Weak Medicine: Obama's Flawed Plan for Reforming the Banks

Editor's note: The following is an excerpt from A Presidency in Peril: The Inside Story of Obama's Promise, Wall Street's Power, and the Struggle to Control our Economic Future by Robert Kuttner.

When Barack Obama entered office, the housing crisis required very strong remedies. Government needed to use a mix of public funds and concessions on the part of the bankers and investors, who held the mortgage paper, to reduce the principal and interest to a monthly payment low enough to allow distressed borrowers to keep their homes. Otherwise, the foreclosure crisis would keep feeding on itself, glutting the market with vacant homes, driving housing values still lower, and trigger¬ing still more foreclosures. But this course would require banks and hold¬ers of mortgage-backed securities to take losses, and it was rejected by both the Bush and Obama administrations. Instead, both Bush and Obama relied on a series of voluntary programs, jawboning bankers to reduce monthly payments. Not surprisingly, this approach failed.

Back in 2007, looking over the brink of this precipice, the Bush admin¬istration had worked with the banking industry to develop the first volun¬tary program, called the HOPE NOW Alliance. The group claimed that member banks participated in 2,911,609 “workouts” (reductions of monthly payments) between July 2007 and November 2008, but that number turned out to be grossly inflated. Only 37 percent of the workouts resulted in modi¬fication of the loan terms, and of these only 49 percent actually cut monthly payments. Most of the reductions were modest.

According to the definitive study of the program by Professor Alan White, 34 percent of the modifi¬cations actually increased costs to the borrower. Lenders discovered that in restructuring a loan, they could profit by charging up-front fees. Since 2007, under Bush and Obama alike, the pace of new foreclosures has far outstripped the number of loan modifications.

In July 2008, Congress attempted stronger legislative medicine. A program called HOPE for Homeowners authorized the Federal Housing Administration to insure distressed mortgages if private lenders would provide refinancing. But subprime loans are deliberately structured to extract a large prepayment penalty if the borrower refinances. Many of these loans now had negative equity—the loan was worth more than the property—and lenders balked at refinancing even with the FHA insurance. When the HOPE for Homeowners program was enacted, its sponsors predicted that it would help 400,000 homeowners—not nearly enough compared with the millions of defaults. But by February 2009, the scheme had processed exactly 373 applications and closed just 13 refinancings. Hardly any of the distressed properties fit the terms of the program. “HOPE for Homeowners has been a failure by virtually every metric,” declared Representative Spencer Bachus of Alabama, the ranking Republican on the House Financial Services Committee—describing a program signed by a Republican president.

By the time Obama took office, serious defaults and foreclosures were on track to reach more than 8 million during the new president’s first term. This was a moment for a radical break, yet Obama’s plan basically contin¬ued the Bush administration’s voluntary approach, lubricated by $75 billion in government incentive payments to banks. The Obama variation has also been a complete failure, adding to the general economic downdraft.

Obama’s program, called Making Home Affordable, was announced February 18, just four weeks into the new administration. The plan had four major parts. One, a more liberal variant of the old Bush program, allowed homeowners with mortgages to refinance their loans with FHA insurance, even if the outstanding loan was worth 5 percent more than the current value of the house. In July 2009, this ceiling was increased to a premium of 25 percent, meaning that a borrower with a $200,000 home could qualify for a $250,000 mortgage—something inconceivable in ordinary circumstances. This unprecedented remedy of encouraging a homeowner to borrow more than the value of the house was itself very risky, since a homeowner with negative equity loses nothing by just walking away if a better housing option becomes available. Millions did, leaving banks stuck with vacant homes.

A second part of the plan, known as the Home Affordable Modification Program (HAMP), offered lenders incentive payments of up to $4,500 per loan modification, if they reduced a borrower’s monthly payment to 31 percent of gross monthly income. A third element increased government capital infusions to the housing finance market, to keep mortgage interest rates low generally. Finally, as a last resort the administration nominally supported a bill authorizing bankruptcy judges to compel the lender to modify the terms of the loan, if the judge concluded that this was on balance preferable to a foreclosure.

The plan had several fatal flaws. Except for the bankruptcy-judge provision, the whole program was voluntary to the banks. Even with the bonus payment from the government, bankers had little motivation to shave the principal and interest on a loan, since this would typically reduce their income by far more than the $4,500 bonus payment. It also turned out that banks relied heavily on fee income that would be undermined by loan refinancings or modifications.

Further complicating the mess, something like half of the distressed loans had been turned into packages of bonds; they were now owned by an investor other than the original lender. Typically, that lender was now merely the “servicer,” meaning that it was paid a fee for collecting the monthly payment and forwarding the money to the trust that held the securitized package of loans on behalf of the investor, often a hedge fund, a pension fund, or another bank. “The rules by which servicers are reimbursed for expenses may provide a perverse incentive to foreclose rather than modify,” according to a 2009 research paper by experts at the Federal Reserve Bank of Boston.

