The Volokh Conspiracy - Paying Loan Servicers to Modify Loans: Mayer, Morrison, and Piskorski reply

to my comments (in italics) on their proposal:

1. If it has ex ante effects (that is, creditors expect that in any future financial crisis, the government will do the same), then it will help reinflate a credit and housing bubble. Loan servicers, creditors, and homeowners can divide ex ante the future government bounty. By contrast, loan moratoria, Chapter 13 reform, and the like, should reduce the incentive to extend credit (for better or worse).

First, we think you are criticizing TARP, not necessarily our proposal. TARP could generate ex ante effects of this sort, if you believe (which we do not) that the government is likely to spend this kind of money again. Also, we don't need to rely on TARP. Our original draft relied on an industry tax, but this would likely cause further damage to the industry when it is already receiving government help. We settled on TARP funds because we want a plan that can be implemented quickly and want to limit the waste of these funds on other proposals such as Hope for Homeowners and the FDIC plan proposed by Sheila Bair.

Second, loan moratoria would only prolong the current crisis; the last thing we want to do right now is restrict the supply of credit.

Third, if you want to restrict lending, we don't need Chapter 13 reform. Given recent experience, future lenders will be naturally more cautious in offering credit, with or without changes to bankruptcy law.

Fourth, our proposal corrects a well-defined market failure (badly-written servicing contracts) and, by its very nature, is a temporary intervention. Changes to the bankruptcy code would have permanent, unintended consequences.

Put differently, while the ex ante effects of our proposal are highly speculative, the welfare losses from bankruptcy cramdown are real and documented.

2. Mayer et al. criticize the bankruptcy reform proposals for being crude, but their approach is crude as well. Why ten percent capped at $60 per month? Why not lower or higher? The proposal rests on pretty aggressive empirical assumptions about such things as the risk aversion of loan servicers and the likelihood that beneficiaries of renegotiated loans will default. And then there is the question of whether the estimated $9 billion in TARP funds have a better use.

We computed our Incentive Fee to mimic the fee earned by existing servicers who are successfully modifying mortgages. Also, please take a look at our cost-benefit analysis in Appendices 2 and 4 of our proposal. The empirical assumptions may seem aggressive to you, but they are fairly conservative and (importantly) were checked by many market participants.

Our litigation safe harbor should address your risk-aversion concerns.

Finally, your last point (about better uses of TARP) is a critique of TARP, not our proposal. If the $9 billion is going to be spent, how would you spend it?

3. Servicers will have an incentive to renegotiate loans even in cases where the homeowner should lose the house. In some places, the foreclosure value of the house will not necessarily be much lower than the market value—for example, in healthy neighborhoods where a homeowner defaults not because housing prices have plummeted but because the homeowner suffers a permanent loss in income. Here, the house should be foreclosed and resold. Instead, the servicer will renegotiate the loan down to a level the homeowner can afford, thanks to the subsidy from the taxpayer. The proposal makes a fetish of foreclosure: we don't want to avoid all foreclosures; we want to reduce the incidence of inefficient foreclosure that results in the loss of home value.

Your hypothetical doesn't track our proposal. Under it, a servicer is incentivized to modify a loan only if modification generates a greater recovery to investors than foreclosure. Your hypothetical is just the opposite: it is a case where modification generates a lower recovery to investors than foreclosure. Your servicer is acting contrary to investor interest and opening itself to lawsuits. This servicer would not be protected by our litigation safe harbor.

Perhaps you are thinking that there will be no lawsuit, because investors and servicers will split the booty. If that kind of coordination were possible, we wouldn't have inefficient foreclosures in the first place. Put differently, your critique is valid only in a world without coordination failures and transaction costs.

4. Servicers will have an incentive to renegotiate loans even in cases where the homeowner would be able to avoid default without a loan renegotiation. Consider people with low or even negative equity who nonetheless want to stay where they are and possess the wherewithal to make loan payments. The loan servicer would be willing offer the homeowner better terms in return for a loan renegotiation that would enable the loan servicer to claim TARP funds. Perhaps, this behavior would be considered bad faith, creating a risk of litigation by MBS holders. But the loan servicer might be able to avoid the litigation by adjusting the loan only minimally—it would still be entitled to the TARP funds and the MBS holders might think that the cost of litigation exceeds the gain from any remedy.

This critique misunderstands our proposal. Our Incentive Fee does not depend on whether a loan is modified or not. A servicer receives an Incentive Fee for _every_ loan being serviced. The Fee continues to be paid until either (1) our program expires or (2) the loan goes to foreclosure. So a servicer will never be tempted to modify a loan when there is no risk of default. That would be a self-inflicted wound: the servicer would be reducing monthly payments by the borrower and, as a result, lowering its own Incentive Fee. Moreover, modification isn't free. No servicer will invest up to $1,000 to modify a loan that needs no modification.

Our proposal should be contrasted with the FDIC plan, put forth by Sheila Bair. That plan offers $1,000 to servicers for every loan that is modified in a specified way. The FDIC plan, not ours, makes a "fetish of foreclosure," because it encourages too many modifications.

Note also that our plan avoids micromanaging the modification process. We leave the choice—foreclose, modify a little, modify a lot, or don't modify at all—in the hands of the servicer, who is incentivized to keep loans ongoing and modify only when modification is better than foreclosure for investors.

In a world where something is going to be done by Congress, we are trying to find an alternative that does the most good at the lowest cost. Doing nothing is not an option, at least from the perspective of Congress, and from our perspective too.

