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Clearing the Mortgage Market

Clearing the Mortgage Market

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Published by Foreclosure Fraud
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Categories:Types, Research, Law
Published by: Foreclosure Fraud on Jul 06, 2012
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C
LEARING THE
M
ORTGAGE
M
ARKET THROUGH
P
RINCIPAL
R
EDUCTION
:A
 
B
AD
B
ANK FOR
H
OUSING
(RTC
 
2.0)
A
DAM
J.
 
L
EVITIN
 
Abstract
This paper examination of why mortgage markets have not cleared since the bursting of the housing bubble. It considers the range of possiblemarket clearing strategies and presents a proposal for clearing the market via negotiated, quasi-voluntary principal reduction using a privately-funded 
 Resolution Trust Corporation style entity (“RTC 2.0”) for pooling and 
standardized restructuring and resecuritization of underwater mortgages.
Such an RTC 2.0 would provide a framework for implementing “quasi
-
voluntary” principal reductions in the context of a litigation or regulatory settlement or the federal government’s exercise of its secondary
market  power to exclude non-compliant financial institutions from FHA insuranceor access to the GSE market.
I. The Negative Equity Problem ........................................................................................ 1
 
II. Making Market Clear .................................................................................................... 5
 
A. Do Nothing ................................................................................................................ 5
 
B. Affordability .............................................................................................................. 6
 
C. Voluntary Principal Reductions ................................................................................ 6
 
1. The Dearth of Voluntary Principal Reductions ..................................................... 6
 
2. Reasons for the Lack of Voluntary Principal Reductions ...................................... 8
 
3. The Dearth of Short Sales .................................................................................... 12
 
4. Reasons for the Lack of Short Sales .................................................................... 12
 
D. Involuntary Principal Reductions............................................................................ 13
 
E. Negotiated Principal Reductions ............................................................................. 14
 
III. A Transactional Framework ...................................................................................... 15
 
A. Loss Allocation ........................................................................................................ 15
 
B. Basic Principles of Principal Reduction .................................................................. 16
 
C. The Bad Bank Model .............................................................................................. 16
 
IV. RTC2........................................................................................................................... 18
 
A. A New RTC ............................................................................................................ 18
 
B. Transfer Mechanisms for Addressing Varied Loan Ownership ............................... 18
 
C. Transfer Pricing and Funding ................................................................................... 20
 
D. Management and Operations ................................................................................... 21
 
Conclusion ........................................................................................................................ 22
 
Professor of Law, Georgetown University Law Center. Comments?adam.levitin@law.georgetown.edu. 
 
 
© 2012, Adam J. Levitin
 – 
 
The research and conclusions expressed in this paper are those of the author(s)and do not necessarily reflect the views of Pew, its management or its Board.
 
1
C
LEARING THE
M
ORTGAGE
M
ARKET THROUGH
P
RINCIPAL
R
EDUCTION
:
 
A
 
B
AD
B
ANK FOR
H
OUSING
(RTC2.0)
U.S. housing prices peaked in March 2006. Since then they have fallen 34%,
1
anda further 9%-10% decline is predicted.
2
Despite this precipitous fall in housing prices,the market has still not cleared, meaning that willing buyers and willing sellers arefrequently unable to meet on a price.This paper examines why mortgage markets have failed to clear, particularly theproblems created by negative equity. The paper considers ways in which the negativeequity problem might be addressed and then turns to assessment of the feasibility of usinga
“bad bank”
entity for pooling and standardized restructuring and resecuritization of underwater mortgages.The idea animating this paper is that restructuring is a superior method forclearing the mortgage market than foreclosures and that doing so could also alleviate theliability overhang affecting the banking sector and which threatens another $80 billion inlosses over the next three years.
3
Whatever the tradeoffs between restructuring andforeclosure in the case of an individual loan, when viewed from a macroeconomicperspective, large numbers of foreclosures present a serious problem due to their negativeexternalities. Large scale reduction of negative equity is necessary for clearing housingmarkets. Principal reductions to date have been limited and proposed expansions of existing principal reduction programs are too modest and too slow to havemacroeconomic effects. Instead, a framework is needed for a large scale, one-timer
esolution of the United States’ negative equity problem. Use of 
bad bank provides atransactional framework for such resolution that would avoid some of the problemscurrently impeding restructuring efforts. A bad bank for housing also offers a cleanbreak from the mortgage legacy issues that continue to weigh on the financial sector.
I.
 
