Author Archives: David Reiss

Reiss and Lederman on Affordable Housing Goals

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Jeff Lederman and I have posted our comment to the FHFA’s proposed housing goals for Fannie Mae and Freddie Mac for 2015 through 2017.  We argue,

As the FHFA sets the housing goals for 2015-2017, it should focus on maximizing the creation and preservation of affordable housing. Less efficient proposed subgoals should be rejected unless the FHFA has explicitly identified a compelling rationale to adopt them. The FHFA has not identified one in the case of the proposed small multifamily subgoal. Thus, it should be withdrawn.

Reiss on Legal Snares for Entrepreneurs

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Inc.com quoted me in 6 Legal Snares All Entrepreneurs Should Be Ready to Dodge. It reads,

The last thing you want to do as an entrepreneur is pour through long dull documents written by lawyers for lawyers. But there’s a reason it’s called work and not fun. Miss taking care of this aspect of your business and you might find yourself being investigated by the federal government, on the hook for thousands in otherwise unnecessary costs, in a never- ending fight with others involved in the company, or stuck at the exact time you need to be moving.

I was speaking with David Reiss, a professor of law at the Brooklyn Law School and research director of its Center for Urban Business Entrepreneurship (CUBE). Entrepreneurs often lack the broad business experience that would help them avoid a number of traps on the way to growing a business, he said. Here are some of the most common.

Real estate contract snags

“You have a great idea but know nothing about the basics of being a small business person, so you sign the first lease [you’re offered],” he said. But a commercial property lease is a complex document that makes an apartment lease look like nothing in comparison. It typically is something to be negotiated, and getting help to understand the ramifications of various clauses is crucial. “Often there are pretty complicated rent increase provisions that entrepreneurs don’t get,” he said. The document as written might assign you a portion of the building’s increased operating expenses in addition to rent increases. Overly strong restrictions on the ability or reassign or sublease the lease’s obligations could mean an inability to move to a larger space when the business grows. “What are the use restrictions?” Reiss asked “What if the business morphs into something else? Does that violate the use limitations on the space? “

Pick the right corporate structure

You’ll likely have many choices of how to legally and financially structure the company. Some are an LLC, sole proprietorship, partnership, S-corp. , or C-corp. “They have different tax implications, different implications as you increase in size and revenues,” Reiss said. If you have the wrong structure in place, you might find yourself having to unwind it as the business expands. Not only might that be unnecessarily expensive, but you’ve potentially opened yourself to renegotiating some basic arrangements that could be troublesome.

Get a fitting partner agreement

If you need a reminder of how badly partnerships can go, look at Snapchat or Square. One day everything is fine. The next, former best friends are at each other’s throat. You have to consider how to allocate both profits and losses (some investors might like more of the latter).

“Some people are putting in time, some are putting in intellectual property, and some are putting in cash,” Reiss said. “People have different expectations for each of those contributions.” A thorough and well-constructed partner agreement provides a framework for addressing the important issues before everyone is at an impasse.

Have appropriate protection for intellectual property

All businesses have intellectual property. Getting protection on every aspect can burn through cash. For example, patents are great, but if you can’t lock down broad enough protection, competitors might be able to easily work around the walls you built, in which case you may have wasted money. Perhaps trade secrets might be more appropriate. Do you really need to trademark every single name and phrase? Maybe yes, maybe no. Talk to a professional to devise a useful strategy, keeping an eye on what you can afford and how much effort you might need to divert from getting business done.

Check insurance

You’ll need commercial general liability insurance and might also need property insurance. Might directors and officers liability insurance, also known as D&O, be advisable to protect principals in the company? Does your lease or contracts with clients demand particular levels of coverage?

Regulatory compliance

On one hand, anyone who says that regulations make it impossible to open a business is someone to be questioned. On the other, you can get badly tripped up in some common areas like taxes, handling inventory, or labor laws. “A little bit of planning can save you lots of headaches, money, and bandwidth,” Reiss said. “If you’re working 16 hours a day, you don’t want to be thinking about an investigation by the Department of Labor. You need someone to run through a checklist with you of the regulatory overlays on small businesses.”

Bringing lawyers, accountants, insurance brokers, and others in for reviews and discussions isn’t cheap, but it’s a lot less expensive than trying to solve problems after they’ve snared and tripped you.

Tall Mortgage Tales

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Todd Zywicki has posted The Behavioral Law and Economics of Fixed-Rate Mortgages (and Other Just-So Stories) to SSRN. The article contains

SPOILER ALERT!

a spoof, in order to make a larger point.

The abstract reads,

A major cause of the recent financial crisis was the traditional American mortgage, which is distinctive for the following features: it is a thirty-year, self-amortizing loan with an unlimited right to prepay. The United States is unique in the world for standardizing on a mortgage product with these features. Yet not only have a majority of the foreclosures that occurred during the financial crisis been fixed-rate mortgages, the fixed-interest-rate characteristics have undermined efforts by the Federal Reserve and government to assist recovery of the housing market. Moreover, the long fixed-rate term and ability to refinance are highly expensive and suboptimal features for many consumers. Nevertheless, many consumers persist in purchasing this mortgage. Drawing on the methodology of behavioral law and economics, this article provides rationalizations for how behavioral law and economics can explain the persistence of a product that is so harmful to many consumers and to the economy at large. The article then draws conclusions about what this analysis means for the behavioral law and economics research program generally and for the use of behavioral law and economics in government policymaking.

