LEVITIN† Abstract This paper examination of why mortgage markets have not cleared since the bursting of the housing bubble. It considers the range of possible market 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 “quasivoluntary” 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 insurance or 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,







CLEARING THE MORTGAGE MARKET THROUGH PRINCIPAL REDUCTION: A BAD BANK FOR HOUSING (RTC2.0) U.S. housing prices peaked in March 2006. Since then they have fallen 34%,1 and a 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 are frequently unable to meet on a price. This paper examines why mortgage markets have failed to clear, particularly the problems created by negative equity. The paper considers ways in which the negative equity problem might be addressed and then turns to assessment of the feasibility of using a “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 for clearing the mortgage market than foreclosures and that doing so could also alleviate the liability overhang affecting the banking sector and which threatens another $80 billion in losses over the next three years.3 Whatever the tradeoffs between restructuring and foreclosure in the case of an individual loan, when viewed from a macroeconomic perspective, large numbers of foreclosures present a serious problem due to their negative externalities. Large scale reduction of negative equity is necessary for clearing housing markets. Principal reductions to date have been limited and proposed expansions of existing principal reduction programs are too modest and too slow to have macroeconomic effects. Instead, a framework is needed for a large scale, one-time resolution of the United States’ negative equity problem. Use of bad bank provides a transactional framework for such resolution that would avoid some of the problems currently impeding restructuring efforts. A bad bank for housing also offers a clean break from the mortgage legacy issues that continue to weigh on the financial sector. I. THE NEGATIVE EQUITY PROBLEM The central problem affecting the United States housing market today is that the market 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 equity nationwide.4 Negative equity or near negative equity affects approximately 12.3 million

S&P/Case-Shiller Composite 10-CSXR-SA Index. 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, BLOOMBERG, 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, THEMREPORT.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.


2 mortgagees,5 who are in turn 27.1 percent of all residential mortgages.6 The average underwater 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); in California, the average underwater borrower is upside down by $93,000.8 To put these figures in some perspective, the median annual household income in the United States in 2009 was $49,777,9 meaning that the average amount of negative equity is considerably greater than most households’ annual disposable income. The depth of negative equity is likely to increase as housing prices drop due to foreclosure sales and lack of upkeep on underwater 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 from clearing. People need to be able to sell and buy homes. Normal life-cycle events necessitate 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 a price. When they do the deal, the market clears at the deal price, and welfare is enhanced when 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 problem with the housing market, currently, is that even when willing buyers and willing sellers can agree on a price, they often cannot close the deal because there is a mortgage on the property for more than the deal price. To wit, if someone agrees to buy a house for $200,000, it is impossible to close the 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 the homeowner 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 pays off the remaining $65,000. In such circumstances, few, if any, people are willing to buy; they would, by definition, be overpaying for the house. Put differently, the buyer must pay for both the house and the deficiency in order to obtain the house. The result is that even though the buyer and seller can agree on the value of the house, they cannot complete the deal because 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,
Core Logic Id. 7 CoreLogic, supra note 4 (calculations by author, averaging first-lien only and first-line plus junior lien data). 8 Id. 9 U.S. Census Bureau, at There are good reasons 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.Germain Depository Institutions Act of 1982, codified at 12 U.S.C. § 1701j-3. © 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.
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3 are not marked-to-market. Mortgages are usually held-to-maturity assets and therefore carried at book, rather than market value. Mortgages are therefore only marked-tomarket (or carried at fair value) if they are impaired or sold (including in foreclosure sales).11 If mortgages were marked-to-market, mortgage debt would closely track home values. A change in the accounting treatment of mortgages is both unlikely and ill advised; there is no justification for distinct accounting treatment of home mortgage loans from other secured loans. Therefore, it is necessary to look to other approaches for clearing the market. At present, there is only one major way of clearing the housing market: foreclosures.12 Foreclosures, however, are an incredibly slow and inefficient method of market clearing, even in the best of times. Both servicers and judicial systems have limited “bandwidth” for processing foreclosures, and in some states, such as Florida these limits are constraining foreclosure activity.13 Foreclosures are rife with negative externalities on neighbors, communities, and local government.14 Foreclosures can also result in the market over-clearing (meaning sales at artificially low prices) because foreclosure sale purchasers have very limited information about foreclosure properties and no warranties about the condition of the property; foreclosure sale purchasers (at sheriff’s or trustee’s sales, as opposed to REO sales) have no right to inspect the property before bidding, so they cannot know the condition of the property or often even its layout. This is a particular problem given the poor condition of many foreclosure properties. In such an information-poor environment, the market for foreclosure properties is thin and bids are heavily discounted. Because foreclosure sale properties compete with private, arms-length sale properties for buyers, they depress real estate prices.15 The result is to diminish the equity of other non-defaulted homeowners, pushing at least some of them into negative equity and deepening the negative equity of others, thereby exacerbating the marketclearing problem. At the current pace, it is estimated that there is already a three-year backlog of some 2.2 million foreclosure properties (and this does not account for another 4.1 million delinquent properties), all of which contribute to a “shadow inventory” that will continue to depress the real estate market.16 In some states, the backlog is even longer,17 as

Statement of Financial Accounting Standards (SFAS) 114. Short sales are a market clearing mechanism too, but they are frustrated by mortgagee concerns about buyer-seller collusion, desire to avoid or delay loss recognition, and realtors’ unwillingness to handle short sales, which take more time, but frequently do not close, meaning that the realtor does not get paid. 13 Florida has even reactivated retired judges to handle cases. Gretchen Morgenson & Geraldine Fabrikant, Florida’s High-Speed Answer to a Forelcosure Mess, N.Y. TIMES, Sept. 5, 2010 at BU1. 14 Adam J. Levitin & Tara Twomey, Mortgage Servicing, 28 YALE J. ON REG. 1 (2010). 15 See, e.g., Atif Mian et al., Foreclosures, House Prices, and the Real Economy, NBER Working Paper No. 16685, Jan. 2011, at; John P. Harding, Eric Rosenblatt & Vincent W. Yao, The Contagion Effect of Foreclosed Properties, working paper, July 13, 2009, at 16 Eric Dash, As Lenders Hold Homes in Foreclosure, Sales are Hurt, N.Y. TIMES, May 22, 2011; Kate Berry, Mortgage Industry Faces “Staggering” Backlog of Foreclosed Homes—Fitch, AM. BANKER, Dec. 14, 2011. © 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.


