Clearing the Mortgage Market

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CLEARING THE MORTGAGE MARKET THROUGH PRINCIPAL REDUCTION:

ABAD BANK FOR HOUSING (RTC2.0)

ADAM J.LEVITIN

Abstract

This paper examination of why mortgage markets have not clearedsince the bursting of the housing bubble. It considers the range of possiblemarket clearing strategies and presents a proposal for clearing the marketvia negotiated, quasi-voluntary principal reduction using a privately-fundedResolution Trust Corporation style entity (RTC 2.0) for pooling andstandardized restructuring and resecuritization of underwater mortgages.Such an RTC 2.0 would provide a framework for implementing quasi-voluntary principal reductions in the context of a litigation or regulatory

settlement or the federal governments exercise of its secondary marketpower to exclude non-compliant financial institutions from FHA insuranceor access to the GSE market.

I. The Negative Equity Problem ........................................................................................ 1II. Making Market Clear .................................................................................................... 5

A. Do Nothing ................................................................................................................ 5B. Affordability .............................................................................................................. 6C. Voluntary Principal Reductions ................................................................................ 6

1. The Dearth of Voluntary Principal Reductions ..................................................... 62. Reasons for the Lack of Voluntary Principal Reductions ...................................... 83. The Dearth of Short Sales .................................................................................... 124. Reasons for the Lack of Short Sales .................................................................... 12

D. Involuntary Principal Reductions............................................................................ 13E. Negotiated Principal Reductions ............................................................................. 14

III. A Transactional Framework ...................................................................................... 15A. Loss Allocation ........................................................................................................ 15B. Basic Principles of Principal Reduction .................................................................. 16C. The Bad Bank Model .............................................................................................. 16

IV. RTC2........................................................................................................................... 18A. A New RTC ............................................................................................................ 18B. Transfer Mechanisms for Addressing Varied Loan Ownership ............................... 18C. Transfer Pricing and Funding ................................................................................... 20D. Management and Operations ................................................................................... 21

Conclusion ........................................................................................................................ 22

Professor of Law, Georgetown University Law Center. [email protected].
mailto:[email protected]:[email protected]:[email protected]


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2012, Adam J. LevitinThe research and conclusions expressed in this paper are those of the author(s)and do not necessarily reflect the views of Pew, its management or its Board.

1

CLEARING THE MORTGAGE MARKET THROUGH PRINCIPAL REDUCTION:

ABAD BANK FOR HOUSING (RTC2.0)

U.S. housing prices peaked in March 2006. Since then they have fallen 34%,1 anda further 9%-10% decline is predicted.2 Despite this precipitous fall in housing prices,the market has still not cleared, meaning that willing buyers and willing sellers arefrequently unable to meet on a price.

This paper examines why mortgage markets have failed to clear, particularly theproblems created by negative equity. The paper considers ways in which the negativeequity problem might be addressed and then turns to assessment of the feasibility of usinga bad bank entity for pooling and standardized restructuring and resecuritization ofunderwater mortgages.

The idea animating this paper is that restructuring is a superior method forclearing the mortgage market than foreclosures and that doing so could also alleviate theliability overhang affecting the banking sector and which threatens another $80 billion inlosses over the next three years.3 Whatever the tradeoffs between restructuring andforeclosure in the case of an individual loan, when viewed from a macroeconomicperspective, large numbers of foreclosures present a serious problem due to their negativeexternalities. Large scale reduction of negative equity is necessary for clearing housingmarkets. Principal reductions to date have been limited and proposed expansions ofexisting principal reduction programs are too modest and too slow to havemacroeconomic effects. Instead, a framework is needed for a large scale, one-timeresolution of the United States negative equity problem. Use ofbad bank provides atransactional framework for such resolution that would avoid some of the problemscurrently impeding restructuring efforts. A bad bank for housing also offers a cleanbreak from the mortgage legacy issues that continue to weigh on the financial sector.

I. THE NEGATIVE EQUITY PROBLEM

The central problem affecting the United States housing market today is that themarket is not clearing and has not since at least 2008, if not since its peak in early 2006.The reason for this is because of the approximately $700 billion in negative equitynationwide.4 Negative equity or near negative equity affects approximately 12.3 million

1 S&P/Case-Shiller Composite 10-CSXR-SA Index.2 Fitch Ratings, U.S. RMBS 3Q11 Sustainable Home Price Projection (predicting a further 9.1%

housing price decline); Kathleen M. Howley, Home Prices Seen Dropping 10% in U.S. on Foreclosures:Mortgages, BLOOMBERG, Apr. 3, 2012 (citing RealtyTracs prediction of 10% drop in home prices).

3 Ryan Schuette, Fitch: Top 20 Banks May See $80B in Losses, THEMREPORT.COM, Feb. 29,2012.

4 CoreLogic, Corelogic Third Quarter 2011 Negative Equity Data Shows Slight Decline ButRemains Elevated, Nov. 29, 2011, at http://www.corelogic.com/about-us/news/asset_upload_file955_13539.pdf.
http://www.corelogic.com/about-us/news/asset_upload_file955_13539.pdfhttp://www.corelogic.com/about-us/news/asset_upload_file955_13539.pdfhttp://www.corelogic.com/about-us/news/asset_upload_file955_13539.pdfhttp://www.corelogic.com/about-us/news/asset_upload_file955_13539.pdfhttp://www.corelogic.com/about-us/news/asset_upload_file955_13539.pdf


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mortgagees,5 who are in turn 27.1 percent of all residential mortgages.6 The averageunderwater borrower is upside down by $65,000 on a loan with a $256,000 balance,7although there is considerable variation among states (and presumably within states); inCalifornia, the average underwater borrower is upside down by $93,000.8 To put thesefigures in some perspective, the median annual household income in the United States in

2009 was $49,777,

9

meaning that the average amount of negative equity is considerablygreater than most households annual disposable income. The depth of negative equity islikely to increase as housing prices drop due to foreclosure sales and lack of upkeep onunderwater properties by homeowners who see no reason to spend on taking care ofproperties in which they have no equity.

Negative equity matters first and foremost because it prevents the market fromclearing. People need to be able to sell and buy homes. Normal life-cycle eventsnecessitate relocation, meaning both sales and purchases: employment changes, divorce,disability and illness, death, children, etc. These home sales and purchases cannot occur,however, unless the market is clearing.

In a functioning market, willing buyers and willing sellers meet and agree on aprice. When they do the deal, the market clears at the deal price, and welfare is enhancedwhen parties are able to enter into exchanges that they both see as value enhancing.Based on the parties revealed preferences, the exchange is Pareto efficient. The problemwith the housing market, currently, is that even when willing buyers and willing sellerscan agree on a price, they often cannot close the deal because there is a mortgage on theproperty for more than the deal price.

To wit, if someone agrees to buy a house for $200,000, it is impossible to closethe deal if there is a $265,000 mortgage on the house. Virtually every mortgage containsa due-on-sale clause that accelerates the entire debt upon sale.10 Therefore, unless thehomeowner has other resources from which s/he can pay off the difference between the

mortgage debt and the sale price (the deficiency), the mortgage lien would remain onthe house, which would permit the lender for foreclose on the buyerunless the buyer paysoff the remaining $65,000.

In such circumstances, few, if any, people are willing to buy; they would, bydefinition, be overpaying for the house. Put differently, the buyer must pay for both thehouse and the deficiency in order to obtain the house. The result is that even though thebuyer and seller can agree on the value of the house, they cannot complete the dealbecause of the additional cost of the deficiency. Thus, the market does not clear.

The root of this market-clearing problem, then, is that mortgages, unlike houses,

5

Core Logic6Id.7 CoreLogic, supra note 4 (calculations by author, averaging first-lien only and first-line plus

junior lien data).8Id.9 U.S. Census Bureau, at http://quickfacts.census.gov/qfd/states/00000.html. There are good

reasons to believe that median income is based on unreported income, but the basic point remainsnegative equity is still much larger than underwater households income.

10 State prohibitions on due-on-sale clauses were generally preempted by the Garn-St.GermainDepository Institutions Act of 1982, codified at12 U.S.C. 1701j-3.


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are not marked-to-market. Mortgages are usually held-to-maturity assets and thereforecarried at book, rather than market value. Mortgages are therefore only marked-to-market (or carried at fair value) if they are impaired or sold (including in foreclosuresales).11 If mortgages were marked-to-market, mortgage debt would closely track homevalues. A change in the accounting treatment of mortgages is both unlikely and ill

advised; there is no justification for distinct accounting treatment of home mortgage loansfrom other secured loans. Therefore, it is necessary to look to other approaches forclearing the market.

