The 'Evil Part of Securitization'

Part of the problem is that when the servicing agreements were written several years ago, no one anticipated a widespread need for modifications, according to Wharton finance professor Richard Marston. "That's the evil part of securitization. Once you get into trouble there should be a [modification] mechanism.... It should have been written into the contracts that some neutral party had the authority to change the mortgages."

But including such a mechanism could make the securities less attractive to investors, since projected cash flows would be less certain.

Frey notes that modifications are fairly easy to accomplish when loans remain on the lender's books or in the accounts of government-sponsored entities like Fannie Mae and Freddie Mac. "The parties are sitting across from each other [and] they can do whatever they want," he says. But the bulk of the troubled loans, such as subprime and Alt-A loans to borrowers with less-than-perfect credit, were packaged into mortgage-backed securities now held by investors scattered around the world, he adds. As a practical matter, only the servicing firms are in a position to agree to modifications, making questions about their legal authority critical.

A Congressional Research Services analysis done for the House Financial Services Committee in October 2007 noted the difficulty.  "The holders of different securities from the same mortgage pool are often paid different amounts -- interest vs. principal, or paid-first vs. paid-last, to name two examples," the CRS report said. "The loan servicer that renegotiates the loan may have the effect of benefiting some tranches and hurting others rather than sharing gains and losses evenly.... Further clarification may be required to assure servicers and trusts that they will not be subject to investor lawsuits if they provide workouts to troubled borrowers."

Even if servicers think they do have modification authority, they may be reluctant to use it for fear of favoring some investors over others, Frey suggests. Complicating matters even further, the servicers could be accused of using modifications for their own benefit -- to avoid losing fees as mortgages fall into foreclosure.

If the FDIC proposal does not gain support, there are ways to tweak the strategy. Guttentag and a colleague, for example, responded to a Treasury Department request for proposals by suggesting a system that would slash interest rates but also write down principal. It would be costly to lenders and investors but could avert deeper costs from foreclosures. As a sweetener for investors, the government would shoulder part of the write-down cost, and investors would be insured against deeper-than-anticipated losses.

Clearly, any approach has shortcomings. Marston notes, for example, that the FDIC, by focusing on borrowers who are at least 60 days late in their payments, could encourage some homeowners to fall behind simply to obtain modifications even if they are capable of keeping up with payments. "Boy, oh boy, what strange incentives," he says.

All foreclosure remedies are open to charges of unfairness, Marston adds. They help borrowers who may have made unwise decisions and those who have been financially careless, while doing nothing for homeowners who struggle to keep abreast of payments. And they are disproportionately favorable to people who live in California, Nevada, Florida and other areas where the housing bubble was biggest.

Wharton finance professor Jeremy J. Siegel warns against too much focus on foreclosures, arguing that the problem is small compared to other financial and economic issues of the day. A major stimulus package and further efforts to encourage bank lending would be far more valuable. "It seems to me these [mortgage] workouts are going to take a number of months," he says. "The [federal government] has got to take measures now."