4 foreclosure timetables have become extended and then distended with more foreclosures than can be handled by the legal infrastructure in judicial foreclosure states and increased litigation stemming from mortgage documentation and chain-of-title problems such as robosigning, MERS, and securitization fails. Nor is it clear that the federal-state servicing fraud settlement will significantly decrease the backlog. The market-clearing problem in housing is not an abstraction, and it is not simply a housing market problem. It is the central problem in the U.S. economy. Consumer spending is often estimated at around 70% of GDP;18 while this figure is somewhat overstated,19 what is clear is that the US is a domestic consumer demand-driven economy. Any stagnation or contraction in consumer spending has major effects throughout the economy. Even a modest percentage of households contracting their spending results in an economic slowdown. As it stands, many households are pulling back on their spending because of their uncertain financial position. For many households, their major financial asset—their house—is worth much less than it was six years ago, and in many cases, worth less than the debt it secures. Unless households feel more confident in their balance sheets, they won't go out and spend (and banks won't make them loans to spend). Diminished consumer demand means less employment, which itself fuels household economic contraction in a vicious balance sheet recession cycle.20 Put differently, housing is dragging down the economy, and the economy is in turn dragging down housing. The housing market also continues to cast a liability overhang that weighs down the financial sector. Until the housing market clears, financial institutions will continue to have unrecognized losses, and will be carrying assets at inflated values. While loss reserving can offset some of the unrealized losses, reserves cannot be set aside unless losses are probable and estimable. This makes loss reserving for performing underwater loans difficult—while there will likely be significant losses on some of those loans, when and how large is unknown. Moreover, continued litigation over securitization and
See, e.g., Kevin Post, Bottom Lines, Foreclosures in New Jersey Now Take an Average of 849 Days, PRESS OF ATLANTIC CITY, Feb. 12, 2011, at 18 See, e.g., Michael Mandel, Consumer Spending Is *Not* 70% of GDP, Bloomberg BusinessWeek, Aug. 14, 2011, at 19 See id. 20 See Atif Mian & Amir Sufi, How Household Debt Contributes to Unemployment: Mian & Sufi, BLOOMBERG, Nov. 16, 2011, at; Atif Mian & Amir Sufi, What Explains High Unemployment? The Aggregate Demand Channel, working paper, Nov. 2011, at; Atif Mian, Kamalesh Rao, & Amir Sufi, Household Balance Sheets, Consumption, and the Economic Slump, working paper, Nov. 2011, But see James Surowiecki, The Deleveraging Myth, The New Yorker, Nov. 14, 2011, at (arguing that the recession is driven by a wealth effect, namely a perceived loss of wealth due to housing, rather than from leverage per se). © 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.

5 servicing practices presents a further liability overhang for the financial sector. In particular, Bank of America and Citigroup had book-market valuation gaps of $113 billion and $76 billion respectively at the end of the first quarter of 2012. What this means is that negative equity is a macro-economic problem. Accordingly, it must be approached with an eye to maximizing the scope of any solution. Not every dollar of the $700 billion in negative equity needs to be eliminated for mortgage markets to begin to clear, but considerable inroads must be made. This in turn dictates a key feature of any approach to principal reduction for market-clearing: it must have sufficient scope, even at the expense of compromising on other factors. Without an overriding macro-economic impact goal, principal reductions will result in little more than charity toward a population of more-or-less deserving borrowers. A final important point to understand about the market-clearing problem is that it is not a mortgage default problem per se. The failure of the market to clear will result in elevated mortgage default levels as some homeowners rationally decide to walk-away from underwater properties and as life cycle events—death, disability, divorce, dismissal—result in some unavoidable defaults. When these defaults occur, a foreclosure is likely to follow, which means that the market will clear, even if inefficiently. The market-clearing problem, however, is one that affects performing loans, rather than defaulted loans. This means that the universe of loans to be targeted is not underwater and defaulted (indeed, those may well be lost causes if the loan is seriously delinquent), but the much vaster universe of underwater and performing loans. II. MAKING MARKET CLEAR If negative equity is the root cause of the market-clearing problem, then enabling market clearing means addressing negative equity. There are five basic approaches to dealing with negative equity: doing nothing, making mortgages more affordable, voluntary principal reductions, involuntary principal reductions, and “quasi-voluntary” principal reductions. Each is reviewed in turn below. A. Do Nothing The first strategy for dealing with the negative equity problem is to do nothing. The basic idea behind doing nothing is that other routes are costly and have uncertain benefits, and there is a chance that the negative equity problem will disappear on its own via housing price appreciation or inflation or foreclosures.21 It is dubious that either of these things will occur in the near future, much less to the degree necessary to make the market clear. Yet, doing nothing lets financial institutions delay and possibly avoid loss recognition (which enables greater continued servicing income), enabling losses to be recognized against earnings over time.

See Stephen Tetreault, Reid Hits Romney on Foreclosures, Las Vegas Review-Journal, Oct. 18, 2011, at (noting that GOP Presidential candidate Mitt Romney stated that government let the foreclosure process “run its course and hit the bottom.”). © 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.


6 B. Affordability The second strategy is to concentrate on making mortgages more affordable without reducing principal owed. This can be done in numerous ways, such as mortgage modifications or refinancings that lower interest rates or change terms and amortization schedules to reduce monthly payments. The Home Affordable Refinance Program (HARP) and most of the modifications undertaken by the Home Affordable Modification Program (HAMP) are examples of the affordability strategy. The idea animating the affordability strategy is two-fold: first, to prevent foreclosures due to acute affordability problems, meaning that the homeowner cannot make the monthly mortgage payments, and second, to discourage jingle mail by making it less unattractive for homeowners to stay in an underwater property even if they can afford the monthly mortgage payments. Reducing monthly payment obligations via rate reductions and term extensions can obviously address affordability issues in the shortterm, if the payment reductions are sufficient (and homeowners’ total debt loads are a factor in this equation). Affordability, however, does help markets clear except indirectly. By avoiding some foreclosures, affordability programs reduce downward price pressure on the housing market. But even if a mortgage is affordable as modified or refinanced, if there is negative equity a foreclosure is still likely in the event of a life-cycle event like death, disability, divorce, or dismissal (the “four Ds”). The result is that foreclosure properties will still be heavily overrepresented among properties on the market; nationally, as of April 2012, over a quarter of sales were either foreclosure sales or short sales.22 In some regions, however, April 2012 distressed sales were as much as 61 percent of sales.23 As these sales are heavily discounted from arms-length prices they drive down housing prices overall.24 The high percentage of distressed sales is likely to continue for the foreseeable future given the “shadow inventory.” C. Voluntary Principal Reductions A third approach to market clearing is to rely on mortgagees to act in their selfinterest to avoid foreclosures and have the market clear. 1. The Dearth of Voluntary Principal Reductions Some voluntary principal reduction modifications have occurred, but they have been the exception, rather than the rule. The GSEs do not offer principal reduction

Nat’l Assoc. of Realtors, News Release, April Existing-Home Sales Up, Prices Rise Again, May 22, 2012, at (noting that foreclosures and short sales respectively accounted for 17% and 11% of sales in April 2012, down from a combined 37% a year prior). 23 CalculatedRisk, Sacramento: Percentage of Distressed House Sales increases slightly in April, CALCULATEDRISKBLOG.COM, May 10, 2012, at 24 See Nat’l Assoc. of Realtors, supra note 22 (noting that foreclosures sold for an average discount of 21% from market and short sales at an average discount of 14%). © 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.