If the modification seemed unreasonable to the investor, the servicer could get sued for altering the terms. The one provision of the bill with some teeth—the proposed new authority for bankruptcy judges—was fiercely opposed by the financial industry as a threat to its ability to collect debts, and voted down by the Senate. In this key battle, the White House did not lift a finger to urge wavering legislators to support their president. I was told by Tim Geithner that the industry experts he relied upon counseled against this bankruptcy authority, and he did nothing to promote it. Word was quickly passed on Capitol Hill that this was not a provision that mattered to the White House. Twelve Senate Democrats looking for an easy pro-industry vote ended up voting against the administration’s proposed bankruptcy measure.

Indulging the Banks

At bottom, the failure of the voluntary mortgage modification program suffered from the same core deficiency as the rest of the Obama financial strategy. If lenders or holders of securitized loans expected that the government would eventually make them whole through one of Geithner’s innumerable schemes to levitate the value of depressed financial assets, then they had no incentive to modify the terms and book an immediate loss.

One further flaw: The Obama program was for people whose ability to meet monthly payments was only marginally impaired. It offered nothing for millions of the hardest-hit homeowners in places such as much of Florida, Arizona, Nevada, central California, and inner-city America, where housing values had dropped 30 to 50 percent since the 2006 peak and negative equity far exceeded the program’s limits.

Congressman Alan Grayson, whose district is centered in Orlando, Florida, one of the hardest-hit centers of the mortgage collapse, gives the following example. A constituent has a $250,000 mortgage on a house that is now worth only $150,000. She is in default and heading for foreclosure. She could afford to make payments on a $100,000 mortgage, which would enable her to keep the house. If her house is foreclosed, it becomes one more vacant property, dragging down the value of other homes in the neighborhood. But the bank would rather foreclose—and eventually take an even bigger loss—than give this woman such a large break on her mortgage. Only government, Grayson notes, can act to compel a refinancing.

An investigative piece by The New York Times concluded that “data on delinquencies reinforces the notion that servicers are inclined to let problem loans float in purgatory—neither taking control of houses and selling them, nor modifying loans to give homeowners a break.” Reporter Peter Goodman added, “As a home slides toward foreclosure, mortgage companies pay for many services required to take control of the property and resell it. They typically funnel orders for title searches, insurance policies, appraisals and legal filings to companies they own or share revenue with.”

So there is a direct conflict between the public interest in keeping distressed borrowers in their homes, the mortgage company’s interest in reaping fees, and the investor’s interest in not acknowledging a loss. This is yet another hidden cost of what was touted as a great innovation—the fragmentation of mortgage origination, servicing, and ownership of the debt through the genius of securitization. In fact, the conversion of home loans into abstract securities created a doomsday machine.

Banks have also been loath to allow what’s known in the business as a “short sale,” in which the house is sold for less than the amount of the mort¬gage owed. They resist both because they don’t want to book the accounting loss and because they collect hidden fees by maintaining the status quo. The New York Times reported on the efforts of Alfred Crawford of Los Angeles to sell a house on which he owes about $800,000, far more than its present market value. Bank of America, which holds the mortgage, blocked sales three times, the highest offer of which was $620,000. Each time, its subsidiary, Land Safe, booked an appraisal fee.

This is the same Bank of America that has received $45 billion in taxpayer largesse, and which supposedly operates under close supervision of the Treasury. But that supervision doesn’t extend to its mortgage practices. As of December 2009, despite all of the administration’s jawboning, this giant bank had permanently modified exactly 98 mortgages. Citi had modified 271. JPMorgan Chase led the pack with 4,302. Compared with the 8 million projected foreclosures, it was a drop in the bucket.

Because of the incoherence of the government’s overall approach, the Treasury Department is caught between two opposite and incompatible goals. One is to prevent the downward spiral of mortgage foreclosures, vacancies, and collapsing housing prices. But the other goal is to maximize bank earnings, the better to shore up bank balance sheets. That, in turn, means regulatory indulgence for rapacious bank practices and little pressure for the banks to refinance mortgages and eat losses.

Meanwhile, a whole new industry of bottom-feeders—many of them veteran perpetrators of the subprime disaster—organized syndicates to buy up bank-owned real estate at a few cents on the dollar. Representative Marcy Kaptur of Toledo, Ohio, where entire neighborhoods are littered with vacant, bank-owned homes, complained bitterly that bankers preferred to sell pack¬ages of properties to absentee speculators, rather than selling to a city-run program that was working to purchase empty houses, rehabilitate them, and quickly convert them to affordable rentals or owner-occupied homes. The vacant and boarded-up house next door to her own home in Toledo turned out to be owned by a bottom-feeding company based in North Carolina.

