Bull by the Horns

by Sheila Bair

  But it was an uphill climb to convince investors, and here was the main problem: they said they were reluctant to agree to loan modifications because of redefault risk. As discussed in earlier chapters, in a flat market, there is not much risk in trying a loan restructuring first because if it works, you have preserved substantial economic value and if it redefaults, you still have the option of going to foreclosure and recovering what you can. However, in a declining market, waiting to see if a loan mod works runs the risk that you will end up having to foreclose several months later, at a steeper loss because of further home price declines. And in 2008, home prices were going down dramatically. That led to a “rush to foreclosure” phenomenon where mortgage investors would try to repossess and sell properties quickly, before prices went down further. But the dumping of millions of properties on the market at one time was becoming part of the problem, as it made prices go down even faster. Like a dog chasing its tail, mortgage investors rushing to liquidate properties to get higher prices were actually forcing those prices to drop more rapidly. It was that vicious, self-reinforcing cycle that needed to be broken.

  Our idea was this: if investors would agree to support systematic, sustainable loan modifications—and insist that their servicers devote the time and resources necessary to achieve wide-scale loan restructurings—the government would agree to absorb half of the losses from redefaults due to declining home prices. That would accomplish several things.

  First, it would qualify more borrowers for loan modifications. Most troubled borrowers were being denied loan modifications because they failed to pass something called the net present value (NPV) test. That test, included in virtually all securitization agreements, required a servicer to determine that a modified loan would have more value for investors than the likely recovery if the borrower were put into foreclosure. But in making that calculation, servicers would lower the value of the modified loan based on the chance that it could redefault later on. Servicers were assuming very high loss rates from redefaults, particularly in areas of the country where home prices were falling rapidly—which, of course, were exactly the areas of the country where borrowers needed the most help. By agreeing to insure half of the loss from subsequent home price declines, we could increase the value of the modified loan and change the NPV calculation to help many more borrowers qualify.

  Second, by producing more modifications and fewer foreclosures, we would slow downward pressure on home prices by disrupting the self-destructive dog-chasing-tail cycle of investors rushing to foreclosure to try to get ahead of home price declines.

  Finally, we would create powerful economic incentives for investors to support loan modifications. If they refused to participate, they would leave money on the table, something they hated to do. And yes, we said it would be expensive—we estimated the cost at $38 billion—but it would also prevent 2.1 million foreclosures in 2009 and 2010. You get what you pay for, as they say, and real money was needed to counter the economic incentives relentlessly driving borrowers into foreclosure.

  Our critics at the White House and the Treasury Department tried to attack us in the media by saying that our insurance program would result in payments to investors, not to borrowers. (That was quite a mode of attack after the government had happily shoveled out $125 billion to nine large banks.) That was, of course, true, but investors would not be eligible to participate in the program unless they agreed to lower borrowers’ payments significantly, to affordable levels. The program required that Main Street home owners get some specific benefit, unlike the TARP infusions, which were accompanied only by vague, general commitments to make and restructure loans.

  In truth, I think Hank was generally sympathetic to a loan modification program, but he was caught between two administrations. The new Obama Administration wanted its own program. The hard-line free-market economists at both the Treasury and White House did not want to make more than token public relations efforts to help borrowers. Hank had only a few months left in office, and he didn’t have the focus or commitment to override the naysayers and simply launch the program. Instead, he asked me to work with the White House economic staff to try to get their sign-off, which proved to be a hopeless task.

  We dutifully attended a series of meetings at the White House. Between some of the Treasury and White House free-market economists, it was death by a thousand cuts. Unbelievably, they rejected the notion that foreclosures had much of anything to do with downward pressure on home prices. “Eliminating even all foreclosures81 is unlikely to qualitatively change the amount of inventory” was the conclusion of a policy options paper presented by senior White House economists. It was unbelievable. According to RealtyTrac82, 2.3 million homes had received foreclosure filings in 2008, an 81 percent increase from 2007 and a whopping 225 percent increase from 2006. One in every fifty-four homes had received a foreclosure filing. Home prices were already down83 by 20 percent, and respected experts such as Robert Shiller were predicting declines even greater than the 30 percent drop the nation had experienced during the Great Depression.

  Without explanation or analysis, they said our program would cost $76 billion, not $38 billion, and would help at most 700,000 borrowers. The whole discussion was maddening, rigged from the beginning, I felt, to lead to inaction. Not a single White House or Treasury staff person sitting around that table had ever modified a loan or read a pooling and servicing agreement. Not one had ever visited a foreclosure-plagued low-income neighborhood. This was Washington at its most myopic, concluding against all the evidence to the contrary that the burgeoning number of foreclosed, empty houses had nothing to do with declining home values. We did get some constructive input and support from James Lockhart, the head of Fannie and Freddie’s regulator, the Federal Housing Finance Agency (FHFA). But the rest had already decided they were going to block us, and the meetings were simply a staged process designed for them to be able to say that they had taken a serious look at our proposal before they turned it down.