7 modifications.25 As a result the majority of mortgages are simply ineligible for principal reduction.26 For non-GSE loans, voluntary principal reductions are also rare. HAMP’s Principal Reduction Alternative (PRA) “requires servicers of non-GSE loans to evaluate the benefit of principal reduction on mortgages with a loan-to-value ratio of 115% or greater when evaluating a homeowner for a HAMP first lien modification.”27 PRA does not require principal reduction, only evaluation of its benefits. As of March 2012, 51,732 principal reductions had been undertaken through the program.28 Similarly, according to the OCC’s Mortgage Metrics Reports, national bank servicers have undertaken only 103,372 principal reduction modifications from 20092011.29 This accounts for less than 5% of all mortgage modifications.30 Even voluntary principal deferrals (which may overlap with principal reduction modifications) were rare. From 2009-2011, national bank servicers undertook only 204,126 principal deferrals, or 9.8% of all modifications.31 Notably, principal reductions are much more likely to be undertaken on portfolio loans than on private-label securitized loans. According to OCC Mortgage Metric Reports, from 2009-2011, 20.2% of modifications of portfolio loans have involved principal reduction, compared to only 3.1% of modifications of private-label securitized loans.32 Simply counting the number of modifications in which principal was forgiven, however, is itself an incomplete story that likely overstates the importance of the principal reduction modifications undertaken to date. It does not address the qualitative issue of the modifications. While principal may be forgiven, borrowers are almost never placed into positive equity through principal forgiveness, as that would enable refinancing and the loss of the servicing income stream for the servicer. Instead, negative equity is typically reduced, not eliminated.

OCC Mortgage Metrics Report, Forth Quarter 2011, at 28, at 26 It is unknown what percentage of underwater mortgages are owned or guaranteed by the GSEs. Fannie Mae’s 2011 Credit Supplement lists 17.9% of loans owned or guaranteed by Fannie Mae as underwater, with 7.5% of them at above 125% LTV. See Fannie Mae 2011 Credit Supplement, Feb. 29, 2012, at at 6. 27 U.S. Dept. of Treasury, Making Home Affordable Program Performance Report Through Feb. 2012, at 4. 28 Id. 29 OCC Mortgage Metrics Reports. This figure is derived by adding all principal modifications for private-label and portfolio loans. It excludes 1,035 erroneously reported principal modifications for Agency loans. 30 Id. OCC Mortgage Metrics Reports 2,087,807 from 2009-2011. This figure double counts multiple modifications of the same loan, so the total number of loans modified is likely smaller than two million. 31 Id. 32 Id. © 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.


8 Yet a principal reduction only matters in terms of reducing defaults if it puts the borrower in a position where positive equity is foreseeable in the near future; a principal reduction modification that changes a loan from 250% LTV to 175% LTV is unlikely to affect borrower behavior vis-à-vis negative equity, although is will make the loan more affordable if reamortized. And as long as borrowers are left with any negative equity, markets will not clear. In short, voluntary principal reductions are rare and of questionable impact because they have been too modest in their loan forgiveness. To the extent that voluntary principal reductions have occurred to date they are reportedly on primarily deeply underwater loans (often payment-option ARMs) or on whole loans that have been purchased at a discount with an eye toward restructuring and refinancing. There are several possibilities for expanded voluntary principal reductions. First, more generous HAMP incentive payments for principal reduction might bear fruit. Second, FHFA might accede to continued political pressure to direct principal write downs on mortgages owned or guaranteed by the GSEs. Third, as servicers gain experience with principal reduction modifications, including the 200,000 principal reduction modifications promised by Bank of America,33 they may become more comfortable with them. Even so, it is not clear whether any of these options would produce voluntary principal reductions of sufficient scope to help clear the housing market. 2. Reasons for the Lack of Voluntary Principal Reductions There are several reasons why voluntary principal reductions have been rare. It is impossible at this juncture to ascertain which reasons are more or less important, and the answer may vary by servicer and may have varied over time. Thus, the listing of factors below should not be interpreted as a ranked ordering of importance. The first factor contributing to the lack of voluntary principal reduction modifications is a simple capacity issue. Servicers have and may continue to have insufficient staffing and systems for handling defaulted loans. Servicing is primarily a transaction processing business, which can be highly automated and involves little discretion.34 Loan modification, in contrast, is a personnel intensive business requiring significant judgment on behalf of employees.35 While one would have imagined that personnel deficiencies would have been remedied five years into the foreclosure crisis, servicers have little incentive to expand their staffing, as their compensation does not correspond with the quality of their loss mitigation. Simply put, servicers are not in the loan modification business and have little interest in getting into this short-term business. Given this, the number of loan modifications that has occurred is in fact surprisingly high. Second, there continue to be significant problems in coordination and communication between servicers and homeowners. Sometimes these problems relate to

Associated Press, Bank of America: Principal Reduction for 200,000 Homeowners, Mar. 9,

2012. Levitin & Twomey, supra note 14, at 25-26. Id. © 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.
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9 servicers’ modus operandi, such as using fax as a primary mode of communication; large servicers receive tens of thousands of pages of fax daily, which makes errors and lost documents all but inevitable. Sometimes, however, the communication problems are on the consumer end, such as consumers to do not respond timely to requests for information or who submit incomplete information. Either way, there continue to be breakdowns in servicer-homeowner communications, and the result is to frustrate modifications of all sorts. Third, legal constraints have limited the number of principal modifications. RMBS pooling and servicing agreements (PSAs) often place limitations on servicers’ ability to undertake loan modifications.36 PSAs rarely prohibit principal modifications outright. Instead, they place other limitations on modifications, including the number and frequency of modifications, and requirements that modifications only be done on loans where default is imminent or reasonably foreseeable. More problematic than direct, explicit contractual restrictions on principal modification are more general provisions, such as PSAs that reference the GSE’s servicing standards. The GSEs do not currently permit principal reductions on loans they own or guarantee. Beyond this, PSAs almost never explicitly authorize principal reductions. Some servicers point to the lack of explicit authorization to explain why they eschew principal reductions. Fourth, the legal landscape for servicers has been constantly shifting since 2009. Servicers have been required to comply with the provisions of the HAMP program and its numerous add-on components and changed rules. Servicers have also been required to comply with changed GSE servicing standards and to change their procedures in the wake of legal challenges to MERS and various foreclosure practices like robosigning and various local mediation programs and court rulings. All of this has required changes in servicers’ operating procedures and systems, which has distracted servicers’ time and attention from loan modifications and generally slowed down loss mitigation. Fifth, second liens complicate principal reductions. First lien lenders are reluctant to reduce principal without some concessions from second lien lenders. Second lien lenders are often completely out of the money, so the main value of their liens is the possibility that the borrower will foolishly pay them while defaulting on the first lien and the holdup value in preventing a refinancing or modification of the first lien. Thus, at the very least, second liens add a coordination problem that raises transaction costs, and they may also serve as to disincentivize or even prevent principal reduction modifications. Sixth, the desire to avoid or delay loss recognition is another factor that may be contributing to the dearth of principal reduction modifications. For loans on banks’ books a reduction in interest rates or term extension will change the risk-weighting of the loan (if the modification is done outside of HAMP), but those changes affect future income statements, rather than the current balance sheet. While a write-down on an individual residential mortgage loan is immaterial to a bank, if done en masse principal reduction could raise some capital adequacy issues. For securitized loans, servicers may be reluctant to undertake principal modifications because a substantial component of their compensation—servicing fee
See Anna Gelpern & Adam J. Levitin, Rewriting Frankenstein Contracts: Workout Prohibitions in Residential Mortgage-Backed Securities, 82 S.CAL. L. REV. 1075, 1089-91 (2009). © 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.

