Loans.” The New York Times, October 19, 2007] Ms. Bair would like to see these adjustable-rate mortgages converted to fixed-rate loans at the lower (but still risk-adjusted and profitable) initial rate for the remaining term of the loan. Subprime borrowers “need a better deal,” Ms. Bair wrote in The New York Times, “One that they can afford.”

Other federal regulators (the Federal Reserve, and the Office of Thrift Supervision) have also endorsed this approach, or a more cautious but still systematic approach to modifications. In an unusual stroke, the editorial pages of both the New York Times and the more conservative Wall Street Journal have both signed on to the Bair plan:

“Yes, the banks would have to accept a lower income stream, but that's better than taking the write-off from a foreclosure. As many as a million borrowers nationwide might benefit from such treatment, and for hundreds of thousands it could mean keeping their home. We understand the delicacy of asking banks to rewrite their contracts, which is why Ms. Bair says this should be voluntary. But if there’s a case of enlightened business self-interest, this is probably it.” [“Mortgage Meltdown,” Wall Street Journal, October 24, 2007; Page A20 (emphasis added)]

California Governor Takes Positive Step to Providing Accountability for Systematic Modifications

In an unprecedented move, Gov. Arnold Schwarzenegger announced on Nov. 20 an agreement with four lender/servicers—Countrywide, Litton, GMAC and HomeEq—to begin instituting streamlined, fast-track procedures to help keep more borrowers in their homes for a sustainable period of time. This is the first time that individual lenders have agreed to a Bair-like systematic approach. The governor’s announcement holds promise in part because it will be enforced by regular data collection and monitoring by the state Department of Corporations. Hopefully more lenders here in California and across the nation will adopt this approach.

What Will Break the Logjam?

The biggest question before us today is what kinds of pressures will be sufficient to pry open the modification floodgates. There are a few possibilities:

• Data collection and reporting: The regular public reporting of data from all servicers will be critical to hold them accountable for their results in offering affordable modifications. There are several groups now vying to develop standard metrics: an ad hoc group of state Attorneys General, the Hope Now Initiative led by U.S. Secretary Paulson, and some individual state regulators like the California Department of Corporations. Much like the Home Mortgage Disclosure Act provided a new level of transparency to home mortgage lending patterns, the quick development of a reliable database to track servicer-specific loss mitigation activities is essential. With such data, it will be impossible for lenders to hide behind hollow promises of wide-scale loan modifications.

• Tilting financial incentives toward modifications and away from foreclosure: Another strategy for generating more modifications would be for states to change the foreclosure process to make foreclosures more expensive, and thereby less frequent. Such provisions could include new disclosure and notification requirements for lenders or extending the time frame for the foreclosure process.

Mandatory loss mitigation: Another procedural change that would shift the balance toward loan modification is the establishment of mandatory loss mitigation efforts before foreclosure. The federal regulators have issued a call to lenders and servicers to engage in loss mitigation efforts prior to pursuing foreclosure. More concrete steps are needed, however. To adequately stem the tide of foreclosures Congress should act to require specific loss mitigation efforts prior to any foreclosure filing and establish that failure to provide such loss mitigation can be used as an affirmative defense against foreclosure. Legislation such as Senator Reed’s Homeownership Protection and Enhancement Act (S.1386) is a step in the right direction, as it would make important inroads into foreclosure prevention by creating an affirmative duty for lenders and servicers to engage in loss mitigation efforts prior to foreclosure.

• Continued political and public pressure for change: While there do not appear to be easy legal avenues for compelling systematic loan modifications, continued and growing public and political pressure on servicers and investors to adopt wholesale approaches to loan modifications is essential. We have seen great progress from both regulators and senior administration officials of late in seeking more systematic approaches. Keeping political pressure on is likely to be necessary.

Tweak Federal Bankruptcy Code to Protect Troubled Homeowners
Loan modifications, while the best solution for a fair number of borrowers, may not be appropriate for large numbers of others. For those borrowers with no hope of staying in their home, a simple tweak to the federal bankruptcy code could provide them with much-needed relief.

Current federal law excludes homeowners from Chapter 13 bankruptcy protections that are readily available to owners of vacation beachfront property. People who own investment properties, vacation homes and boats are allowed to get loan modifications as part of debt relief, but the law specifically excludes homeowners from similar protections. Urgently needed is federal legislation that would allow lenders and loan servicers to modify mortgages to permit families to continue paying on their loans and keep their home. This would provide judges the authority to modify harmful mortgages marketed by subprime lenders in recent years, and would help more than 600,000 financially-troubled families remain in their homes.

Further, amending the bankruptcy code has a number of additional benefits:

• It will cost the U.S. Treasury nothing.

• It narrowly targets families who would otherwise lose their homes.

• It saves American families not facing foreclosure $72.5 billion in wealth by avoiding 600,000 foreclosures by their neighbors. [Families lose 1.14% of their own house’s value for every foreclosure that occurs on their block. Woodstock Institute, “There Goes the Neighborhood: The Effect of Single-Family Mortgage Foreclosures on Property Values,” June 2005, . Median house value of $212,000 * 1.14% * 50 houses/block = $121,000 cost/foreclosure * 600,000 avoided = $72.5 billion saved.]

Is there any possible downside to saving 600,000 U.S. homes from foreclosure?

In fact, there is no evidence that such a step would significantly raise the cost of mortgage credit, disrupt secondary markets, or lead to substantial abuses. Given that the total cost of foreclosure is much greater than that associated with a Chapter 13 bankruptcy, there is no reason to believe that the cost of mortgage credit across all mortgage loan products should rise. Indeed, the cost of mortgage credit to prime borrowers may decline. It is unlikely that secondary markets will be materially impacted, as other consumer loans that already have similar protection in Chapter 13 have well functioning secondary markets. The residential mortgage securities market will go through substantial changes in response to the recent financial shock and will easily adjust to the new rules. Abuses should also be limited given that a workout in Chapter 13 is a very costly process for borrowers.

Conclusion

Today we are seeing massive disruptions in the financial markets following years of reckless lending on subprime mortgages. This issue has been prominent in the media recently, but the problems are not new. For years, housing analysts and many policymakers have known that most predatory lending occurs in the subprime market, and that subprime loans too often lead to foreclosure rather than sustainable ownership.

Indeed, the subprime lending system has failed millions of middle-class families—families who were trying to do everything right: working hard at their jobs; taking care of their children; and seeking a more secure future. Now these very same families are on the verge of losing any semblance of security, and we will all be worse off as a result.

Loan modifications—and a willingness on the part of lenders and servicers to offer them to borrowers—are sorely needed to help mitigate the tremendous losses that will befall homeowners, communities and economies if foreclosures continue to mount. Prescriptive solutions like systematic loan modifications are needed for borrowers in crisis at this moment.

While we look to provide immediate relief to the hundreds of thousands of subprime borrowers currently at risk of losing their homes to foreclosure, we must not forget that this crisis could have been averted. Policymakers must continue to work to implement solutions and standards that will bring responsibility and accountability back to the mortgage marketplace through legislative or regulatory means, or both. Without systemic changes to the ways loans originate, we run the risk of re-living this foreclosure nightmare.

We strongly urge you to adopt and support our recommended actions to protect homeowners and promote sustainable home ownership.

For more articles in the California Progress Report, please visit our Responsible Lending topic.