  At least I wasn’t alone. During the meeting they also trashed other proposals made by the noted conservative economists Martin Feldstein, Larry Lindsey, Glenn Hubbard, and Charles Calomiris. All of those distinguished economists had proposed separate measures, which frankly were much more aggressive (and expensive) than ours. But they also recognized the urgency of major action to staunch the tidal wave of foreclosures and excess inventory washing up on our shores. In contrast, none of the economists at the White House or Treasury got it—nor did they want to. After the worst financial crisis since the Great Depression, they were still mired in the ideology of government laissez-faire and “self-correcting” markets.

  But the markets would not correct on their own. Securitization had created conflicting and skewed economic incentives among the owners of the mortgage-backed securities as well as the servicers who had the frontline responsibility to mitigate losses through restructuring. In past crises, the market had worked because the owners of loans had also serviced those loans. Now responsibility for loan mods was in the hands of understaffed and undercompensated servicers who made more money from foreclosing than modifying. Investors were not pressing them to mitigate losses because of conflicts and perverse economic incentives among the different tranches.

  Toward the end of the White House discussions, a new proposal popped up, concocted by Phillip Swagel, a Bush-appointed economist at the Treasury Department with close ties to the White House hard-liners. I had not dealt with Swagel directly but had received negative reports from my staff that he had been a key obstacle in discussions of our proposal and had also worked to undermine Hope for Homeowners, an FHA program Congress had authorized to help distressed home owners. Instead of an insurance program, his proposal involved Treasury contributing some money to each borrower’s interest payment reduction. The idea was that Treasury would pay down a portion of a distressed borrower’s interest, while the lenders or mortgage-backed investors would agree to absorb further interest rate reductions to g
et the borrower’s payment down to an affordable level. In that way, Treasury would pay only for success by subsidizing reduced payments to borrowers so long as they paid on their restructured mortgages.

  Desperate to get something done, I asked our staff to analyze the proposal. Could it be another way to get foreclosure rates down? But as we delved deeper into it, we became convinced that it would not work.

  For one thing, it was an administrative nightmare, requiring the government to track monthly cash flows on potentially millions of mortgages to ensure continued borrower and servicer compliance. If the borrower became delinquent, the government’s payments would have to stop, but if the borrower “cured”—that is, eventually made up the late payments—the government would start up the payments again. The subsidy would be good for only five years, with the borrower reverting back to the original higher rate at that time, promising another wave of defaults down the road. Moreover, the subsidy was bigger the higher the interest rate on the current loan, meaning that investors in the most abusive loans—those high-rate 2/28s and 3/27s—would get the biggest subsidies.

  But most important, by not addressing redefault risk, the proposal failed to meaningfully change the NPV calculation. The majority of borrowers would still not be able to pass that crucial test and thus would not even qualify for a loan mod. The program was significantly cheaper—we estimated it would cost about $8 billion, as opposed to $38 billion for our program. But you get what you pay for, as they say, and our economists were convinced that the program wouldn’t deliver. Investors would keep pressing for speedy foreclosures, and “robo servicers” would comply. They were operating within their contractual rights—rights that the government could not constitutionally abrogate. Unless the government made it economically worth their while to stop, they would continue to foreclose.

  I communicated my concerns84 to Hank, but it was Treasury’s program, and he was obviously free to do what he wanted. TARP was his, not ours. Indeed, through Treasury’s lobbying efforts, we had been excluded from the oversight board that would oversee how the TARP money was used. I had no control of or power over the outcome of the discussions other than the strength of our arguments and Hank’s moral commitment to me and Congress to implement a loan modification program. The White House meetings ended without reaching a decision. The participants basically bucked the issue back to Treasury. We continued our discussions85 with Treasury staff and kept agreeing to pare our proposal back in response to their criticisms. We agreed to require six months of performance on a modified loan before the loan would qualify for redefault insurance. We agreed to exclude GSE loans. We agreed to exclude mortgages on homes that were deeply underwater. Finally I suggested that since Treasury remained unconvinced, it should fund a small pilot program to test it. But it refused to do even that.

  Media and congressional pressure continued. Even the American Bankers Association86 weighed in with support for a variation of the FDIC’s loan modification program. Treasury and the White House continued blaming us for the criticism they were receiving, preferring to ignore the reality that the administration itself had set up expectations for a major loan-restructuring program when securing votes for TARP. Yes, the press was playing us up as the “good guys,” but that was because it agreed with our policy position, not because we were feeding it stories.