10 income—is based on the outstanding principal balance of the securitized loan pool. While a reduction in interest rates will result in a smaller payment and thus slightly reduced float income for the servicer, an equivalent payment reduction from reducing principal would result in a much larger reduction in servicing fee income. A seventh factor that disincentivizes principal reduction modifications is a freeriding problem. Principal reduction modifications have positive externalities on other nearby homeowners. Those homeowners do not necessarily have mortgages, much less ones serviced by the same servicer as undertook the principal reduction modification. Thus, if the servicer believes that a defaulted loan will re-perform without a principal reduction, there is no incentive for the servicer to reduce principal; a single servicer, acting alone to do large scale principal modification, would be unlikely to unfreeze the mortgage market. It would take several large servicers acting in concert. This results in a collective action problem. Moving alone, the servicer faces a free-riding issue, while to move together requires coordination. The eighth factor that has impeded principal reduction modifications is servicers’ concern about moral hazard, namely that principal reductions for defaulted loans could encourage other borrowers to default in order to get principal reductions. There is some evidence that consumers will default strategically when loan modifications are contingent upon default.37 It is not clear how much concerns about moral hazard have actually prevented principal reductions or whether moral hazard instead serves as a rhetorical device to shift attention away from other factors impeding principal reduction. There are possibilities for reducing moral hazard, namely not making principal reduction contingent upon default; limiting principal reductions to loans that have already defaulted; making principal reduction contingent upon either future loan performance; or combining principal reduction with shared appreciation. All of these factors have complications, however. Servicers are reluctant to delink principal reduction and default because they see no reason to reduce principal on a performing loan. While this approach makes a great deal of sense when viewed from a servicer’s loan-by-loan vantage point, it makes little sense when trying to deal with a national problem of a mortgage market that isn’t clearing. Limiting principal reductions to loans that have already defaulted would eliminate moral hazard concerns, but it would also limit the systemic benefits of principal reduction. As most underwater loans are not yet in default, it would be only a partial solution to the problem and it would penalize those homeowners who have managed to keep making payments despite being underwater—the good or foolish actors depending on one’s perspective. Contingent forgiveness forgives principal over time as the loan continues to perform, rather than forgiving it in a lump sum immediately. The appeal of contingent forgiveness is that it is a reward for underwater borrowers to continue paying on their
Christopher J. Mayer, Edward R. Morrison, Tomasz Piskorski, & Arit Gupta, Mortgage Modification and Strategic Behavior: Evidence from a Legal Settlement with Countrywide, Columbia Law & Econ. Working Paper No. 404, May 16, 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.

11 mortgage. It also allows losses to be recognized over time. Contingent forgiveness, however, means that market clearing will also be stretched out over time. If a loan is reduced from 150% LTV to 100% LTV over five years (10% LTV reduction per year), it will take (at least) five years before that property can be marketable. A foreclosure is faster. It’s important to distinguish contingent forgiveness from deferred principal. Deferred principal is merely a partial deamortization of the loan, with some principal deferred to a later repayment date. Typically this results in a balloon or bullet payment at the end of the loan. It does not change how much the borrower owes, so it does not deal with the problem of negative equity. Instead, it reduces monthly payments for a limited time period, followed by a payment shock when the deferred principal comes due. Share appreciation is, in theory, the most promising method of dealing with moral hazard and with the possibility (that housing prices will uptick noticeably after a principal reduction. To date, lenders have showed little interest in shared appreciation modifications. The most fundamental reason for this might be that lenders do not anticipate significant appreciation. Moreover, lenders have not generally figured out a workable shared appreciation modification structure. For securitized loans, shared appreciation modifications create two separate problems. First, they change the servicer’s income stream, which is based primarily on the unpaid principal balance. The servicer has no way of recapturing the servicing fee from any shared appreciation, and even if it did, that would be uncertain future income. Second, the uncertain future income stream from shared appreciation shifts value around among investors. Shared appreciation provisions are likely to backload income, which can affect the income’s allocation within a securitization structure. It is also not clear whether the appreciation would be treated as principal or interest; nothing in pooling and servicing agreements contemplates this, yet it matters because securitizations allocate principal and interest payments in different “waterfalls.” Thus for securitized loans (private-label and GSE), shared appreciation raises likely insurmountable obstacles. Absent a binding appraisal mechanism, lenders are only able to capture their share of appreciation upon the sale of the property. This creates problems for a lender, as the loan can be paid off or refinanced before there is a sale, in which case the lender would lose the shared appreciation. Moreover, the tax treatment of shared appreciation mortgages for both homeowners and lenders is uncertain, because it is not clear whether the shared appreciation would be treated as debt or equity and if debt as principal or interest.38 Similar confusion exists in terms of Truth in Lending disclosures: is a modification that adds a shared appreciation component really a refinancing and if so, is the shared appreciation a finance charge necessitating new disclosures? A shared appreciation provision might be viewed as a refinancing, rather than a modification, because with sufficient appreciation it could increase a borrower’s total liability. If so, it
Rev. Rul. 83-51; Andrew Caplin, Thomas Cooley, Noel Cunningham, & Mitchell Engler, Facilitate Shared Appreciation Mortgages to Prevent Housing Crashes and Affordability Crises, Brookings Discussion Paper 2008-12, Sept. 2008, at aplin/0923_mortgages_caplin.PDF; Andrew Caplin, Thomas Cooley, Noel Cunningham, & Mitchell Engler, We Can Keep People In Their Homes, WALL ST. J., Oct. 29, 2008. © 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.