T
HE
N
EGATIVE
E
QUITY
P
ROBLEM
 
The central problem affecting the United States housing market today is that themarket is not clearing and has not since at least 2008, if not since its peak in early 2006.The reason for this is because of the approximately $700 billion in negative equitynationwide.
4
Negative equity or near negative equity affects approximately 12.3 million
1
S&P/Case-Shiller Composite 10-CSXR-SA Index.
2
Fitch Ratings,
U.S. RMBS 3Q11 Sustainable Home Price Projection
(predicting a further 9.1%housing price decline); Kathleen M. Howley,
 Home Prices Seen Dropping 10% in U.S. on Foreclosures: Mortgages
, B
LOOMBERG
, Apr. 3, 2012 (citing RealtyTrac’s prediction of 10% drop in home prices).
3
Ryan Schuette,
Fitch: Top 20 Banks May See $80B in Losses
, T
HE
MR
EPORT
.
COM
, Feb. 29,2012.
4
CoreLogic,
Corelogic® Third Quarter 2011 Negative Equity Data Shows Slight Decline But  Remains Elevated 
, Nov. 29, 2011,
at 
 
 
© 2012, Adam J. Levitin
 – 
 
The research and conclusions expressed in this paper are those of the author(s)and do not necessarily reflect the views of Pew, its management or its Board.
 
2mortgagees,
5
who are in turn 27.1 percent of all residential mortgages.
6
The averageunderwater borrower is upside down by $65,000 on a loan with a $256,000 balance,
7
 although there is considerable variation among states (and presumably within states); inCalifornia, the average underwater borrower is upside down by $93,000.
8
To put thesefigures in some perspective, the median annual household income in the United States in2009 was $49,777,
9
meaning that the average amount of negative equity is considerably
greater than most households’ annual disp
osable income. The depth of negative equity islikely to increase as housing prices drop due to foreclosure sales and lack of upkeep onunderwater properties by homeowners who see no reason to spend on taking care of properties in which they have no equity.Negative equity matters first and foremost because it prevents the market fromclearing. People need to be able to sell and buy homes. Normal life-cycle eventsnecessitate relocation, meaning both sales and purchases: employment changes, divorce,disability and illness, death, children, etc. These home sales and purchases cannot occur,however, unless the market is clearing.In a functioning market, willing buyers and willing sellers meet and agree on aprice. When they do the deal, the market clears at the deal price, and welfare is enhancedwhen parties are able to enter into exchanges that they both see as value enhancing.
Based on the parties’ revealed
preferences, the exchange is Pareto efficient. The problemwith the housing market, currently, is that even when willing buyers and willing sellerscan agree on a price, they often cannot close the deal because there is a mortgage on theproperty for more than the deal price.To wit, if someone agrees to buy a house for $200,000, it is impossible to closethe deal if there is a $265,000 mortgage on the house. Virtually every mortgage contains
a “due
-on-
sale” clause that accelerates the entire debt upon sale.
10
Therefore, unless thehomeowner has other resources from which s/he can pay off the difference between the
mortgage debt and the sale price (the “deficiency”), the mortgage lien would remain on
the house, which would permit the lender for foreclose on the
buyer 
unless the buyer paysoff the remaining $65,000.In such circumstances, few, if any, people are willing to buy; they would, bydefinition, be overpaying for the house. Put differently, the buyer must pay for both thehouse and the deficiency in order to obtain the house. The result is that even though thebuyer and seller can agree on the value of the
house
, they cannot complete the dealbecause of the additional cost of the deficiency. Thus, the market does not clear.The root of this market-clearing problem, then, is that mortgages, unlike houses,
5
Core Logic
6
 
 Id.
 
7
CoreLogic,
supra
note4
(calculations by author, averaging first-lien only and first-line plus junior lien data).
8
 
 Id.
9
U.S. Census Bureau,
at 
http://quickfacts.census.gov/qfd/states/00000.html. There are goodreasons to believe that median income is based on unreported income, but the basic point remains
 — 
negative equity is
still much larger than underwater households’ income.
10
State prohibitions on due-on-sale clauses were generally preempted by the Garn-St.GermainDepository Institutions Act of 1982,
codified at 
12 U.S.C. § 1701j-3.

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