At present, there is only one major way of clearing the housing market:foreclosures.12 Foreclosures, however, are an incredibly slow and inefficient method ofmarket clearing, even in the best of times. Both servicers and judicial systems havelimited bandwidth for processing foreclosures, and in some states, such as Florida these

limits are constraining foreclosure activity.13 Foreclosures are rife with negativeexternalities on neighbors, communities, and local government.14

Foreclosures can also result in the market over-clearing (meaning sales atartificially low prices) because foreclosure sale purchasers have very limited informationabout foreclosure properties and no warranties about the condition of the property;foreclosure sale purchasers (at sheriffs or trustees sales, as opposed to REO sales) haveno right to inspect the property before bidding, so they cannot know the condition of theproperty or often even its layout. This is a particular problem given the poor condition ofmany foreclosure properties. In such an information-poor environment, the market forforeclosure properties is thin and bids are heavily discounted.

Because foreclosure sale properties compete with private, arms-length saleproperties for buyers, they depress real estate prices.15 The result is to diminish theequity of other non-defaulted homeowners, pushing at least some of them into negativeequity and deepening the negative equity of others, thereby exacerbating the market-

clearing problem.At the current pace, it is estimated that there is already a three-year backlog of

some 2.2 million foreclosure properties (and this does not account for another 4.1 milliondelinquent properties), all of which contribute to a shadow inventory that will continueto depress the real estate market.16 In some states, the backlog is even longer,17 as

11 Statement of Financial Accounting Standards (SFAS) 114.12 Short sales are a market clearing mechanism too, but they are frustrated by mortgagee concerns

about buyer-seller collusion, desire to avoid or delay loss recognition, and realtors unwillingness to handleshort sales, which take more time, but frequently do not close, meaning that the realtor does not get paid.

13

Florida has even reactivated retired judges to handle cases. Gretchen Morgenson & GeraldineFabrikant,Floridas High-Speed Answer to a Forelcosure Mess, N.Y.TIMES, Sept. 5, 2010 at BU1.

14 Adam J. Levitin & Tara Twomey,Mortgage Servicing, 28 YALE J. ON REG. 1 (2010).15See, e.g., Atif Mian et al., Foreclosures, House Prices, and the Real Economy, NBER Working

Paper No. 16685, Jan. 2011, athttp://www.nber.org/papers/w16685; John P. Harding, Eric Rosenblatt &Vincent W. Yao, The Contagion Effect of Foreclosed Properties, working paper, July 13, 2009, athttp://www.fhfa.gov/webfiles/15046/website_rosenblatt.pdf.

16 Eric Dash,As Lenders Hold Homes in Foreclosure, Sales are Hurt, N.Y.TIMES, May 22, 2011;Kate Berry, Mortgage Industry Faces Staggering Backlog of Foreclosed HomesFitch,AM.BANKER,Dec. 14, 2011.
http://www.nber.org/papers/w16685http://www.nber.org/papers/w16685http://www.nber.org/papers/w16685http://www.fhfa.gov/webfiles/15046/website_rosenblatt.pdfhttp://www.fhfa.gov/webfiles/15046/website_rosenblatt.pdfhttp://www.fhfa.gov/webfiles/15046/website_rosenblatt.pdfhttp://www.nber.org/papers/w16685


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foreclosure timetables have become extended and then distended with more foreclosuresthan can be handled by the legal infrastructure in judicial foreclosure states and increasedlitigation stemming from mortgage documentation and chain-of-title problems such asrobosigning, MERS, and securitization fails. Nor is it clear that the federal-stateservicing fraud settlement will significantly decrease the backlog.

The market-clearing problem in housing is not an abstraction, and it is not simplya housing market problem. It is the central problem in the U.S. economy. Consumerspending is often estimated at around 70% of GDP;18 while this figure is somewhatoverstated,19 what is clear is that the US is a domestic consumer demand-driveneconomy. Any stagnation or contraction in consumer spending has major effectsthroughout the economy. Even a modest percentage of households contracting theirspending results in an economic slowdown.

As it stands, many households are pulling back on their spending because of theiruncertain financial position. For many households, their major financial assettheirhouseis worth much less than it was six years ago, and in many cases, worth less thanthe debt it secures. Unless households feel more confident in their balance sheets, theywon't go out and spend (and banks won't make them loans to spend). Diminishedconsumer demand means less employment, which itself fuels household economiccontraction in a vicious balance sheet recession cycle.20 Put differently, housing isdragging down the economy, and the economy is in turn dragging down housing.

The housing market also continues to cast a liability overhang that weighs downthe financial sector. Until the housing market clears, financial institutions will continueto have unrecognized losses, and will be carrying assets at inflated values. While lossreserving can offset some of the unrealized losses, reserves cannot be set aside unlesslosses are probable and estimable. This makes loss reserving for performing underwaterloans difficultwhile there will likely be significant losses on some of those loans, when

and how large is unknown. Moreover, continued litigation over securitization and

17See, e.g., Kevin Post, Bottom Lines, Foreclosures in New Jersey Now Take an Average of 849Days, PRESS OF ATLANTIC CITY, Feb. 12, 2011, at http://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.html.

18 See, e.g., Michael Mandel, Consumer Spending Is *Not* 70% of GDP, BloombergBusinessWeek, Aug. 14, 2011, athttp://www.businessweek.com/the_thread/economicsunbound/archives/2009/08/the_retail-impo.html.

19See id.20See Atif Mian & Amir Sufi, How Household Debt Contributes to Unemployment: Mian & Sufi ,

BLOOMBERG, Nov. 16, 2011, at http://www.bloomberg.com/news/2011-11-17/how-household-debt-

contributes-to-job-cuts-commentary-by-mian-and-sufi.html; Atif Mian & Amir Sufi, What Explains HighUnemployment? The Aggregate Demand Channel, working paper, Nov. 2011, athttp://faculty.chicagobooth.edu/amir.sufi/MianSufi_WhatExplainsUnemployment_Nov2011.pdf; AtifMian, Kamalesh Rao, & Amir Sufi, Household Balance Sheets, Consumption, and the Economic Slump,working paper, Nov. 2011,http://faculty.chicagobooth.edu/amir.sufi/MianRaoSufi_EconomicSlump_Nov2011.pdf. But see JamesSurowiecki, The Deleveraging Myth, The New Yorker, Nov. 14, 2011, athttp://www.newyorker.com/talk/financial/2011/11/14/111114ta_talk_surowiecki(arguing that the recessionis driven by a wealth effect, namely a perceived loss of wealth due to housing, rather than from leverageper se).
http://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.htmlhttp://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.htmlhttp://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.htmlhttp://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.htmlhttp://www.businessweek.com/the_thread/economicsunbound/archives/2009/08/the_retail-impo.htmlhttp://www.businessweek.com/the_thread/economicsunbound/archives/2009/08/the_retail-impo.htmlhttp://www.bloomberg.com/news/2011-11-17/how-household-debt-contributes-to-job-cuts-commentary-by-mian-and-sufi.htmlhttp://www.bloomberg.com/news/2011-11-17/how-household-debt-contributes-to-job-cuts-commentary-by-mian-and-sufi.htmlhttp://www.bloomberg.com/news/2011-11-17/how-household-debt-contributes-to-job-cuts-commentary-by-mian-and-sufi.htmlhttp://faculty.chicagobooth.edu/amir.sufi/MianSufi_WhatExplainsUnemployment_Nov2011.pdfhttp://faculty.chicagobooth.edu/amir.sufi/MianSufi_WhatExplainsUnemployment_Nov2011.pdfhttp://faculty.chicagobooth.edu/amir.sufi/MianRaoSufi_EconomicSlump_Nov2011.pdfhttp://faculty.chicagobooth.edu/amir.sufi/MianRaoSufi_EconomicSlump_Nov2011.pdfhttp://www.newyorker.com/talk/financial/2011/11/14/111114ta_talk_surowieckihttp://www.newyorker.com/talk/financial/2011/11/14/111114ta_talk_surowieckihttp://www.newyorker.com/talk/financial/2011/11/14/111114ta_talk_surowieckihttp://faculty.chicagobooth.edu/amir.sufi/MianRaoSufi_EconomicSlump_Nov2011.pdfhttp://faculty.chicagobooth.edu/amir.sufi/MianSufi_WhatExplainsUnemployment_Nov2011.pdfhttp://www.bloomberg.com/news/2011-11-17/how-household-debt-contributes-to-job-cuts-commentary-by-mian-and-sufi.htmlhttp://www.bloomberg.com/news/2011-11-17/how-household-debt-contributes-to-job-cuts-commentary-by-mian-and-sufi.htmlhttp://www.businessweek.com/the_thread/economicsunbound/archives/2009/08/the_retail-impo.htmlhttp://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.htmlhttp://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.htmlhttp://www.pressofatlanticcity.com/business/bottom-lines-foreclosures-in-new-jersey-now-take-an-average/article_cdfa639e-3726-11e0-beaa-001cc4c002e0.html


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servicing practices presents a further liability overhang for the financial sector. Inparticular, Bank of America and Citigroup had book-market valuation gaps of $113billion and $76 billion respectively at the end of the first quarter of 2012.