12 could raise a variety of issues from the need for Truth in Lending and Real Estate Settlement Procedures Act disclosures to lien priority problems (absent a resubordination agreement), to title insurance issues. Clarification of tax and TILA status of shared appreciation modifications might help facilitate shared appreciation mortgages, but unless significant shared appreciation is anticipated, it is unclear how attractive shared appreciation will ever be to lenders. 3. The Dearth of Short Sales In terms of market clearing, short sales would have a similar effect to principal reduction modifications, although the event sequencing difference between them are important. In a short sale, the principal forgiveness occurs only after there is a sale proposed, whereas a modification can occur at any time, and is not contingent on a sale. This difference matters because in a short sale, the transaction is contingent upon the lender forgiving principal, and if lenders are slow or curmudgeonly about approving short sales, it can chill future transactions. If principal is forgiven before the sale is proposed, then the market clearing (the sale) is separated from the elimination of the obstacle to clearance (principal reduction). There is limited information on the number of short sales that have occurred. FHFA data indicates that there have been slightly over 300,000 short sales of GSE loans from the fourth quarter of 2008 through the first quarter of 2012.39 Relative to the number of distressed, underwater properties, during this period, the number is quite small. While short sales some do happen, they still appear to be fairly exceptional. 4. Reasons for the Lack of Short Sales Several factors militate against short sales. First, a short sale requires the lender to recognize a loss immediately. The lender has no way of knowing if denying the short sale would result in a default and foreclosure, and even if it would, that would still be delayed by some months (or even years in some parts of the country). Thus, if the homeowner is not currently in default, the lender would not otherwise have to take an immediate right down. If a lender is hoping to avoid or delay loss recognition, then short sales are not appealing. Second, lenders are concerned about collusive short sale offers in which the buyer is in cahoots with the seller and offers a low-ball price. The seller and buyer have a significant information advantage over the lender, and the sluggish arms-length, nonforeclosure sales market provides limits comparables for appraisal purposes. Accordingly, lenders may be reluctant to approve short sales lest they give up too much value. Better to take delayed loss recognition and have the confidence in the pricing based on the sale out of REO after foreclosure. Third, if there is a junior lien on the property, a short sale is a non-starter. The junior lien will remain on the property unless it is paid off. It will also become the senior lien after the short sale, and the payment obligation will rest on the seller, not the buyer. Accordingly, the buyer will insist on discounting the purchase price by the amount of the junior lien. This means that the junior lien would get paid off in full, while the senior
Federal Housing Finance Agency, Foreclosure Prevention & Refinance Report, Feb. 2012, at at 3. © 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.

13 would incur a loss. Senior lenders are likely to eschew such sales. Thus, the presence of second liens may frustrate short sales absent coordination between the lenders to allocate the loan forgiveness among them. Coordination issues between lienholders have been an issue in general with loan modification. Even when coordination is possible, it imposes delay. Delay is particularly likely to frustrate short sales. The additional step in a short sale of getting lender approval from a single lender can itself be fatal to a short sale. Buyers are often looking to close within a finite window of time. They do not want to have an offer outstanding for months while they (and the seller) wait to get a response from the lender. Similarly, buyers (and sellers) do not want to wait for months to find out if multiple lienholders have reached an agreement on loss allocation in a short sale. Because so many short sales get denied, realtors are often reluctant to work on them. Realtors generally only get paid if a deal closes. Realtors put in the same amount of work (if not more) on a short sale as on a regular sale, but their likelihood of being paid is lower in a short sale. Accordingly, some realtors refuse to work on short sales. D. Involuntary Principal Reductions There are two major approaches involuntary principal reductions: either through bankruptcy (“cramdown”) or through governmental “takings”. Cramdown would necessitate a legislative change to allow modification of single-family principal residence mortgages in bankruptcy, which is currently prohibited.40 Cramdown had several appeals: it dealt with negative equity; it offered impartial, judicial valuation; it addressed moral hazard concerns by imposing bankruptcy costs on borrowers and could be limited to borrowers with mortgages before a cutoff date; it offered a judicial airing of all claims and defenses to the mortgage; and it created incentives for voluntary principal reductions in the shadow of bankruptcy. Cramdown legislation passed the House but failed to achieve cloture in the Senate in 2009.41 Cramdown legislation could take many forms besides that in the failed legislation, such as changes to make it more standardization of loan restructuring and to offer offsetting benefits to lenders, such as standardized, accelerated foreclosures on nonviable borrowers.42 Nonetheless, there appears to be little if any appetite in Congress for reopening the debate; a second attempt to move cramdown legislation in the House in 2010 failed as Democratic leadership permitted Blue Dogs to vote freely, knowing that passage in the Senate was unlikely. The Blue Dogs, under reelection pressure, voted against the legislation. Together with Republican votes in opposition, this doomed cramdown legislation.

See Adam J. Levitin, Resolving the Foreclosure Crisis: Modification of Mortgages in Bankruptcy, 2009 WISC. L. REV. 565 (2009). 41 S. 896, The Helping Families Save Their Homes Act of 2009 (111 th Congress) (failed to achieve cloture while cramdown provision was included; subsequently passed without cramdown provision). 42 See Adam J. Levitin, Chapter M: Standardized Mortgage Bankruptcy Proposal, 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.


14 A second involuntary method of principal reductions would be to exercise the federal government’s eminent domain “takings” power.43 The federal government is permitted to take private property, provided that it pays “just compensation” to the owners. This means that in theory the federal government could “take” all underwater mortgages by paying their owners the market value of those mortgages. The market value may not match the property value, but would be much closer than the unpaid mortgage balance. Mortgagees could always litigate with the government over whether the compensation offered was “just,” but that would not affect the government’s ability to “take” the mortgages, only the price tag for doing so. Having forced the sale of the mortgages at a “just” price, the government could then reduce principal balances on the mortgages to that “just” price and either manage the restructured mortgages itself or resecuritized them (as through a Resolution Trust Corporation entity, with or without a guarantee of some sort). In essence, a “takings” approach could be used to recreate a Home Owners Loan Corporation (HOLC) approach.44 While a “takings” approach is theoretically possible, a massive taking of mortgages would be an unprecedented use of the takings power, which has traditionally been used for taking physical rather than financial assets, and on a much smaller scale. This means that there is some question about the Constitutionality of a “takings” approach. Even if Constitutional, however, a takings approach would not be without problems. It would come with a huge liquidity price tag, as the government would have to pay just compensation for trillions of dollars of mortgages. This would be no small matter for federal budgets. The government would bear the default risk on the taken mortgages, until and unless it could securitize them absent a guarantee. Again, this would affect the federal budget. It would impose a huge operational burden on the federal government, requiring the government to come up with servicing arrangements. Finally, and most importantly, a takings approach would entail significant political risk for an Administration; the exercise of eminent domain power is rarely popular, and a massive taking of mortgages and associated principal write-downs for a group of homeowners not all of whom acted responsibly and blamelessly during the housing bubble might be extremely unpopular politically. E. Negotiated Principal Reductions The final strategy for making the housing market clear is principal reductions through negotiated, quasi-voluntary arrangements, in which the principal reductions are formally done voluntarily by mortgagees, but only in the face of litigation or in response to pressure from regulators. While the precise terms of the principal reduction would be

See, e.g., Lauren E. Willis, Stabilize Home Mortgage Borrowers, and the Financial System Will Follow, Loyola Law Legal Studies Paper 2008-28, available at; Howell E. Jackson, Build a Better Bailout, CHRISTIAN SCI. MONITOR (Sept. 25, 2008), available at; John D. Geanakoplos & Susan P. Koniak, Matters of Principal, N.Y. TIMES, Mar. 4, 2009; John D. Geanakoplos & Susan P. Koniak, Mortgage Justice Is Blind, N.Y. TIMES, Oct. 29, 2008. 44 See, e.g., Andrew Jakabovics, History Lesson, THE NEW REPUBLIC ONLINE, Oct. 10, 2007, at; Brad Miller, UnHAMPered, THE NEW REPUBLIC ONLINE, Feb. 24, 2010, 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.


