Some more thoughts on how to fix the housing crisis

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Here is the smartest thing I’ve read yet about how to stabilize the housing market through loan modifications. If you want the short version, check out the testimony Columbia Business School’s Christopher Mayer gave in front of the House financial services committee on Tuesday.

The argument, made with colleagues Edward Morrison (from Columbia Law) and Tomasz Piskorski (from the B school), comes in two parts: 1) Loan servicers don’t have the right economic incentives to modify loans, even when it’s in the best interest of investors, so we should use TARP money to incent them; and 2) Servicers are still a little afraid of getting sued by investors, so Congress should pass a law to protect servicers from lawsuits if they act in the overall best interest of investors.

To address the first:

We propose that servicers of privately securitized mortgages be paid a monthly Incentive Fee equal to ten percent of all mortgage payments made by borrowers, with a cap for each mortgage of $60 per month ($720 per year). The servicer would also receive a one-time payment equal to twelve times the previous month’s Incentive Fee if the borrower prepays the mortgage, rewarding servicers that accept short sales… By paying an Incentive Fee only when borrowers make payments, we reward successful modifications. A servicer whose loan modifications are unsuccessful and result in a quick re-default would collect few Incentive Fees. Our proposal, therefore, rewards servicers for keeping future payments as high as possible without putting the homeowner in a position where he or she is likely to re-default soon after modification.

In other words, they want to set up a system that has the same set of incentives as mortgage-related securities held directly on banks’ books, which are being modified much more frequently than those in private securitizations. They figure this would cost $9 billion.

To address the fear of lawsuits (which, I know, I was dismissive of the other day), they propose temporary legislation that, they insist, would pass muster under Supreme Court case law. Most servicing agreements allow for pretty free-ranging modifications (partly why I was being so dismissive), but in the few cases where the new law genuinely steps on the contractual rights of certain investors, the government could use TARP fund to compensate them. They figure that would cost no more than $1.7 billion.

Couple those two ideas with the earlier proposal Mayer made with Columbia Business School dean Glenn Hubbard to drum up demand among buyers by docking interest rates on new home loans, and we seem to have got ourselves a plan. Or at least they do, for us.

The one thing you might notice lacking is a change to bankruptcy law to allow judges to revise mortgage terms. Mayer finds that deeply problematic,  wrought with perverse incentives for home owners and servicers alike, potentially ineffective modifications, and a long-term reduction in the number of people likely to be able to buy a home.

To me, this makes much sense all around. I’m not convinced that $720 a mortgage is enough of a carrot (even though Mayer et al go through the math to show why they think it is), but the structure of the incentive is still smarter than other ideas we’ve heard, where the reward for modification isn’t linked to its ultimate outcome.

As for the legal half of the proposal, I like the admission that most servicing agreements already allow modifications. We can stop saying that investors in the aggregate are the problem. And then there’s that wonderful twist, where they don’t let the potential nullification of a few contracts hold up the entire process–simply pay those people off. What an elegant solution.