What this means is that negative equity is a macro-economic problem.Accordingly, it must be approached with an eye to maximizing the scope of any solution.

Not every dollar of the $700 billion in negative equity needs to be eliminated formortgage markets to begin to clear, but considerable inroads must be made. This in turndictates a key feature of any approach to principal reduction for market-clearing: it musthave sufficient scope, even at the expense of compromising on other factors. Without anoverriding macro-economic impact goal, principal reductions will result in little morethan charity toward a population of more-or-less deserving borrowers.

A final important point to understand about the market-clearing problem is that itis nota mortgage default problem per se. The failure of the market to clear will result inelevated mortgage default levels as some homeowners rationally decide to walk-awayfrom underwater properties and as life cycle eventsdeath, disability, divorce,dismissalresult in some unavoidable defaults. When these defaults occur, a foreclosureis likely to follow, which means that the market will clear, even if inefficiently.

The market-clearing problem, however, is one that affects performing loans,rather than defaulted loans. This means that the universe of loans to be targeted is notunderwater anddefaulted (indeed, those may well be lost causes if the loan is seriouslydelinquent), but the much vaster universe of underwater andperforming loans.

II. MAKING MARKET CLEAR

If negative equity is the root cause of the market-clearing problem, then enablingmarket clearing means addressing negative equity. There are five basic approaches to

dealing with negative equity: doing nothing, making mortgages more affordable,voluntary principal reductions, involuntary principal reductions, and quasi-voluntaryprincipal reductions. Each is reviewed in turn below.

A. Do Nothing

The first strategy for dealing with the negative equity problem is to do nothing.The basic idea behind doing nothing is that other routes are costly and have uncertainbenefits, and there is a chance that the negative equity problem will disappear on its ownvia housing price appreciation or inflation or foreclosures.21 It is dubious that either ofthese things will occur in the near future, much less to the degree necessary to make themarket clear. Yet, doing nothing lets financial institutions delay and possibly avoid lossrecognition (which enables greater continued servicing income), enabling losses to berecognized against earnings over time.

21See Stephen Tetreault,Reid Hits Romney on Foreclosures, Las Vegas Review-Journal, Oct. 18,2011, at http://www.lvrj.com/news/reid-hits-romney-on-foreclosures-132106878.html (noting that GOPPresidential candidate Mitt Romney stated that government let the foreclosure process run its course andhit the bottom.).
http://www.lvrj.com/news/reid-hits-romney-on-foreclosures-132106878.htmlhttp://www.lvrj.com/news/reid-hits-romney-on-foreclosures-132106878.htmlhttp://www.lvrj.com/news/reid-hits-romney-on-foreclosures-132106878.html


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B. Affordability

The second strategy is to concentrate on making mortgages more affordablewithout reducing principal owed. This can be done in numerous ways, such as mortgagemodifications or refinancings that lower interest rates or change terms and amortizationschedules to reduce monthly payments. The Home Affordable Refinance Program

(HARP) and most of the modifications undertaken by the Home Affordable ModificationProgram (HAMP) are examples of the affordability strategy.

The idea animating the affordability strategy is two-fold: first, to preventforeclosures due to acute affordability problems, meaning that the homeowner cannotmake the monthly mortgage payments, and second, to discourage jingle mail by makingit less unattractive for homeowners to stay in an underwater property even if they canafford the monthly mortgage payments. Reducing monthly payment obligations via ratereductions and term extensions can obviously address affordability issues in the short-term, if the payment reductions are sufficient (and homeowners total debt loads are afactor in this equation).

Affordability, however, does help markets clear except indirectly. By avoidingsome foreclosures, affordability programs reduce downward price pressure on thehousing market. But even if a mortgage is affordable as modified or refinanced, if thereis negative equity a foreclosure is still likely in the event of a life-cycle event like death,disability, divorce, or dismissal (the four Ds). The result is that foreclosure properties

will still be heavily overrepresented among properties on the market; nationally, as ofApril 2012, over a quarter of sales were either foreclosure sales or short sales.22 In someregions, however, April 2012 distressed sales were as much as 61 percent of sales.23 Asthese sales are heavily discounted from arms-length prices they drive down housingprices overall.24 The high percentage of distressed sales is likely to continue for theforeseeable future given the shadow inventory.

C. Voluntary Principal Reductions

A third approach to market clearing is to rely on mortgagees to act in their self-interest to avoid foreclosures and have the market clear.

1. The Dearth of Voluntary Principal Reductions

Some voluntary principal reduction modifications have occurred, but they havebeen the exception, rather than the rule. The GSEs do not offer principal reduction

22Natl Assoc. of Realtors, News Release, April Existing-Home Sales Up, Prices Rise Again, May22, 2012, at http://www.realtor.org/news-releases/2012/05/april-existing-home-sales-up-prices-rise-again(noting that foreclosures and short sales respectively accounted for 17% and 11% of sales in April 2012,down from a combined 37% a year prior).

23 CalculatedRisk,Sacramento: Percentage of Distressed House Sales increases slightly in April ,CALCULATEDRISKBLOG.COM, May 10, 2012, athttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.html

24 See Natl Assoc. of Realtors, supra note 22 (noting that foreclosures sold for an averagediscount of 21% from market and short sales at an average discount of 14%).
http://www.realtor.org/news-releases/2012/05/april-existing-home-sales-up-prices-rise-againhttp://www.realtor.org/news-releases/2012/05/april-existing-home-sales-up-prices-rise-againhttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.htmlhttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.htmlhttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.htmlhttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.htmlhttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.htmlhttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.htmlhttp://www.calculatedriskblog.com/2012/05/sacramento-percentage-of-distressed.htmlhttp://www.realtor.org/news-releases/2012/05/april-existing-home-sales-up-prices-rise-again


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modifications.25 As a result the majority of mortgages are simply ineligible for principalreduction.26

For non-GSE loans, voluntary principal reductions are also rare. HAMPsPrincipal Reduction Alternative (PRA) requires servicers of non-GSE loans to evaluatethe benefit of principal reduction on mortgages with a loan-to-value ratio of 115% or

greater when evaluating a homeowner for a HAMP first lien modification. 27 PRA doesnot require principal reduction, only evaluation of its benefits. As of March 2012, 51,732principal reductions had been undertaken through the program.28

Similarly, according to the OCCs Mortgage Metrics Reports, national bank

servicers have undertaken only 103,372 principal reduction modifications from 2009-2011.29 This accounts for less than 5% of all mortgage modifications.30 Even voluntaryprincipal deferrals (which may overlap with principal reduction modifications) were rare.From 2009-2011, national bank servicers undertook only 204,126 principal deferrals, or9.8% of all modifications.31

Notably, principal reductions are much more likely to be undertaken on portfolio

loans than on private-label securitized loans. According to OCC Mortgage MetricReports, from 2009-2011, 20.2% of modifications of portfolio loans have involvedprincipal reduction, compared to only 3.1% of modifications of private-label securitizedloans.32

Simply counting the number of modifications in which principal was forgiven,however, is itself an incomplete story that likely overstates the importance of theprincipal reduction modifications undertaken to date. It does not address the qualitativeissue of the modifications. While principal may be forgiven, borrowers are almost neverplaced into positive equity through principal forgiveness, as that would enablerefinancing and the loss of the servicing income stream for the servicer. Instead, negativeequity is typically reduced, not eliminated.

25 OCC Mortgage Metrics Report, Forth Quarter 2011, at 28, athttp://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/mortgage-metrics-2011/mortgage-metrics-q4-2011.pdf.

26 It is unknown what percentage of underwater mortgages are owned or guaranteed by the GSEs.Fannie Maes 2011 Credit Supplement lists 17.9% of loans owned or guaranteed by Fannie Mae asunderwater, with 7.5% of them at above 125% LTV. See Fannie Mae 2011 Credit Supplement, Feb. 29,2012, at http://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/q42011_credit_summary.pdfat 6.