15 negotiated, it would be a negotiation with a regulator or litigant, not with the individual homeowners. Two possible variants are presently feasible. First, principal reductions could be achieved as part of a litigation settlement, most likely involving suits brought by state Attorneys-General against a broad universe of financial institutions (including the GSEs), not just mortgage servicers, over mortgage origination and securitization practices. Alternatively, the federal government could exercising its market power in the secondary market by making lenders and servicers that failed to engage in principal reductions ineligible for FHA insurance on their loans or for doing business with the GSEs. For example, FHA regulations provide that a lender is ineligible for FHA insurance if it is “engaged in business practices that do not conform to generally accepted practices of prudent mortgagees or that demonstrate irresponsibility.”45 “Irresponsibility” is not defined in the regulations, but it could reasonably be interpreted to include failure to engage in principal write-downs (particularly if the principal write-downs are net present value positive for the loan). Similarly, Treasury could make its continued support of the GSEs contingent upon principal reductions by both the GSEs and all private parties doing business with the GSEs. The point here is not to detail the specific legal levers for the government to encourage quasi-voluntary principal reductions, to rather to emphasize that there are levers. The levers are not without risk; they could be subject to legal challenges and pose political, but the levers exist; the key question here is one of political will. III. A TRANSACTIONAL FRAMEWORK Presently, the policy solution to the housing market is a combination of the do nothing, affordability, and voluntary principal reduction strategies. As involuntary principal reduction seems quite unlikely in the current political climate, the only likely change in policy will be as the result of a negotiated, quasi-voluntary solution coming from strong regulatory or litigation pressure. This paper is well cognizant of the formidable political obstacles to even such a negotiated solution, but the alternatives are small-bore solutions that will do little to fundamentally fix the housing market. A. Loss Allocation As a starting point, for considering principal reduction mechanisms, it is necessary to acknowledge that market-clearing in the housing market means loss recognition on underwater mortgages.46 There are serious losses in the housing market, and only limited places to put them: (1) the government; (2) financial institutions involved in mortgage origination, securitization, and servicing; and (3) investors in mortgages (MBS investors and portfolio lenders). There is significant overlap among these categories, as the government guarantees some or all obligations of various financial institutions and MBS investors (including the GSEs and the Federal Reserve),
24 C.F.R. § 202.5(j)(4). An alternative strategy would be to simply wait for the market to grow its way to clearing via normal house price inflation. The feasibility of such a strategy is dubious, however, as it may take quite a while, and, to the extent that the negative equity is the primary factor behind decreased consumer demand and thus lower employment and economic productivity, the U.S.’s consumer-spending driven economy is unlikely to grow its way to higher housing prices other than through population growth. © 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.
46 45

16 and many financial institutions that originated, securitized, and service mortgages are also portfolio lender and/or MBS investors. This paper does not address the proper allocation of losses in the housing market.47 Nonetheless, recognition of the limited loss recognition options is important for understanding the dynamics of principal reduction strategies for clearing the US housing market, as different loss allocation approaches change the political, legal, and economic feasibility of principal reduction strategies. B. Basic Principles of Principal Reduction For a principal reduction program to be effective, there are several basic principles to which it should adhere: (1) Scope is critical for a principal reduction strategy to have a macroeconomic impact, and for participating institutions to enjoy the synergies of the strategy. Uniformity of borrower treatment is important for making principal reductions administrable, transparent, and fair. HAMP ran into trouble because of overly individualized treatment that made it hard to tell if borrowers were being treated fairly and correctly and made it harder still to administer. On these lines, abandoning a net present value (NPV) test for modification eligibility would greatly facilitate the administration of any program. A principal reduction program must apply to all underwater loans regardless of default status. So doing eliminates the moral hazard concern of encouraging defaults.48 Some property types should be excluded from a principal reduction program, namely properties that are not owner-occupied or that are second homes. The extent of non-owner-occupied properties is unclear, but excluding them from a principal reduction program would make the program more palatable politically and less expensive. The effectiveness of a principal reduction program could be enhanced if combined with other features, such as a cash-for-keys option, a deed-for-lease option (including rent-to-own), and/or shared appreciation option. Avoid flooding the market with inventory, which is consistent with keeping homeowners in their homes.






C. The Bad Bank Model A common structure used for dealing with troubled assets is the “bad bank,” meaning a specially-created entity that acquires troubled assets and restructures them, leaving the performing assets in the “good bank.” “Bad banks” have been used
See Adam J. Levitin, Make the Banks Pay, SALON.COM, Oct. 27, 2011, for some thoughts on loss allocation. 48 There is still a moral hazard concern of encouraging high LTV borrowing, but that can be addressed in other way, and a unique principal reduction program in the context of a national economic crisis is unlikely to encourage homeowners to gamble on high LTV loans going forward. © 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.

17 repeatedly and successfully in the United States and abroad to restructuring troubled assets and relieve liability overhangs.49 In the United States, the Home Owners Loan Corporation (HOLC) was a government-owned “bad bank” that was used to restructure mortgages during the Great Depression. HOLC refinanced defaulted mortgages from banks at a discount from par and then restructured the loans into long-term fixed-rate, fully amortized obligations.50 HOLC ultimately established the viability of the long-term fixed-rate mortgage.51 A generation later, the Resolution Trust Corporation (RTC) was created as another government-owned bad bank to restructure the assets of failed savings and loans. The RTC enabled centralized asset management, rather than the management of individual failed S&L’s assets. The RTC restructured obligations and then securitized many of them, pioneering commercial mortgage securitization.52 Something similar to a bad bank is often used in bankruptcy reorganizations. A common bankruptcy plan structure involves the funding of a trust to which the claims of a certain class of liabilities are channeled. This is the formal structure for asbestos bankruptcies, where asbestos-related bankruptcy claims are channeled to a trust that is funded with a large portion of the equity of the reorganized company. 53 The result is a simpler claims adjudication process for asbestos claimants and the elimination of the company’s asbestos liability overhang. The recent GM and Chrysler bankruptcies involved a parallel structure, with the establishment of trusts to fund unionized employees’ and retirees’ health care claims that were funded with the ownership of part of the reorganized companies in satisfaction of the employees’ and retirees’ claims. Likewise, the GM and Chrysler bankruptcies involved the sale of the “good” assets of the companies to newly created corporate entities. This meant that the “bad” assets remained with the old corporate shells, which were functionally bad banks that looked to maximize the liquidation value of the “bad” assets. Outside of the United States, bad banks have also been used extensively. For example, in the wake of the Asian financial crisis in 1999 China created four “asset management companies,” one to take over and manage the trouble assets of each of China’s four major banks.54 In Europe, Sweden and Finland created bad banks to assume the bad assets of their banks after an economic downturn in the early 1990s. More

See, e.g., Conor Downey, Alberto Del Din, Hergen Haas & David Lacaze, Issues and Challenges in Establishing “Bad Banks” in Europe, Paul Hastings Stay Current, July 2009, at; McKinsey & Co., Bad Banks: Finding the Right Exit from the Financial Crisis, McKinsey Working Papers on Risk No. 12, August 2009, at papers/12_Bad_Banks_Finding_the_right_exit_from_the_financial_crisis.ashx. 50 C. LOWELL HARRISS, HISTORY AND POLICIES OF THE HOME OWNERS’ LOAN CORPORATION 1, 36-37 (1951). 51 Adam J. Levitin & Susan M. Wachter, The Rise, Fall and Return of the Public Option in Housing Finance, working paper, Mar. 13, 2012, at 52 Adam J. Levitin & Susan M. Wachter, The Commercial Real Estate Bubble, 2 HARV. BUS. L. REV. (forthcoming 2012). 53 11 U.S.C. 524(g). 54 William Gamble, Really Bad Banks: China’s Asset Management Companies, Seeking Alpha, Mar. 10, 2009, 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.


