Thursday, October 25, 2012

Sheila Bair Displays Practical Good Sense

At least in the spin of her enemies (she had a few) Sheila Bair came across as the Lucy Van Pelt of the mortgage meltdown: as head of the Federal Deposit Insurance Corporation--the "other regulator," alongside Treasury, the Fed and the Office of the Controller of Currency--she was the one who didn't seem to get the memo.  Which memo?  Why, the one that said she was supposed to show up on demand and sign here, here and here, so the big kids could get on with their game.   This was never quite plausible (for one thing, if she was Lucy Van Pelt, who was Charlie Brown?).  But her troops never seemed to have the publicity firepower as her more austere overlords were able to deploy.

So naturally, one looked forward to a memoir from Mrs.Blair, to let her tell (or vent) her side of the policy differences that drove her into the dissenter's role as the A-team struggled so mightily to stay in front of thee onrushing waves.

Now we have it, and so far (I haven't finished it), I'd say she does herself proud.  It's ;perhaps not as entertaining--for which read "intemperate"--as Neal Barofsky's book about his time as inspector-general of TARP (link).  It may lack some of the sophistication that you might expect from a Wall Street Banker, fhe reader is left to her own judgment as to whether that is a defect of a virtue.  What it does display is that Bair had a coherent and clear-headed vision of what her regulatory responsibilities were and a Kansas girl's practicality in trying to meet them..   One gets the sense of her various qaualities at work in the passage below, where she tries to explain one of the great puzzles of the whole sorry episode--why weren't the banks more willing to do workouts on loans that they didn't stand a chance of getting paid off under any scenario.  Here she offers one of the most useful, practical, clear-headed analyses of the problem that I can imagine:
 Prior to the crisis, the job of a residential mortgage servicer consisted primarily of collecting mortgage payments and passing them on to investors. When a loan would occasionally default, the servicer would simply refer the loan to a foreclosure attorney. Servicers were not set up to deal with mortgage default because it happened so infrequently. Similarly, the agreements under which they operated compensated them based on a flat fee; they were not paid more for dealing with a delinquent loan, so their economic incentive was to do as little as possible with a troubled borrower. Indeed, during the go-go years leading up to the crisis,  competition among servicers for the fees generated by the burgeoning securitization market intensified, driving fees down further and making the business one purely of volume, not of effective servicing. Not surprisingly, under that flat fee structure and in the face of intense competition, servicers never invested sufficient resources to deal with significant delinquencies. There are minimal costs associated with collecting mortgage payments from performing borrowers and passing them on to investors. However, when a loan becomes delinquent, working with a troubled borrower to restructure a loan can be a time-consuming, labor-intensive process, particularly if each modification is individually negotiated. Servicers were not compensated for making the extra effort, so why bother?

 Actually, as we would soon discover, if anything, servicers had affirmative economic incentives to go to foreclosure quickly.  That was because when a loan they serviced became delinquent, they were required to continue to advance the mortgage payments to the investors out of their own pockets. If they modified the loan instead of foreclosing, they would be reimbursed by the borrower slowly, over a period of years, by taking out a small part of the borrower’s new monthly payment. On the other hand, if they went to foreclosure, they were paid immediately, off the top, from foreclosure sale proceeds. If you were they, which would you do?

 Why wouldn’t investors tell the servicers to modify loans? After all, if a foreclosure cost more money than a modification, it was the investors, not the servicers, who took the loss. But in point of fact, just the opposite happened, with some investors threatening to sue servicers over modifying loans. Why would investors want to sue servicers for trying to rehabilitate delinquent loans? After all, that would usually save them money over the cost of foreclosure. The answer to that question goes to the heart of what I believe was probably the single biggest impediment to getting the toxic loans restructured: the conflicting economic incentives of investors themselves.

 Remember the tranches we discussed? As you will recall, most mortgage securitizations were set up to provide the senior tranche— the triple-A portion of the securitization— with substantial overcollateralization. What that meant was that if a mortgage   defaulted, it had no impact whatsoever on the senior tranche— unless the defaulting mortgages exceeded 20 to 30 percent of the mortgage pool. However, here is the catch: because of the way in which many securitization documents were written, if, instead of a foreclosure sale, the loan was modified, the reduced mortgage payments flowed through to all investors in the securitization pool, meaning that everyone’s income was reduced, including that of the triple-A investors. 

So again,  would you do if you were a triple-A investor? If a loan becomes delinquent and the servicer modifies it with a 30 percent payment reduction, your portion of the payment flows from that mortgage will be reduced along with all the other bond holders. If, however, the servicer simply forecloses on the loan, even if the losses on foreclosure amount to 50 percent, you will still prefer the foreclosure because that entire loss will be absorbed by the lower tranches. From the standpoint of investors as a whole, it obviously makes more sense for the loan to be modified with a 30 percent loss instead of a 50 percent loss on foreclosure. However, from the standpoint of the triple-A bondholders, it makes more sense to foreclose. And the triple-A bondholders were more numerous and more powerful than investors and more powerful than investors holding the subordinate tranches.
 Bair, Sheila (2012-09-25). Bull by the Horns (Kindle Locations 1149-1181). Simon & Schuster, Inc.. Kindle Edition.

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