  The hardliners in the administration went back at us in the press, and again, it backfired. Even the Washington Times—a newspaper known for its conservative bent—was sympathetic to our position and was pursuing a story, which the White House killed, that the administration had orchestrated the leaks to discredit me. Then, early in December, I was participating on a regulatory panel with John Dugan, John Reich, and Randy Kroszner, who was still on the Fed board at that point, at a housing conference sponsored by OTS. The moderator asked me for my reaction about a report from the OCC showing redefault rates in excess of 50 percent on loans modified by national banks. I was flabbergasted. I had no idea what she was talking about, but she had been given a copy of that surprise OCC report, as had other panel members. I had been left out of the loop. I told her honestly that I had not seen the report but that redefaults were driven heavily by whether the modification resulted in meaningful payment relief and that in any event, even at 50 percent redefault, you were still keeping the other 50 percent of borrowers in their homes (and the houses off the market). The boys on the panel were all smiling broadly.

  After the conference, we obtained a copy of the OCC report and couldn’t believe the lengths the OCC had gone to generate high redefault rates. First, it counted anything that changed the mortgage terms as a modification. As it turned out, more than half of the “modifications” included in its initial report included repayment plans that actually increased the borrowers’ payments by adding in delinquent amounts, late charges, and other fees. Second, it included as a redefault any payment that was more than thirty days late. But the vast majority of thirty-day delinquent loans “cure”—that is, the borrower usually catches up in the next month. By including repayment plans that increased mortgage payments, as well as short-term delinquencies, the OCC was able to make it appear as if even when borrowers were helped, most of them defaulted again. By comparison, a report prepared by Credit Suisse, which used a sixty-day delinquency rate for redefault (the industry norm) and looked only at borrowers who actually received interest rate reductions, found a 15 percent redefault rate.

  The OCC press office87 went into overdrive promoting the report. But as its obvious weaknesses became apparent, the report was discredited, and the OCC was eventually embarrassed into changing its reporting metrics to differentiate between early and late delinquencies and whether the borrower’s payment had actually been reduced. Two years later, of course, the agency would have egg on its face as private litigants and investigators unearthed wide-scale improprieties in the way banks regulated by the OCC serviced mortgage loans.

  But the lowest point in the whole miserable affair occurred when our press office was contacted by Charles Duhigg at The New York Times, who had clearly been fed the Treasury line that I was a power-grabbing self-promoter who just wouldn’t play nice. Yes, the narrative was that the Treasury had been unable to launch a program that would help home owners because I was “difficult.” Duhigg had all88 of the propaganda that had been launched against us, OMB’s over-the-top cost estimates, the OCC’s inflated redefault rates, and lots of unkind comments from anonymous sources at the Treasury and White House. The notion was ridiculous—that somehow I was stopping the Treasury from making a decision. It didn’t need me. We had a proposal, but it was free to do something else if it wanted. If it didn’t want to work with me, there were plenty of smart people out there in the academic community who could have helped it. I liked Martin Feldstein’s program89 (which was a variation of our original HOP loan proposal) as much as our insurance guarantee, but I didn’t try to push it because the cash outlays would have been much more substantial than the $38 billion we were asking for and because I assumed that MBS bondholders—an important Treasury constituency since the firms also bought government debt—would just shoot it down again, as they had earlier in the year. The reality was that the free-market die-hards in the administration didn’t want to do anything but wanted it to look as though the reason for their inaction was my being difficult.

  As nasty as that whole episode was, I don’t think Hank personally encouraged it. Rather, it was being driven90 by free-market hard-liners in his press office and economic staff. And Tony Fratto, the head of the Bush White House press office, worked with us constructively to try to counter the troublemakers. With Tony’s help, the Duhigg piece turned into a reasonably balanced profile, though it still included venomous quotes from unnamed sources within the outgoing administration. The tragedy of all of that was that nothing got done. I turned my hopes to the new administration. Elected on a “change” agenda, the new administration, would presumably bring fresh perspectives and a stronger commitmen
t to helping Main Street. But on that score, my expectations proved dead wrong.

  CHAPTER 12

  Obama’s Election: The More Things Change . . .

  Both John McCain and Barack Obama had embraced major programs for housing relief for troubled borrowers during their campaigns, so I was hopeful that a change of administration would bring stronger action. A lifelong Republican, I had voted for John McCain. I knew him from my Senate days and had deep respect for him. I also had deep respect for Barack Obama, particularly his amazing organizational capacity for grassroots campaigning, his promise of fundamental change in Washington, and his considerable oratorical skills. What’s more, outrage over the financial mess we were in and the generosity of the TARP bailouts had clearly helped catapult him into office. I had high hopes that his administration would bring greater separation from the financial community and more independence of judgment.

  Soon after Obama was elected, the president-elect announced that John Podesta would be the head of his transition team. I had known John for decades, dating back to the early 1980s, when he and I had served together as legal counsels on the Senate Judiciary Committee. I had been working for Senator Bob Dole at the time, and he had been working for Vermont Democrat Patrick Leahy. We had also been neighbors for many years.