27 U.S. Dept. of Treasury, Making Home Affordable Program Performance Report Through Feb.

2012, at 4.28Id.29 OCC Mortgage Metrics Reports. This figure is derived by adding all principal modifications for

private-label and portfolio loans. It excludes 1,035 erroneously reported principal modifications forAgency loans.

30Id. OCC Mortgage Metrics Reports 2,087,807 from 2009-2011. This figure double countsmultiple modifications of the same loan, so the total number of loans modified is likely smaller than twomillion.

31Id.32Id.
http://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/mortgage-metrics-2011/mortgage-metrics-q4-2011.pdfhttp://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/mortgage-metrics-2011/mortgage-metrics-q4-2011.pdfhttp://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/mortgage-metrics-2011/mortgage-metrics-q4-2011.pdfhttp://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/q42011_credit_summary.pdfhttp://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/q42011_credit_summary.pdfhttp://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/q42011_credit_summary.pdfhttp://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/q42011_credit_summary.pdfhttp://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/q42011_credit_summary.pdfhttp://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/mortgage-metrics-2011/mortgage-metrics-q4-2011.pdfhttp://www.occ.treas.gov/publications/publications-by-type/other-publications-reports/mortgage-metrics-2011/mortgage-metrics-q4-2011.pdf


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Yet a principal reduction only matters in terms of reducing defaults if it puts theborrower in a position where positive equity is foreseeable in the near future; a principalreduction modification that changes a loan from 250% LTV to 175% LTV is unlikely toaffect borrower behavior vis--vis negative equity, although is will make the loan moreaffordable if reamortized. And as long as borrowers are left with any negative equity,

markets will not clear.In short, voluntary principal reductions are rare and of questionable impact

because they have been too modest in their loan forgiveness. To the extent that voluntaryprincipal reductions have occurred to date they are reportedly on primarily deeplyunderwater loans (often payment-option ARMs) or on whole loans that have beenpurchased at a discount with an eye toward restructuring and refinancing.

There are several possibilities for expanded voluntary principal reductions. First,more generous HAMP incentive payments for principal reduction might bear fruit.Second, FHFA might accede to continued political pressure to direct principal writedowns on mortgages owned or guaranteed by the GSEs. Third, as servicers gainexperience with principal reduction modifications, including the 200,000 principalreduction modifications promised by Bank of America,33 they may become morecomfortable with them. Even so, it is not clear whether any of these options wouldproduce voluntary principal reductions of sufficient scope to help clear the housingmarket.

2. Reasons for the Lack of Voluntary Principal Reductions

There are several reasons why voluntary principal reductions have been rare. Itis impossible at this juncture to ascertain which reasons are more or less important, andthe answer may vary by servicer and may have varied over time. Thus, the listing offactors below should not be interpreted as a ranked ordering of importance.

The first factor contributing to the lack of voluntary principal reductionmodifications is a simple capacity issue. Servicers have and may continue to haveinsufficient staffing and systems for handling defaulted loans. Servicing is primarily atransaction processing business, which can be highly automated and involves littlediscretion.34 Loan modification, in contrast, is a personnel intensive business requiringsignificant judgment on behalf of employees.35 While one would have imagined thatpersonnel deficiencies would have been remedied five years into the foreclosure crisis,servicers have little incentive to expand their staffing, as their compensation does notcorrespond with the quality of their loss mitigation. Simply put, servicers are not in theloan modification business and have little interest in getting into this short-term business.Given this, the number of loan modifications that has occurred is in fact surprisingly

high.Second, there continue to be significant problems in coordination and

communication between servicers and homeowners. Sometimes these problems relate to

33 Associated Press, Bank of America: Principal Reduction for 200,000 Homeowners, Mar. 9,2012.

34 Levitin & Twomey, supra note 14, at 25-26.35Id.


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servicers modus operandi, such as using fax as a primary mode of communication; large

servicers receive tens of thousands of pages of fax daily, which makes errors and lostdocuments all but inevitable. Sometimes, however, the communication problems are onthe consumer end, such as consumers to do not respond timely to requests for informationor who submit incomplete information. Either way, there continue to be breakdowns in

servicer-homeowner communications, and the result is to frustrate modifications of allsorts.

Third, legal constraints have limited the number of principal modifications.RMBS pooling and servicing agreements (PSAs) often place limitations on servicersability to undertake loan modifications.36 PSAs rarely prohibit principal modificationsoutright. Instead, they place other limitations on modifications, including the number andfrequency of modifications, and requirements that modifications only be done on loanswhere default is imminent or reasonably foreseeable. More problematic than direct,explicit contractual restrictions on principal modification are more general provisions,such as PSAs that reference the GSEs servicing standards. The GSEs do not currentlypermit principal reductions on loans they own or guarantee. Beyond this, PSAs almost

never explicitly authorize principal reductions. Some servicers point to the lack ofexplicit authorization to explain why they eschew principal reductions.

Fourth, the legal landscape for servicers has been constantly shifting since 2009.Servicers have been required to comply with the provisions of the HAMP program and itsnumerous add-on components and changed rules. Servicers have also been required tocomply with changed GSE servicing standards and to change their procedures in thewake of legal challenges to MERS and various foreclosure practices like robosigning andvarious local mediation programs and court rulings. All of this has required changes inservicers operating procedures and systems, which has distracted servicers time and

attention from loan modifications and generally slowed down loss mitigation.

Fifth, second liens complicate principal reductions. First lien lenders are reluctantto reduce principal without some concessions from second lien lenders. Second lienlenders are often completely out of the money, so the main value of their liens is thepossibility that the borrower will foolishly pay them while defaulting on the first lien andthe holdup value in preventing a refinancing or modification of the first lien. Thus, at thevery least, second liens add a coordination problem that raises transaction costs, and theymay also serve as to disincentivize or even prevent principal reduction modifications.

Sixth, the desire to avoid or delay loss recognition is another factor that may becontributing to the dearth of principal reduction modifications. For loans on banks

books a reduction in interest rates or term extension will change the risk-weighting of theloan (if the modification is done outside of HAMP), but those changes affect future

income statements, rather than the current balance sheet. While a write-down on anindividual residential mortgage loan is immaterial to a bank, if done en masse principalreduction could raise some capital adequacy issues.

For securitized loans, servicers may be reluctant to undertake principalmodifications because a substantial component of their compensationservicing fee

36 See Anna Gelpern & Adam J. Levitin, Rewriting Frankenstein Contracts: WorkoutProhibitions in Residential Mortgage-Backed Securities, 82 S.CAL.L.REV. 1075, 1089-91 (2009).


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incomeis based on the outstanding principal balance of the securitized loan pool.While a reduction in interest rates will result in a smaller payment and thus slightlyreduced float income for the servicer, an equivalent payment reduction from reducingprincipal would result in a much larger reduction in servicing fee income.

A seventh factor that disincentivizes principal reduction modifications is a free-

riding problem. Principal reduction modifications have positive externalities on othernearby homeowners. Those homeowners do not necessarily have mortgages, much lessones serviced by the same servicer as undertook the principal reduction modification.Thus, if the servicer believes that a defaulted loan will re-perform without a principalreduction, there is no incentive for the servicer to reduce principal; a single servicer,acting alone to do large scale principal modification, would be unlikely to unfreeze themortgage market. It would take several large servicers acting in concert. This results in acollective action problem. Moving alone, the servicer faces a free-riding issue, while tomove together requires coordination.

The eighth factor that has impeded principal reduction modifications is servicersconcern about moral hazard, namely that principal reductions for defaulted loans couldencourage other borrowers to default in order to get principal reductions. There is someevidence that consumers will default strategically when loan modifications are contingentupon default.37 It is not clear how much concerns about moral hazard have actuallyprevented principal reductions or whether moral hazard instead serves as a rhetoricaldevice to shift attention away from other factors impeding principal reduction.

There are possibilities for reducing moral hazard, namely not making principalreduction contingent upon default; limiting principal reductions to loans that have alreadydefaulted; making principal reduction contingent upon either future loan performance; orcombining principal reduction with shared appreciation.

All of these factors have complications, however. Servicers are reluctant to

delink principal reduction and default because they see no reason to reduce principal on aperforming loan. While this approach makes a great deal of sense when viewed from aservicers loan-by-loan vantage point, it makes little sense when trying to deal with anational problem of a mortgage market that isnt clearing.

Limiting principal reductions to loans that have already defaulted would eliminatemoral hazard concerns, but it would also limit the systemic benefits of principalreduction. As most underwater loans are not yet in default, it would be only a partialsolution to the problem and it would penalize those homeowners who have managed tokeep making payments despite being underwaterthe good or foolish actors dependingon ones perspective.