18 recently, Ireland and Spain have both created bad banks to assume their banks’ troubled assets.55 IV. RTC2 A. A New RTC All of this suggests that the basic mechanism for market clearing through a quasivoluntary program would involve the pooling of underwater mortgages in a bad bank structure (“RTC 2.0” or for convenience, “RTC2”), which would then restructure and resecuritize the mortgages according to a transparent, standardized restructuring formula (e.g., write all mortgages down to a specified LTV and restructure them to 15-, 20- or 30year, fully amortized, fully prepayable, fixed-rate obligations), ideally, coupled with intensive borrower outreach.56 The basic idea behind using a bad bank entity is that it helps address several market clearing problems simultaneously. First, the transfer of troubled mortgages to a single entity would reunite fractured ownership and eliminate second lien issues. Second, transfer of the mortgages to a single new entity would remove all contractual limitations on mortgage modification. Third, unified ownership would mean consistent standards for the treatment of homeowners and modifications. Fourth, unified ownership enables a standard and thus more liquid resecuritization of restructured mortgages with clearer risks for investors. Fifth, transfer of the mortgages to a new entity would relieve the banks of the legacy issues and liability overhang on the mortgages, in terms of unrecognized credit losses, the hassle and cost (financial and reputational) of managing the loans, and litigation risk. An RTC2 would enable US financial institutions to have a fresh start postcrisis. B. Transfer Mechanisms for Addressing Varied Loan Ownership The mechanism for transferring a mortgage loan to the RTC2 depends on the loan’s current ownership. For loans held in banks’ or GSEs’ portfolios, the transfer would be just a simple sale. The terms of the sale are an issue discussed below (and might very by institution), but there would be no transactional complications regarding the transfer. There are no legal obstacles to principal reduction in those cases. Instead, there is simply a question of whether the financial institution is willing to recognize the losses. The loss recognition problem could potentially be eased through shared-appreciation arrangements on mortgages with reduced principal; such shared appreciation would likely be accounted for as an option, and thus carried at fair value, mitigating some of the principal reduction. On a large scale, it basically recognizes the real economics of
Ireland has created a National Asset Management Agency to hold bad commercial real estate loans. Eamon Quinn, Ireland’s Bad Bank Expert Urges Spain to Follow Suit, WALL ST. J., May 22, 2012, at See also Spain has created a limited entity to deal solely with a single failed cajas. See Sara Schaeffer-Muñoz & Christopher Bjork, Spain Weighs Wider Use of “Bad Bank” Model for Cajas, WALL ST. J., May 11, 2011, at 56 From the HOLC to current outreach efforts, borrower contact and social work appears to pay off in terms of loan performance. See, e.g. HARRISS, supra note 50, at 66-69. © 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.

19 holding a portfolio of underwater mortgage—it is like holding a portfolio of above water mortgages and a call option on the housing market. Second liens, relatively few of which are securitized, present some complications, but they are primarily of three sorts. First, there is a matching problem, which can be addressed if there is adequate information sharing, albeit at some cost. Second, there is a valuation problem. And third, many second liens are held by smaller financial institutions, against whom there may not be the same litigation or regulatory leverage and who present many more coordination problems. Whether the second liens held by smaller financial institutions would be covered in a quasi-voluntary scenario is questionable; if they are not covered, any concessions on first liens would benefit the smaller financial institutions. The larger problem with portfolio loans is that large-scale principal write-downs will significantly decapitalize many major financial institutions, particularly the largest commercial banks. For the GSEs, moreover, loss recognition means putting the bill to the federal government, and thus the taxpayers. It is important, however, to distinguish between financial institutions’ book value and their market capitalization. Some of the largest financial institutions have book equity that greatly exceeds their market capitalization. This is an indication that the market believes these institutions are carrying assets at inflated values or failing to recognize liabilities. A large part of the book-market gap is due to mortgages. To the extent that principal is reduced until the face value of a mortgage is equal to its market value, then principal reductions should help narrow the book-market gap, not only by reducing inflated book values, but also by increasing market value to the extent that it is done in the context of a litigation settlement that relieves some of the banks’ liability. Indeed, wide-scale, rather than single-institution principal reductions would serve as a rising tide that would lift all boats—and all housing prices, thereby increasing the value of the written-down mortgages. Housing prices are currently likely incorporating the prospect of a frozen market, which further depresses them. The synergistic benefits of wide-scale principal reductions would be enjoyed by all financial institutions. Nonetheless, it is possible that some financial institutions would need to be recapitalized or resolved as the result of principal reductions. Securitized loans present different challenges. Securitized GSE loans may only be removed from securitization pools under specified circumstances, all of which require the GSE to buy the loan out of the pool at its outstanding face value. A potential solution to this is to have the GSEs themselves partially prepay underwater loans. While GSE servicers are generally prohibited from soliciting refinancings of GSE mortgages, these prohibitions do not apply to the GSEs themselves (which do not directly interact with borrowers). Moreover, a partial prepayment is not a refinancing. Partial prepayment of loans by the GSEs thus presents a possible mechanism for principal reduction of GSE mortgages without saddling the GSEs with the liquidity requirements of repurchasing all of their underwater mortgages at face value from securitization pools. Private-label mortgage-backed securities (PLS) also cannot generally be removed from their securitization trusts; a PLS trustee has no authority to sell the mortgages other than in a foreclosure. A major exception to this, however, is as part of a settlement,
© 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.