There was a further practical weakness in the design of the administration program. Like so much else sponsored by Tim Geithner, it was run by the banking industry, on the familiar (if lately discredited) premise that private industry operates better than government. Typically, however, loan origination offices are assembly-line, paint-by-the-numbers operations. Everything is done according to formula. A loan applicant qualifies for a loan (or not) based on a credit score and a property appraisal. Computers do all the work, with relatively few human employees, and the humans need only a fairly rudimentary level of training.

But a loan modification or refinancing, in circumstances of general distress, is exactly the opposite kind of exercise. It requires labor-intensive, custom¬ized analysis, since everyone’s situation is different and there is no one-size-fits-all formula. For a lender, human employees are expensive cost centers. They are under immense pressure to close loans fast. The more human effort an employee spends on a good-faith effort to do a workout, the more money he or she costs the company. So, beyond the problem of a purely voluntary approach not delivering modifications, loan servicing offices were exactly the wrong institutions to do these workouts.

In 2009, as the administration attempted to put the new mortgage relief program into operation, story after story appeared in the financial press and the general newspapers about borrowers who could not get phone calls returned or who finally were offered modification packages that turned out to provide only trivial relief or actually raised costs. The Times recounted the story of a woman named Eileen Ulery. Facing default, she tried to get Bank of America to modify the terms of her mortgage. Instead, the bank tried to persuade her take out a new loan with a slightly lower monthly payment, but up-front charges of $13,000 in principal reduction and $5,000 in new fees.

In another case, a Lakeland, Florida, woman named Jaime Smith persuaded Chase to lower her monthly payments from $1,250 to $1,033.63 on a trial basis, in April. She made three payments on time, as required by the program, and then applied to make the modification permanent, telephoning weekly to inquire about the status. In October, she received a letter advising that her house had been foreclosed and sold at auction for $100. The buyer was Chase. Eventually, she hired a lawyer who persuaded a judge to vacate the sale.

In these circumstances, it was not surprising that defaults and foreclosures continued to outpace refinancings and loan modifications. When the admin¬istration reported to Congress in December 2009, the Treasury claimed that about 756,000 homeowners had qualified for “trial modifications,” in which their lenders provisionally reduced their monthly costs—provided that they stayed current on their payments for several months, after which the new terms would be made permanent. However, Treasury quietly admitted that fewer than 32,000 homeowners had been given permanent modifications. As this book went to press, the number had risen to 116,000.

Jawboning the Bankers

Faced with the failure of its program to produce more than token mortgage relief, the administration resorted to public displays of arm-twisting. In July 2009, Treasury Secretary Geithner and Housing and Urban Development Secretary Shaun Donovan summoned executives of the twenty-five larg¬est mortgage-lending and mortgage-servicing companies to a meeting to demand that they do more. But the shell game continued, with temporary “trial modifications” but precious few permanent cuts in monthly payments. In November, Michael Barr, the assistant Treasury secretary for financial insti¬tutions, flatly declared that “the banks are not doing a good enough job.” In a blunt criticism of Wall Street rare for the Obama administration, Barr added, “Some of the firms ought to be embarrassed, and they will be,” vowing to pressure and shame the banks into increasing trial modifications and making them permanent.

According to my sources, Barr got into some trouble with his supervisors for his populist attack on the banks, which had not been cleared with the White House. But the story played well; and two weeks later, in an inter¬view on the CBS program 60 Minutes, President Obama himself went Barr one better, declaring that he didn’t run for president in order to help a lot of “fat-cat bankers.” In one of his earliest explicit attacks on the banks, Obama noted that some big banks had sought to exit TARP early, in order to escape its limits on executive pay, adding: “which I think tells me that the people on Wall Street still don’t get it.”

The following Monday, December 14, the president called top bankers to the White House for a photo opportunity and a meeting in which he personally pressed them to do more to help struggling homeowners. But three of the bank CEOs stood the president up. They had not bothered to fly in the night before for the morning meeting, and bad weather grounded their flights. When they participated by speakerphone, it was Obama who sounded almost apologetic, and those present at the meeting reported that there was none of the tough talk that the president had used on TV.

Given the flawed structure of the whole approach, banks have no real incentive to provide deep and permanent reductions in mortgage costs, and foreclosures are on track to increase faster than loan modifications or refinanc¬ings, needlessly prolonging the great stagnation. Despite this ramping up of rhetoric, the Obama administration has remained in a bubble of denial about the failure of its program of mortgage relief. Geithner, testifying before the Congressional Oversight Panel, said, in a moment of uncharacteristic candor, “We do not have a mortgage market today except for that directly supported by the Government.”


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