Contingent forgiveness forgives principal over time as the loan continues toperform, rather than forgiving it in a lump sum immediately. The appeal of contingentforgiveness is that it is a reward for underwater borrowers to continue paying on their

37 Christopher J. Mayer, Edward R. Morrison, Tomasz Piskorski, & Arit Gupta, MortgageModification and Strategic Behavior: Evidence from a Legal Settlement with Countrywide, Columbia Law& Econ. Working Paper No. 404, May 16, 2011, athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1836451.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1836451http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1836451http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1836451


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mortgage. It also allows losses to be recognized over time. Contingent forgiveness,however, means that market clearing will also be stretched out over time. If a loan isreduced from 150% LTV to 100% LTV over five years (10% LTV reduction per year), itwill take (at least) five years before that property can be marketable. A foreclosure isfaster.

Its important to distinguish contingent forgiveness from deferred principal.Deferred principal is merely a partial deamortization of the loan, with some principaldeferred to a later repayment date. Typically this results in a balloon or bullet payment atthe end of the loan. It does not change how much the borrower owes, so it does not dealwith the problem of negative equity. Instead, it reduces monthly payments for a limitedtime period, followed by a payment shock when the deferred principal comes due.

Share appreciation is, in theory, the most promising method of dealing with moralhazard and with the possibility (that housing prices will uptick noticeably after a principalreduction. To date, lenders have showed little interest in shared appreciationmodifications. The most fundamental reason for this might be that lenders do notanticipate significant appreciation. Moreover, lenders have not generally figured out aworkable shared appreciation modification structure.

For securitized loans, shared appreciation modifications create two separateproblems. First, they change the servicers income stream, which is based primarily on

the unpaid principal balance. The servicer has no way of recapturing the servicing feefrom any shared appreciation, and even if it did, that would be uncertain future income.Second, the uncertain future income stream from shared appreciation shifts value aroundamong investors. Shared appreciation provisions are likely to backload income, whichcan affect the incomes allocation within a securitization structure. It is also not clearwhether the appreciation would be treated as principal or interest; nothing in pooling andservicing agreements contemplates this, yet it matters because securitizations allocate

principal and interest payments in different waterfalls. Thus for securitized loans(private-label and GSE), shared appreciation raises likely insurmountable obstacles.

Absent a binding appraisal mechanism, lenders are only able to capture their shareof appreciation upon the sale of the property. This creates problems for a lender, as theloan can be paid off or refinanced before there is a sale, in which case the lender wouldlose the shared appreciation. Moreover, the tax treatment of shared appreciationmortgages for both homeowners and lenders is uncertain, because it is not clear whetherthe shared appreciation would be treated as debt or equity and if debt as principal orinterest.38 Similar confusion exists in terms of Truth in Lending disclosures: is amodification that adds a shared appreciation component really a refinancing and if so, isthe shared appreciation a finance charge necessitating new disclosures? A shared

appreciation provision might be viewed as a refinancing, rather than a modification,because with sufficient appreciation it could increase a borrowers total liability. If so, it

38 Rev. Rul. 83-51; Andrew Caplin, Thomas Cooley, Noel Cunningham, & Mitchell Engler,Facilitate Shared Appreciation Mortgages to Prevent Housing Crashes and Affordability Crises, BrookingsDiscussion Paper 2008-12, Sept. 2008, athttp://www.brookings.edu/research/papers/2008/09/~/media/Research/Files/Papers/2008/9/mortgages%20caplin/0923_mortgages_caplin.PDF; Andrew Caplin, Thomas Cooley, Noel Cunningham, & MitchellEngler, We Can Keep People In Their Homes, WALL ST.J., Oct. 29, 2008.
http://www.brookings.edu/research/papers/2008/09/~/media/Research/Files/Papers/2008/9/mortgages%20caplin/0923_mortgages_caplin.PDFhttp://www.brookings.edu/research/papers/2008/09/~/media/Research/Files/Papers/2008/9/mortgages%20caplin/0923_mortgages_caplin.PDFhttp://www.brookings.edu/research/papers/2008/09/~/media/Research/Files/Papers/2008/9/mortgages%20caplin/0923_mortgages_caplin.PDFhttp://www.brookings.edu/research/papers/2008/09/~/media/Research/Files/Papers/2008/9/mortgages%20caplin/0923_mortgages_caplin.PDFhttp://www.brookings.edu/research/papers/2008/09/~/media/Research/Files/Papers/2008/9/mortgages%20caplin/0923_mortgages_caplin.PDF


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could raise a variety of issues from the need for Truth in Lending and Real EstateSettlement Procedures Act disclosures to lien priority problems (absent a re-subordination agreement), to title insurance issues. Clarification of tax and TILA statusof shared appreciation modifications might help facilitate shared appreciation mortgages,but unless significant shared appreciation is anticipated, it is unclear how attractive

shared appreciation will ever be to lenders.3. The Dearth of Short Sales

In terms of market clearing, short sales would have a similar effect to principalreduction modifications, although the event sequencing difference between them areimportant. In a short sale, the principal forgiveness occurs only after there is a saleproposed, whereas a modification can occur at any time, and is not contingent on a sale.This difference matters because in a short sale, the transaction is contingent upon thelender forgiving principal, and if lenders are slow or curmudgeonly about approving shortsales, it can chill future transactions. If principal is forgiven before the sale is proposed,then the market clearing (the sale) is separated from the elimination of the obstacle toclearance (principal reduction).

There is limited information on the number of short sales that have occurred.FHFA data indicates that there have been slightly over 300,000 short sales of GSE loansfrom the fourth quarter of 2008 through the first quarter of 2012.39 Relative to thenumber of distressed, underwater properties, during this period, the number is quitesmall. While short sales some do happen, they still appear to be fairly exceptional.

4. Reasons for the Lack of Short Sales

Several factors militate against short sales. First, a short sale requires the lenderto recognize a loss immediately. The lender has no way of knowing if denying the shortsale would result in a default and foreclosure, and even if it would, that would still be

delayed by some months (or even years in some parts of the country). Thus, if thehomeowner is not currently in default, the lender would not otherwise have to take animmediate right down. If a lender is hoping to avoid or delay loss recognition, then shortsales are not appealing.

Second, lenders are concerned about collusive short sale offers in which the buyeris in cahoots with the seller and offers a low-ball price. The seller and buyer have asignificant information advantage over the lender, and the sluggish arms-length, non-foreclosure sales market provides limits comparables for appraisal purposes.Accordingly, lenders may be reluctant to approve short sales lest they give up too muchvalue. Better to take delayed loss recognition and have the confidence in the pricingbased on the sale out of REO after foreclosure.

Third, if there is a junior lien on the property, a short sale is a non-starter. Thejunior lien will remain on the property unless it is paid off. It will also become the seniorlien after the short sale, and the payment obligation will rest on the seller, not the buyer.Accordingly, the buyer will insist on discounting the purchase price by the amount of thejunior lien. This means that the junior lien would get paid off in full, while the senior

39 Federal Housing Finance Agency, Foreclosure Prevention & Refinance Report, Feb. 2012, athttp://www.fhfa.gov/webfiles/23906/Feb2012ForeclosurePrevention.pdfat 3.
http://www.fhfa.gov/webfiles/23906/Feb2012ForeclosurePrevention.pdfhttp://www.fhfa.gov/webfiles/23906/Feb2012ForeclosurePrevention.pdfhttp://www.fhfa.gov/webfiles/23906/Feb2012ForeclosurePrevention.pdf


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would incur a loss. Senior lenders are likely to eschew such sales. Thus, the presence ofsecond liens may frustrate short sales absent coordination between the lenders to allocatethe loan forgiveness among them.

Coordination issues between lienholders have been an issue in general with loanmodification. Even when coordination is possible, it imposes delay. Delay is particularly

likely to frustrate short sales. The additional step in a short sale of getting lenderapproval from a single lender can itself be fatal to a short sale. Buyers are often lookingto close within a finite window of time. They do not want to have an offer outstandingfor months while they (and the seller) wait to get a response from the lender. Similarly,buyers (and sellers) do not want to wait for months to find out if multiple lienholdershave reached an agreement on loss allocation in a short sale.

Because so many short sales get denied, realtors are often reluctant to work onthem. Realtors generally only get paid if a deal closes. Realtors put in the same amountof work (if not more) on a short sale as on a regular sale, but their likelihood of beingpaid is lower in a short sale. Accordingly, some realtors refuse to work on short sales.