20 including the use of the “putback” mechanism for mortgages that do not conform to representations and warranties.57 This creates a possibility of extracting underwater mortgages from PLS as part of a litigation settlement with PLS trustees. The GSEs have slightly more leeway in removing loans from their securitization pools, but they are generally required to repurchase any nonperforming loan at par. Due to the size of GSE MBS pools, the cost of transfers from the pools to an RTC2 would be impracticably immense, irrespective of the particulars of any conceivable transfer pricing. Instead of transferring loans out of the GSE MBS pools, an alternative would be for the GSEs to partially prepay the loans, meaning that the GSEs would make payments to their MBS trusts on behalf of the homeowners. Some GSE investors might object to the prepayments, but the GSEs are not explicitly prohibited from making such prepayments; the only explicit prohibition is on GSE servicers soliciting refinancings. Good faith issues might still arise. Such prepayment would address negative equity. They would not, however, restructure the loan, nor would they reunite first and second liens. Restructuring could be undertaken separately and second liens could be addressed via a MOU between the GSEs and the RTC2. C. Transfer Pricing and Funding The central negotiation point for a negotiated solution will be transfer pricing. What is the price at which the bad bank will acquire the loans? This paper makes no attempt to propose such pricing. It does, however, note some issues that would likely arise in determining transfer pricing. First, the transfers would have to be negotiated in bulk, rather than on an individual mortgage basis. This will raise some particular valuation issues, but ultimately, it will be a question of how much loss recognition the financial institutions can afford as much as anything. Second, a negotiated solution could cover not just entities that own and service mortgages, but also entities that do not, but were part of the origination and securitization process. If these entities cannot contribute mortgages to the RTC2, they can still contribute cash. Third, transfer pricing may vary depending on loan ownership. For whole loans, it is simply a question of a haircut to the banks, but is complicated by loss recognition issues, especially in regard to second liens. For securitized loans, investor rights must also be considered. All told, however, these are not structural details, so much as pricing, and one can imagine a basic transfer pricing schedule along the lines of the modification credit schedule in the federal-state servicing settlement. Related to, but separate from transfer pricing is the question of how the RTC2 would be funded. What would the capital structure look like? The RTC2 would acquire
PLS trustees have wide settlement authority and do not need court approval of their settlements on behalf of their trusts. BONY Mellon’s filing of a NY State Article 77 action for court approval of the proposed Bank of America/Countrywide MBS settlement, Petition, No. 651786-2011 (N.Y. Sup. Ct., June 29, 2011), was not required. BONYM was instead seeking a prophylactic “comfort order” to protect it from potential litigation. © 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.

21 mortgages for a combination of (1) litigation releases/permission to do future business, (2) cash, and (3) its debt and equity. Litigation releases and permission to do future business are the basis for undertaking an RTC2 structure. Cash and debt issuance relate to the RTC2’s liquidity. The RTC2 would require tremendous liquidity in order to acquire a sizeable percentage of the underwater mortgages. The duration of its liquidity needs would depend on the length of time necessary to restructure and resecuritized the mortgages. Undertaking acquisitions on a rolling basis would reduce liquidity needs, but they would still be enormous. There are two realistic sources of liquidity: financial institutions or the government. If transfer pricing were anything close to even market value of mortgages, the liquidity needs of the RTC2 would likely outstrip anything that financial institutions could provide. In other words, the assistance of the Federal Reserve would be necessary. Ideally, however, a two-tiered liquidity structure would be used, with the Federal Reserve providing a senior liquidity tranche and financial institutions providing a junior liquidity tranche (with the risk entailed being reflected in transfer pricing). What of the RTC2’s equity? The equity ownership of the RTC2 is the first loss position on the mortgage restructuring. If the restructuring is convincing and valueenhancing, not just on the individual mortgage, but through the synergies created by large-scale restructuring that enables market clearing, then the equity position could be in the money. In other words, the equity position is essentially a call option on the U.S. housing market. The equity position would likely be given to financial institutions as part of the transfer pricing, in ratio to their transfers to the RTC2. How it would be valued or treated for regulatory capital purposes (and the related issue of its transferability) is beyond the scope of this paper. D. Management and Operations Obviously the RTC2 would need management and employees. While financial institutions would hold the RTC2’s equity, this does not necessarily mean that they would manage it. One possible scenario is that the settlement creating the RTC2 would specify the composition of the RTC2 board of directors, who would then choose the actual managers, presumably from servicing and housing counseling professionals. The RTC2 would presumably operate within predefined parameters on loan restructuring.58 While the details are again not the focus of this paper, they would presumably involve principal reduction to something close to 100% LTV, possibly with a shared appreciation provision, and the loans would be restructured into long-term, fullyamortized fixed-rate obligations. The long-term fixed-rate mortgage is a time proven product that protects borrowers from inflation. Ideally, such restructuring would be accompanied by intensive borrower outreach efforts. One of the important lessons from the operation of the Home Owners Loan Corporation was the importance of borrower contact—basically social work—for loan
A major operational issue that the RTC2 would need to address would be servicing transfers for loans acquired by the RTC2. Servicing transfers can easily result in payment disruption and confusion. When done on a large scale, it raises even more concerns. © 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.

22 performance.59 Borrower contact provided the HOLC with tremendous information about the borrowers, and the HOLC provided financial planning assistance to borrowers to help ensure that its loans would perform. Finally, once the loans are restructured, there is the question of what to do with them. The RTC2 could simply retain them on its books and collect the mortgage payments, but given the financial sector’s sizeable investment in RTC2, it might be preferable to sell the loans to provide liquidity to the financial institutions. This could be done by securitizing the RTC2 portfolio, much as the original RTC did. Resecuritizing the RTC2 loans would present some challenges. The RMBS market is moribund, and MBS backed by restructured RTC2 loans would be a new product, so investors might be even more cautious. Even if the loans were restructured to be 15-, 20-, or 30-year fixed rate obligations, they would look quite different than a pool of conforming fixed-rate mortgages. The borrowers’ credit quality would vary far more than for a GSE pool and some would be jumbo loans. A shared appreciation provision would also be novel. None of this, however, should be an absolute barrier to securitization of RTC2 mortgages. Securitized RTC2 mortgages would be a much less novel product than the commercial mortgage securitizations pioneered by the original RTC. An RTC2 securitization product might have to be issued at a discounted price, something that could be mitigated if a government or third-party guarantee were placed on the RTC2 MBS. CONCLUSION Negative equity remains the single greatest factor dragging on the United States economy. Five years into the foreclosure crisis, there has yet to be a serious government attempt to address negative equity. The unwillingness to address negative equity on a large scale has been the product of wishful thinking that the economy would rebound or that affordable monthly payments would be sufficient to avoid default and the recognition that large scale principal write-downs would seriously impair the capital of many banks. The result, however, is a Catch-22: it is impossible to fix the economy without fixing housing, and the housing market cannot be fixed unless the banks or taxpayers take losses. The banks can’t recognize large losses immediately without needing to be recapitalized, which is politically unacceptable to a large part of the political leadership of both parties, as is putting the losses on taxpayers. Realistically, it is unlikely that this situation will change in the near future. Yet without change— until and unless we undertake larger caliber solutions to the negative equity problem—we face continued malaise in the housing sector and for the economy as a whole. This paper has endeavored to outline a transactional framework for a large caliber approach to the negative equity problem, namely the use of a bad bank for housing as a means of pooling and performing uniform restructurings and resecuritizations of underwater mortgages. While numerous technical questions would bedevil the design of any such bad bank for housing, the feasibility of the proposal is ultimately not a matter of technical design. Instead, it is a question of political will.
HARRISS, supra note 50, at 66-69. © 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.

23 For better or worse the politics of the housing bubble’s aftermath have coalesced on let the market clear primarily through foreclosures while making some motions toward foreclosure relief that is grossly inadequate to the scope of the problem, but which produces some political cover for the decision. This is a political decision with uneven distributional consequences, but its costs will long be felt by the American economy and society as a whole.

© 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.