Anyway, back to reality...
In the news today, Bankruptcy Change Could Save 600,000 Homes:
NEW YORK (CNNMoney.com) -- One consumer group estimates that 600,000 foreclosures could be avoided over the next two years by making a simple change to the bankruptcy code.
The Center for Responsible Lending (CRL) calls it a tweak, but it could be a significant change for homeowners and the market for mortgage-backed securities.
CRL's proposal - reflected in a House bill recently introduced - would make changes to the regulations for Chapter 13 bankruptcies, which don't wipe out debts, but rather establish a repayment plan.
Under current law, when a person files for Ch. 13 bankruptcy, judges cannot reduce mortgage debt owed on a person's primary residence, although they may modify mortgages on investment property or second homes.
Under the House bill, the bankruptcy judge would have the option of reducing what the homeowner owes the lender. Say a homeowner's property is worth less than what he owes. The judge could reduce the principal to match the home's current market value as well as reduce the loan's interest rate.
The rest of the original principal would then be treated as unsecured. That means it becomes a lower priority for repayment than the borrower's secured debt, such as the newly reduced principal on his home. Unsecured debts may be discharged.
OK, indulge me while I give you some "inside" information. Allowing a debtor to pay what the collateral is worth on a secured debt is called a "cram down" in bankruptcy lawyer-speak. A recent Supreme Court case already allowed debtors to cram down the interest rate to the discount rate plus a point or two (or three) on personal items such as cars, furniture and jewelry. Before the 2005 changes, you used to be able to cram down cars, furniture and the like to their value as well. After the BAPCPA law was passed, the feeling among the debtor's counsel was that we should make car dealers "eat steel" unless they agreed to negotiate with the debtor on the price.
The proposed changes in the bankruptcy law would allow debtors to "cram down" the debt to the value of the house in the current market and it seems that they propose that the interest rate rule in Till v. SCS Credit Corp. be extended to houses as well.
I agree with the article that this is more than a tweak, but it is probably a necessary tweak. The representative for the mortgage industry is quoted in the article as saying:
If investors in mortgage debt knew that mortgages could be adjusted by the courts without the consent of the lender, that could increase their perceived risk and change their valuation.
Yes, and some would argue that that is precisely the problem. That is to say: mortgage backed securities (MBS) are not currently getting marked-to-market, but instead are getting marked-to-model.
I admit I am just a lawyer -- not an economist or Wall Street whiz kid. But if I am understanding it right, this article at Sudden Debt: Rocks, Hard Places and Pricing Models probably explains it pretty well. From Hellasious's post:
Which finally brings us to the subject of the pricing models used to issue and mark-to-model all those structured finance securities. It is quite obvious that the primary variable in all pricing models is their sensitivity to credit risk, i.e. the risk of default. During the "virtuous" cycle, when credit risk goes down, such models indicated higher prices, which were used to issue structured finance securities at higher prices and with higher proportions of readily salable AAA-A merchandise. But as the cycle turned "vicious" those models started throwing out lower prices - and when the credit risks signaled by the CDSs jumped suddenly and substantially, as happened in August, those model-calculated prices moved radically down, causing havoc in the balance sheets of existing CDO holders such as banks, SIVs and hedge funds. The trouble was further enhanced by the fact that many holders were highly leveraged, i.e. they had borrowed heavily through ABCPs and prime-bank margin to buy those securities. Judging by market action quite a lot of margin came from the yen carry tactic. Live by the sword, die by the sword...
But why did participants choose to mark-to-model instead of mark-to-market? Two reasons:
(a) Because of the fragmentation in the structured finance business there were thousands of "made to order" issues that had next to zero secondary market liquidity. Usually the issuers pledged they would maintain a secondary market, but for practical purposes this was an empty promise. Even in good times the spreads between quoted bid-offer prices routinely exceeded 5 points ($50 per $1000 face) and in tiny amounts (eg $500k). We call this "trading by appointment only". Therefore, they couldn't truly mark-to-market because there simply was no active market.
(b) During the "virtuous" cycle marking-to-model served to hide the enormous embedded fees paid by real money buyers in the new issue market. For example, pension funds bought large amounts ($50 million and more) of such securities at par, a price that routinely included 5-8% underwriting fees - an atrocious percentage for AAA-A bonds when bought in size. I know of several instances where fees even exceeded 10%. By comparison, highly rated agencies and straight corporates are issued with fees of 0.5-1%.
Which brings us to what could be the "next shoe to drop". As defaults in the mortgage and junk loan sectors rise, as they are already, the models will calculate significantly lower prices, particularly for those issues that were put together with overly optimistic default assumptions. I won't be surprised to see some issues eventually model-priced at 10-20 cents on the dollar, even if their prospects for partial recoveries mean that their true values are double that. In other words, just as the models produced "garbage" prices on the upside, they have the potential to come up with "garbage" prices on the way down.
Also, some mortgage companies don't want to negotiate precisely because they win even if all of their properties go into foreclosure, apparently. From today column by Paul Krugman in the New York Times Enron's Second Coming?:
But Countrywide made more questionable loans than anyone else — and its postbubble behavior does stand out. As Ms. Morgenson reported in yesterday’s Times, Countrywide seems peculiarly unwilling to work out deals that might let borrowers hold on to their homes — even when such a deal, by avoiding the costs of foreclosure, would actually work to the benefit of both sides.
Why block mutually beneficial deals? As the article points out, Countrywide can make money from the fees it charges on foreclosures, while the losses from mortgages that could have been saved, but weren’t, are borne by others.
I think this is an example of moral hazard at work.
Actually, changing the bankruptcy laws to allow debtors to "cram down" their mortgage debts just might be the thing we need to bring back some sanity to this insane housing market in much of the country.