D. Involuntary Principal ReductionsThere are two major approaches involuntary principal reductions: either through

bankruptcy (cramdown) or through governmental takings. Cramdown would

necessitate a legislative change to allow modification of single-family principal residencemortgages in bankruptcy, which is currently prohibited.40 Cramdown had severalappeals: it dealt with negative equity; it offered impartial, judicial valuation; it addressedmoral hazard concerns by imposing bankruptcy costs on borrowers and could be limitedto borrowers with mortgages before a cutoff date; it offered a judicial airing of all claimsand defenses to the mortgage; and it created incentives for voluntary principal reductionsin the shadow of bankruptcy.

Cramdown legislation passed the House but failed to achieve cloture in the Senatein 2009.41 Cramdown legislation could take many forms besides that in the failedlegislation, such as changes to make it more standardization of loan restructuring and tooffer offsetting benefits to lenders, such as standardized, accelerated foreclosures on non-viable borrowers.42 Nonetheless, there appears to be little if any appetite in Congress forreopening the debate; a second attempt to move cramdown legislation in the House in2010 failed as Democratic leadership permitted Blue Dogs to vote freely, knowing thatpassage in the Senate was unlikely. The Blue Dogs, under reelection pressure, votedagainst the legislation. Together with Republican votes in opposition, this doomedcramdown legislation.

40 See Adam J. Levitin, Resolving the Foreclosure Crisis: Modification of Mortgages inBankruptcy, 2009 WISC.L.REV. 565 (2009).

41 S. 896, The Helping Families Save Their Homes Act of 2009 (111 th Congress) (failed to achievecloture while cramdown provision was included; subsequently passed without cramdown provision).

42 See Adam J. Levitin, Chapter M: Standardized Mortgage Bankruptcy Proposal, athttp://www.law.georgetown.edu/faculty/levitin/documents/ChapterMProposal.pdf.
http://www.law.georgetown.edu/faculty/levitin/documents/ChapterMProposal.pdfhttp://www.law.georgetown.edu/faculty/levitin/documents/ChapterMProposal.pdfhttp://www.law.georgetown.edu/faculty/levitin/documents/ChapterMProposal.pdf


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A second involuntary method of principal reductions would be to exercise thefederal governments eminent domain takings power.43 The federal government ispermitted to take private property, provided that it pays just compensation to theowners. This means that in theory the federal government could take all underwater

mortgages by paying their owners the market value of those mortgages. The market

value may not match the property value, but would be much closer than the unpaidmortgage balance. Mortgagees could always litigate with the government over whetherthe compensation offered was just, but that would not affect the governments ability to

take the mortgages, only the price tag for doing so. Having forced the sale of themortgages at a just price, the government could then reduce principal balances on themortgages to that just price and either manage the restructured mortgages itself or

resecuritized them (as through a Resolution Trust Corporation entity, with or without aguarantee of some sort). In essence, a takings approach could be used to recreate a

Home Owners Loan Corporation (HOLC) approach.44

While a takings approach is theoretically possible, a massive taking of

mortgages would be an unprecedented use of the takings power, which has traditionally

been used for taking physical rather than financial assets, and on a much smaller scale.This means that there is some question about the Constitutionality of a takingsapproach.

Even if Constitutional, however, a takings approach would not be withoutproblems. It would come with a huge liquidity price tag, as the government would haveto pay just compensation for trillions of dollars of mortgages. This would be no smallmatter for federal budgets. The government would bear the default risk on the takenmortgages, until and unless it could securitize them absent a guarantee. Again, thiswould affect the federal budget. It would impose a huge operational burden on thefederal government, requiring the government to come up with servicing arrangements.Finally, and most importantly, a takings approach would entail significant political riskfor an Administration; the exercise of eminent domain power is rarely popular, and amassive taking of mortgages and associated principal write-downs for a group ofhomeowners not all of whom acted responsibly and blamelessly during the housingbubble might be extremely unpopular politically.

E. Negotiated Principal Reductions

The final strategy for making the housing market clear is principal reductionsthrough negotiated, quasi-voluntary arrangements, in which the principal reductions areformally done voluntarily by mortgagees, but only in the face of litigation or in responseto pressure from regulators. While the precise terms of the principal reduction would be

43See, e.g., Lauren E. Willis, Stabilize Home Mortgage Borrowers, and the Financial System WillFollow, Loyola Law Legal Studies Paper 2008-28, available atwww.ssrn.com;Howell E. Jackson, Build aBetter Bailout, CHRISTIAN SCI. MONITOR (Sept. 25, 2008), available at www.csmonitor.com; John D.Geanakoplos & Susan P. Koniak, Matters of Principal, N.Y.TIMES,Mar. 4, 2009; John D. Geanakoplos &Susan P. Koniak, Mortgage Justice Is Blind, N.Y.TIMES, Oct. 29, 2008.

44See, e.g., Andrew Jakabovics, History Lesson, THE NEW REPUBLIC ONLINE, Oct. 10, 2007, athttp://www.tnr.com/article/history-lesson; Brad Miller, UnHAMPered, THE NEW REPUBLIC ONLINE, Feb.24, 2010, athttp://www.tnr.com/article/unhampered.
http://www.ssrn.com/http://www.ssrn.com/http://www.ssrn.com/http://www.csmonitor.com/http://www.csmonitor.com/http://www.tnr.com/article/history-lessonhttp://www.tnr.com/article/history-lessonhttp://www.tnr.com/article/unhamperedhttp://www.tnr.com/article/unhamperedhttp://www.tnr.com/article/unhamperedhttp://www.tnr.com/article/unhamperedhttp://www.tnr.com/article/history-lessonhttp://www.csmonitor.com/http://www.ssrn.com/


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negotiated, it would be a negotiation with a regulator or litigant, not with the individualhomeowners.

Two possible variants are presently feasible. First, principal reductions could beachieved as part of a litigation settlement, most likely involving suits brought by stateAttorneys-General against a broad universe of financial institutions (including the GSEs),

not just mortgage servicers, over mortgage origination and securitization practices.

Alternatively, the federal government could exercising its market power in thesecondary market by making lenders and servicers that failed to engage in principalreductions ineligible for FHA insurance on their loans or for doing business with theGSEs. For example, FHA regulations provide that a lender is ineligible for FHAinsurance if it is engaged in business practices that do not conform to generally accepted

practices of prudent mortgagees or that demonstrate irresponsibility.45 Irresponsibilityis not defined in the regulations, but it could reasonably be interpreted to include failureto engage in principal write-downs (particularly if the principal write-downs are netpresent value positive for the loan). Similarly, Treasury could make its continued supportof the GSEs contingent upon principal reductions by both the GSEs and all private partiesdoing business with the GSEs. The point here is not to detail the specific legal levers forthe government to encourage quasi-voluntary principal reductions, to rather to emphasizethat there are levers. The levers are not without risk; they could be subject to legalchallenges and pose political, but the levers exist; the key question here is one of politicalwill.

III. ATRANSACTIONAL FRAMEWORK

Presently, the policy solution to the housing market is a combination of the donothing, affordability, and voluntary principal reduction strategies. As involuntaryprincipal reduction seems quite unlikely in the current political climate, the only likelychange in policy will be as the result of a negotiated, quasi-voluntary solution coming

from strong regulatory or litigation pressure. This paper is well cognizant of theformidable political obstacles to even such a negotiated solution, but the alternatives aresmall-bore solutions that will do little to fundamentally fix the housing market.

A. Loss Allocation

As a starting point, for considering principal reduction mechanisms, it isnecessary to acknowledge that market-clearing in the housing market means lossrecognition on underwater mortgages.46 There are serious losses in the housing market,and only limited places to put them: (1) the government; (2) financial institutionsinvolved in mortgage origination, securitization, and servicing; and (3) investors inmortgages (MBS investors and portfolio lenders). There is significant overlap among

these categories, as the government guarantees some or all obligations of variousfinancial institutions and MBS investors (including the GSEs and the Federal Reserve),

45 24 C.F.R. 202.5(j)(4).46An alternative strategy would be to simply wait for the market to grow its way to clearing via

normal house price inflation. The feasibility of such a strategy is dubious, however, as it may take quite awhile, and, to the extent that the negative equity is the primary factor behind decreased consumer demandand thus lower employment and economic productivity, the U.S.s consumer-spending driven economy isunlikely to grow its way to higher housing prices other than through population growth.