	[Eric Posner, February 9, 2009 at 9:48am] Trackbacks Paying Loan Servicers to Modify Loans: Mayer, Morrison, and Piskorski reply to my comments (in italics) on their proposal: 1. If it has ex ante effects (that is, creditors expect that in any future financial crisis, the government will do the same), then it will help reinflate a credit and housing bubble. Loan servicers, creditors, and homeowners can divide ex ante the future government bounty. By contrast, loan moratoria, Chapter 13 reform, and the like, should reduce the incentive to extend credit (for better or worse). First, we think you are criticizing TARP, not necessarily our proposal. TARP could generate ex ante effects of this sort, if you believe (which we do not) that the government is likely to spend this kind of money again. Also, we don't need to rely on TARP. Our original draft relied on an industry tax, but this would likely cause further damage to the industry when it is already receiving government help. We settled on TARP funds because we want a plan that can be implemented quickly and want to limit the waste of these funds on other proposals such as Hope for Homeowners and the FDIC plan proposed by Sheila Bair. Second, loan moratoria would only prolong the current crisis; the last thing we want to do right now is restrict the supply of credit. Third, if you want to restrict lending, we don't need Chapter 13 reform. Given recent experience, future lenders will be naturally more cautious in offering credit, with or without changes to bankruptcy law. Fourth, our proposal corrects a well-defined market failure (badly-written servicing contracts) and, by its very nature, is a temporary intervention. Changes to the bankruptcy code would have permanent, unintended consequences. Put differently, while the ex ante effects of our proposal are highly speculative, the welfare losses from bankruptcy cramdown are real and documented. 2. Mayer et al. criticize the bankruptcy reform proposals for being crude, but their approach is crude as well. Why ten percent capped at $60 per month? Why not lower or higher? The proposal rests on pretty aggressive empirical assumptions about such things as the risk aversion of loan servicers and the likelihood that beneficiaries of renegotiated loans will default. And then there is the question of whether the estimated $9 billion in TARP funds have a better use. We computed our Incentive Fee to mimic the fee earned by existing servicers who are successfully modifying mortgages. Also, please take a look at our cost-benefit analysis in Appendices 2 and 4 of our proposal. The empirical assumptions may seem aggressive to you, but they are fairly conservative and (importantly) were checked by many market participants. Our litigation safe harbor should address your risk-aversion concerns. Finally, your last point (about better uses of TARP) is a critique of TARP, not our proposal. If the $9 billion is going to be spent, how would you spend it? 3. Servicers will have an incentive to renegotiate loans even in cases where the homeowner should lose the house. In some places, the foreclosure value of the house will not necessarily be much lower than the market value—for example, in healthy neighborhoods where a homeowner defaults not because housing prices have plummeted but because the homeowner suffers a permanent loss in income. Here, the house should be foreclosed and resold. Instead, the servicer will renegotiate the loan down to a level the homeowner can afford, thanks to the subsidy from the taxpayer. The proposal makes a fetish of foreclosure: we don't want to avoid all foreclosures; we want to reduce the incidence of inefficient foreclosure that results in the loss of home value. Your hypothetical doesn't track our proposal. Under it, a servicer is incentivized to modify a loan only if modification generates a greater recovery to investors than foreclosure. Your hypothetical is just the opposite: it is a case where modification generates a lower recovery to investors than foreclosure. Your servicer is acting contrary to investor interest and opening itself to lawsuits. This servicer would not be protected by our litigation safe harbor. Perhaps you are thinking that there will be no lawsuit, because investors and servicers will split the booty. If that kind of coordination were possible, we wouldn't have inefficient foreclosures in the first place. Put differently, your critique is valid only in a world without coordination failures and transaction costs. 4. Servicers will have an incentive to renegotiate loans even in cases where the homeowner would be able to avoid default without a loan renegotiation. Consider people with low or even negative equity who nonetheless want to stay where they are and possess the wherewithal to make loan payments. The loan servicer would be willing offer the homeowner better terms in return for a loan renegotiation that would enable the loan servicer to claim TARP funds. Perhaps, this behavior would be considered bad faith, creating a risk of litigation by MBS holders. But the loan servicer might be able to avoid the litigation by adjusting the loan only minimally—it would still be entitled to the TARP funds and the MBS holders might think that the cost of litigation exceeds the gain from any remedy. This critique misunderstands our proposal. Our Incentive Fee does not depend on whether a loan is modified or not. A servicer receives an Incentive Fee for _every_ loan being serviced. The Fee continues to be paid until either (1) our program expires or (2) the loan goes to foreclosure. So a servicer will never be tempted to modify a loan when there is no risk of default. That would be a self-inflicted wound: the servicer would be reducing monthly payments by the borrower and, as a result, lowering its own Incentive Fee. Moreover, modification isn't free. No servicer will invest up to $1,000 to modify a loan that needs no modification. Our proposal should be contrasted with the FDIC plan, put forth by Sheila Bair. That plan offers $1,000 to servicers for every loan that is modified in a specified way. The FDIC plan, not ours, makes a "fetish of foreclosure," because it encourages too many modifications. Note also that our plan avoids micromanaging the modification process. We leave the choice—foreclose, modify a little, modify a lot, or don't modify at all—in the hands of the servicer, who is incentivized to keep loans ongoing and modify only when modification is better than foreclosure for investors. In a world where something is going to be done by Congress, we are trying to find an alternative that does the most good at the lowest cost. Doing nothing is not an option, at least from the perspective of Congress, and from our perspective too.