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and many financial institutions that originated, securitized, and service mortgages arealso portfolio lender and/or MBS investors. This paper does not address the properallocation of losses in the housing market.47 Nonetheless, recognition of the limited lossrecognition options is important for understanding the dynamics of principal reductionstrategies for clearing the US housing market, as different loss allocation approaches

change the political, legal, and economic feasibility of principal reduction strategies.B. Basic Principles of Principal Reduction

For a principal reduction program to be effective, there are several basicprinciples to which it should adhere:

(1) Scope is critical for a principal reduction strategy to have a macro-economic impact, and for participating institutions to enjoy thesynergies of the strategy.

(2) Uniformity of borrower treatment is important for making principalreductions administrable, transparent, and fair. HAMP ran into troublebecause of overly individualized treatment that made it hard to tell if

borrowers were being treated fairly and correctly and made it harderstill to administer. On these lines, abandoning a net present value(NPV) test for modification eligibility would greatly facilitate theadministration of any program.

(3) A principal reduction program must apply to all underwater loansregardless of default status. So doing eliminates the moral hazardconcern of encouraging defaults.48

(4) Some property types should be excluded from a principal reductionprogram, namely properties that are not owner-occupied or that aresecond homes. The extent of non-owner-occupied properties is

unclear, but excluding them from a principal reduction program wouldmake the program more palatable politically and less expensive.

(5) The effectiveness of a principal reduction program could be enhancedif combined with other features, such as a cash-for-keys option, adeed-for-lease option (including rent-to-own), and/or sharedappreciation option.

(6) Avoid flooding the market with inventory, which is consistent withkeeping homeowners in their homes.

C. The Bad Bank Model

A common structure used for dealing with troubled assets is the bad bank,meaning a specially-created entity that acquires troubled assets and restructures them,leaving the performing assets in the good bank. Bad banks have been used

47See Adam J. Levitin, Make the Banks Pay, SALON.COM, Oct. 27, 2011, for some thoughts onloss allocation.

48 There is still a moral hazard concern of encouraging high LTV borrowing, but that can beaddressed in other way, and a unique principal reduction program in the context of a national economiccrisis is unlikely to encourage homeowners to gamble on high LTV loans going forward.


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repeatedly and successfully in the United States and abroad to restructuring troubledassets and relieve liability overhangs.49 In the United States, the Home Owners LoanCorporation (HOLC) was a government-owned bad bank that was used to restructuremortgages during the Great Depression. HOLC refinanced defaulted mortgages frombanks at a discount from par and then restructured the loans into long-term fixed-rate,

fully amortized obligations.

50

HOLC ultimately established the viability of the long-termfixed-rate mortgage.51 A generation later, the Resolution Trust Corporation (RTC) wascreated as another government-owned bad bank to restructure the assets of failed savingsand loans. The RTC enabled centralized asset management, rather than the managementof individual failed S&Ls assets. The RTC restructured obligations and then securitizedmany of them, pioneering commercial mortgage securitization.52

Something similar to a bad bank is often used in bankruptcy reorganizations. Acommon bankruptcy plan structure involves the funding of a trust to which the claims ofa certain class of liabilities are channeled. This is the formal structure for asbestosbankruptcies, where asbestos-related bankruptcy claims are channeled to a trust that isfunded with a large portion of the equity of the reorganized company.53 The result is a

simpler claims adjudication process for asbestos claimants and the elimination of thecompanys asbestos liability overhang. The recent GM and Chrysler bankruptciesinvolved a parallel structure, with the establishment of trusts to fund unionizedemployees and retirees health care claims that were funded with the ownership of partof the reorganized companies in satisfaction of the employees and retirees claims.Likewise, the GM and Chrysler bankruptcies involved the sale of the good assets of the

companies to newly created corporate entities. This meant that the bad assets remainedwith the old corporate shells, which were functionally bad banks that looked to maximizethe liquidation value of the bad assets.

Outside of the United States, bad banks have also been used extensively. Forexample, in the wake of the Asian financial crisis in 1999 China created four assetmanagement companies, one to take over and manage the trouble assets of each of

Chinas four major banks.54 In Europe, Sweden and Finland created bad banks to assume

the bad assets of their banks after an economic downturn in the early 1990s. More

49 See, e.g., Conor Downey, Alberto Del Din, Hergen Haas & David Lacaze, Issues andChallenges in Establishing Bad Banks in Europe, Paul Hastings Stay Current, July 2009, athttp://www.paulhastings.com/assets/publications/1357.pdf; McKinsey & Co., Bad Banks: Finding theRight Exit from the Financial Crisis, McKinsey Working Papers on Risk No. 12, August 2009, athttp://www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Risk/Workingpapers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashx.

50

C.LOWELL HARRISS,HISTORY AND POLICIES OF THE HOME OWNERSLOAN CORPORATION 1,36-37(1951).

51 Adam J. Levitin & Susan M. Wachter, The Rise, Fall and Return of the Public Option inHousing Finance, working paper, Mar. 13, 2012, athttp://ssrn.com/abstract=1966550.

52 Adam J. Levitin & Susan M. Wachter, The Commercial Real Estate Bubble, 2 HARV.BUS.L.REV. (forthcoming 2012).

53 11 U.S.C. 524(g).54 William Gamble, Really BadBanks: Chinas Asset Management Companies, Seeking Alpha,

Mar. 10, 2009, at http://seekingalpha.com/article/125105-really-bad-banks-chinas-asset-management-companies.
http://www.paulhastings.com/assets/publications/1357.pdfMhttp://www.paulhastings.com/assets/publications/1357.pdfMhttp://www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Risk/Working%20papers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashxhttp://www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Risk/Working%20papers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashxhttp://www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Risk/Working%20papers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashxhttp://ssrn.com/abstract=1966550http://ssrn.com/abstract=1966550http://ssrn.com/abstract=1966550http://seekingalpha.com/article/125105-really-bad-banks-chinas-asset-management-companieshttp://seekingalpha.com/article/125105-really-bad-banks-chinas-asset-management-companieshttp://seekingalpha.com/article/125105-really-bad-banks-chinas-asset-management-companieshttp://seekingalpha.com/article/125105-really-bad-banks-chinas-asset-management-companieshttp://seekingalpha.com/article/125105-really-bad-banks-chinas-asset-management-companieshttp://ssrn.com/abstract=1966550http://www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Risk/Working%20papers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashxhttp://www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Risk/Working%20papers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashxhttp://www.paulhastings.com/assets/publications/1357.pdfM


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recently, Ireland and Spain have both created bad banks to assume their banks troubled

assets.55

IV.RTC2

A. A New RTC

All of this suggests that the basic mechanism for market clearing through a quasi-voluntary program would involve the pooling of underwater mortgages in a bad bankstructure (RTC 2.0 or for convenience, RTC2), which would then restructure andresecuritize the mortgages according to a transparent, standardized restructuring formula(e.g., write all mortgages down to a specified LTV and restructure them to 15-, 20- or 30-year, fully amortized, fully prepayable, fixed-rate obligations), ideally, coupled withintensive borrower outreach.56

The basic idea behind using a bad bank entity is that it helps address severalmarket clearing problems simultaneously. First, the transfer of troubled mortgages to asingle entity would reunite fractured ownership and eliminate second lien issues. Second,transfer of the mortgages to a single new entity would remove all contractual limitations

on mortgage modification. Third, unified ownership would mean consistent standards forthe treatment of homeowners and modifications. Fourth, unified ownership enables astandard and thus more liquid resecuritization of restructured mortgages with clearer risksfor investors. Fifth, transfer of the mortgages to a new entity would relieve the banks ofthe legacy issues and liability overhang on the mortgages, in terms of unrecognized creditlosses, the hassle and cost (financial and reputational) of managing the loans, andlitigation risk. An RTC2 would enable US financial institutions to have a fresh start post-crisis.

B. Transfer Mechanisms for Addressing Varied Loan Ownership

The mechanism for transferring a mortgage loan to the RTC2 depends on the

loans current ownership. For loans held in banks or GSEs portfolios, the transferwould be just a simple sale. The terms of the sale are an issue discussed below (andmight very by institution), but there would be no transactional complications regardingthe transfer.

There are no legal obstacles to principal reduction in those cases. Instead, there issimply a question of whether the financial institution is willing to recognize the losses.The loss recognition problem could potentially be eased through shared-appreciationarrangements on mortgages with reduced principal; such shared appreciation would likelybe accounted for as an option, and thus carried at fair value, mitigating some of theprincipal reduction. On a large scale, it basically recognizes the real economics of

55 Ireland has created a National Asset Management Agency to hold bad commercial real estateloans. Eamon Quinn,Irelands Bad Bank Expert Urges Spain to Follow Suit, WALL ST.J., May 22, 2012,at http://online.wsj.com/article/SB10001424052702304019404577420300134053184.html. See alsohttp://www.ilauk.com/docs/academic/bad_banks_-_ireland__others.pdf. Spain has created a limited entityto deal solely with a single failed cajas. See Sara Schaeffer-Muoz & Christopher Bjork, Spain WeighsWider Use of Bad Bank Model for Cajas, WALL ST. J., May 11, 2011, athttp://online.wsj.com/article/SB10001424052748704681904576315290202382146.html.

56 From the HOLC to current outreach efforts, borrower contact and social work appears to pay offin terms of loan performance. See, e.g.HARRISS, supra note 50, at 66-69.
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holding a portfolio of underwater mortgageit is like holding a portfolio of above watermortgages and a call option on the housing market.

Second liens, relatively few of which are securitized, present some complications,but they are primarily of three sorts. First, there is a matching problem, which can beaddressedif there is adequate information sharing, albeit at some cost. Second, there is a

valuation problem. And third, many second liens are held by smaller financialinstitutions, against whom there may not be the same litigation or regulatory leverage andwho present many more coordination problems. Whether the second liens held bysmaller financial institutions would be covered in a quasi-voluntary scenario isquestionable; if they are not covered, any concessions on first liens would benefit thesmaller financial institutions.

The larger problem with portfolio loans is that large-scale principal write-downswill significantly decapitalize many major financial institutions, particularly the largestcommercial banks. For the GSEs, moreover, loss recognition means putting the bill tothe federal government, and thus the taxpayers. It is important, however, to distinguishbetween financial institutions book value and their market capitalization. Some of thelargest financial institutions have book equity that greatly exceeds their marketcapitalization. This is an indication that the market believes these institutions arecarrying assets at inflated values or failing to recognize liabilities. A large part of thebook-market gap is due to mortgages. To the extent that principal is reduced until theface value of a mortgage is equal to its market value, then principal reductions shouldhelp narrow the book-market gap, not only by reducing inflated book values, but also byincreasing market value to the extent that it is done in the context of a litigationsettlement that relieves some of the banks liability.

Indeed, wide-scale, rather than single-institution principal reductions would serveas a rising tide that would lift all boatsand all housing prices, thereby increasing the

value of the written-down mortgages. Housing prices are currently likely incorporatingthe prospect of a frozen market, which further depresses them. The synergistic benefitsof wide-scale principal reductions would be enjoyed by all financial institutions.Nonetheless, it is possible that some financial institutions would need to be recapitalizedor resolved as the result of principal reductions.

Securitized loans present different challenges. Securitized GSE loans may only beremoved from securitization pools under specified circumstances, all of which require theGSE to buy the loan out of the pool at its outstanding face value. A potential solution tothis is to have the GSEs themselves partially prepay underwater loans. While GSEservicers are generally prohibited from soliciting refinancings of GSE mortgages, theseprohibitions do not apply to the GSEs themselves (which do not directly interact with

borrowers). Moreover, a partial prepayment is not a refinancing. Partial prepayment ofloans by the GSEs thus presents a possible mechanism for principal reduction of GSEmortgages without saddling the GSEs with the liquidity requirements of repurchasing allof their underwater mortgages at face value from securitization pools.

Private-label mortgage-backed securities (PLS) also cannot generally be removedfrom their securitization trusts; a PLS trustee has no authority to sell the mortgages otherthan in a foreclosure. A major exception to this, however, is as part of a settlement,


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including the use of the putback mechanism for mortgages that do not conform to

representations and warranties.57 This creates a possibility of extracting underwatermortgages from PLS as part of a litigation settlement with PLS trustees.

The GSEs have slightly more leeway in removing loans from their securitizationpools, but they are generally required to repurchase any nonperforming loan at par. Due

to the size of GSE MBS pools, the cost of transfers from the pools to an RTC2 would beimpracticably immense, irrespective of the particulars of any conceivable transfer pricing.Instead of transferring loans out of the GSE MBS pools, an alternative would be for theGSEs to partially prepay the loans, meaning that the GSEs would make payments to theirMBS trusts on behalf of the homeowners. Some GSE investors might object to theprepayments, but the GSEs are not explicitly prohibited from making such prepayments;the only explicit prohibition is on GSE servicers soliciting refinancings. Good faithissues might still arise.

Such prepayment would address negative equity. They would not, however,restructure the loan, nor would they reunite first and second liens. Restructuring could beundertaken separately and second liens could be addressed via a MOU between the GSEsand the RTC2.

C. Transfer Pricing and Funding

The central negotiation point for a negotiated solution will be transfer pricing.What is the price at which the bad bank will acquire the loans? This paper makes noattempt to propose such pricing. It does, however, note some issues that would likelyarise in determining transfer pricing.

First, the transfers would have to be negotiated in bulk, rather than on anindividual mortgage basis. This will raise some particular valuation issues, butultimately, it will be a question of how much loss recognition the financial institutions

can afford as much as anything.Second, a negotiated solution could cover not just entities that own and service

mortgages, but also entities that do not, but were part of the origination and securitizationprocess. If these entities cannot contribute mortgages to the RTC2, they can stillcontribute cash.

Third, transfer pricing may vary depending on loan ownership. For whole loans,it is simply a question of a haircut to the banks, but is complicated by loss recognitionissues, especially in regard to second liens. For securitized loans, investor rights mustalso be considered. All told, however, these are not structural details, so much as pricing,and one can imagine a basic transfer pricing schedule along the lines of the modificationcredit schedule in the federal-state servicing settlement.

Related to, but separate from transfer pricing is the question of how the RTC2would be funded. What would the capital structure look like? The RTC2 would acquire

57 PLS trustees have wide settlement authority and do not need court approval of their settlementson behalf of their trusts. BONY Mellons filing of a NY State Article 77 action for court approval of theproposed Bank of America/Countrywide MBS settlement, Petition, No. 651786-2011 (N.Y. Sup. Ct., June29, 2011), was not required. BONYM was instead seeking a prophylactic comfort order to protect itfrom potential litigation.


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mortgages for a combination of (1) litigation releases/permission to do future business,(2) cash, and (3) its debt and equity.

Litigation releases and permission to do future business are the basis forundertaking an RTC2 structure. Cash and debt issuance relate to the RTC2s liquidity.The RTC2 would require tremendous liquidity in order to acquire a sizeable percentage

of the underwater mortgages. The duration of its liquidity needs would depend on thelength of time necessary to restructure and resecuritized the mortgages. Undertakingacquisitions on a rolling basis would reduce liquidity needs, but they would still beenormous.

There are two realistic sources of liquidity: financial institutions or thegovernment. If transfer pricing were anything close to even market value of mortgages,the liquidity needs of the RTC2 would likely outstrip anything that financial institutionscould provide. In other words, the assistance of the Federal Reserve would be necessary.Ideally, however, a two-tiered liquidity structure would be used, with the Federal Reserveproviding a senior liquidity tranche and financial institutions providing a junior liquiditytranche (with the risk entailed being reflected in transfer pricing).

What of the RTC2s equity? The equity ownership of the RTC2 is the first lossposition on the mortgage restructuring. If the restructuring is convincing and value-enhancing, not just on the individual mortgage, but through the synergies created bylarge-scale restructuring that enables market clearing, then the equity position could be inthe money. In other words, the equity position is essentially a call option on the U.S.housing market. The equity position would likely be given to financial institutions aspart of the transfer pricing, in ratio to their transfers to the RTC2. How it would bevalued or treated for regulatory capital purposes (and the related issue of itstransferability) is beyond the scope of this paper.

D. Management and Operations

Obviously the RTC2 would need management and employees. While financialinstitutions would hold the RTC2s equity, this does not necessarily mean that they would

manage it. One possible scenario is that the settlement creating the RTC2 would specifythe composition of the RTC2 board of directors, who would then choose the actualmanagers, presumably from servicing and housing counseling professionals.

The RTC2 would presumably operate within predefined parameters on loanrestructuring.58 While the details are again not the focus of this paper, they wouldpresumably involve principal reduction to something close to 100% LTV, possibly with ashared appreciation provision, and the loans would be restructured into long-term, fully-amortized fixed-rate obligations. The long-term fixed-rate mortgage is a time proven

product that protects borrowers from inflation.

Ideally, such restructuring would be accompanied by intensive borrower outreachefforts. One of the important lessons from the operation of the Home Owners LoanCorporation was the importance of borrower contactbasically social workfor loan

58 A major operational issue that the RTC2 would need to address would be servicing transfers forloans acquired by the RTC2. Servicing transfers can easily result in payment disruptio

Clearing the Mortgage Market

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