 I have a lot to say about this article but I don’t want to ruin it for you!  Suffice it to say, the article is a provocative critique of behavioral law and economics. Those of us who hope to see a healthy mortgage market develop would do well to take this critique seriously — even if you end up rejecting its broader implications.

Housing Vouchers for Landlords

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Collinson and Ganong have posted The Incidence of Housing Voucher Generosity to SSRN. The abstract of this important paper is a little technical for non-economists. It reads:

What is the incidence of housing vouchers? Housing voucher recipients in the US typically pay their landlord a fixed amount based on their income and the government pays the rest of the rent, up to a rent ceiling. We consider a policy that raises the generosity of the rent ceiling everywhere, which is equivalent to an income effect, and a policy which links generosity to local unit quality, which is equivalent to a substitution effect.

Using data on the universe of housing vouchers and quasi-experimental variation from HUD policy changes, we analyze the incidence of these policies. Raising the generosity of the rent ceiling everywhere appears to primarily benefit landlords, who receive higher rents with very little evidence of medium-run quality improvements. Setting ZIP code-level rent ceilings causes rent increases in expensive neighborhoods and decreases in low-cost neighborhoods, with little change in aggregate rents. The ZIP code policy improves neighborhood quality as much as other, far more costly, voucher interventions.

The eye-catching part is that raising “the generosity of the rent ceiling everywhere appears to primarily benefit landlords, who receive higher rents with very little evidence of medium-run quality improvements.” The paper itself fleshes this out more: “a $1 increase in the rent ceiling raises rents by 41 cents; consistent with this policy change acting like an income effect, we find very small quality increases of around 5 cents, meaning that as much as 89% of the increase in government expenditure accrues to landlords.” (20-21)

Given the inelasticity of the supply in many housing markets, this is not such a surprising result. That is, if demand increases because of an increase in income but supply does not, the producer (landlords) can capture more of that income just by raising prices. This finding should give policymakers pause as they design and implement voucher programs. The question that drives them.should be — how can they maximize the portion of the subsidy that goes to the voucher recipient?

Reiss on Easing Credit

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Law360 quoted me in With Lessons Learned, FHFA Lets Mortgage Giants Ease Credit (behind a paywall). It reads in part,

The Federal Housing Finance Agency’s plan to boost mortgage lending by allowing Fannie Mae and Freddie Mac to purchase loans with 3 percent down payments may stir housing bubble memories, but experts say better underwriting standards and other protections should prevent the worst subprime lending practices from returning.

FHFA Director Mel Watt on Monday said that his agency would lower the down payment requirement for borrowers to receive the government-sponsored enterprises’ support in a bid to get more first-time and lower-income borrowers access to mortgage credit and into their own homes.

However, unlike the experience of the housing bubble years — where subprime lenders engaged in shoddy and in some cases fraudulent underwriting practices and borrowers took on more home than they could afford — the lower down payment requirements would be accompanied by tighter underwriting and risk-sharing standards, Watt said.

“Through these revised guidelines, we believe that the enterprises will be able to responsibly serve a targeted segment of creditworthy borrowers with lower down payment mortgages by taking into account ‘compensating factors,’” Watt said at the Mortgage Bankers Association’s annual meeting in Las Vegas, according to prepared remarks.

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The realities of the modern mortgage market, and the new rules that are overseeing it, should prevent the lower down payment requirements from leading to Fannie Mae, Freddie Mac, and by extension taxpayers taking on undue risk, Brooklyn Law School professor David Reiss said.

Tighter underwriting requirements such as the Consumer Financial Protection Bureau’s qualified mortgage standard and ability to repay rules have made it less likely that people are taking on loans that they cannot afford, he said.

Prior to the crisis, many subprime mortgages had the toxic mix of low credit scores, low down payments and low documentation of the ability to repay, Reiss said.

“If you don’t have too many of those characteristics, there is evidence that loans are sustainable” even with a lower down payment, he said.

The FHFA is also pushing for private actors to take on more mortgage credit risk as a way to shrink Fannie Mae and Freddie Mac. There is a very good chance that private mortgage insurers could step in to take on the additional risks to the system from lower down payments, rather than taxpayers, Platt said.

“You’ll need a mortgage insurer to agree to those lower down payment requirements because they’re going to have to bear the risk of that loss,” he said.

The 97 percent loan-to-value ratio that the FHFA will allow for Fannie Mae and Freddie Mac backing is not significantly higher than the 95 percent that is currently in place, Platt said.

Having the additional risk fall to insurers could mean that the system can handle that additional risk, particularly with the FHFA looking to increase capital requirements for mortgage insurers, Reiss said.

“It could be that the whole system is capitalized enough to take this risk,” he said.

Reiss on Catching FIRREA

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Inside ABS & MBS quoted me in Experts: New AG Likely to Continue Aggressive Use of FIRREA Against Industry, Individual Executives Targeted (behind a paywall). It reads in part,

Mortgage industry executives should be aware and expect continued – and perhaps even more muscular – use of a 1989 federal law by government prosecutors to pursue mortgage-related claims. At the direction of Attorney General Eric Holder, the Department of Justice embraced the use of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) in MBS lawsuits. Despite Holder’s announcement late last month that he is stepping down after six years as AG, there is little reason to expect that President Obama’s new attorney general will surrender use of such a “potent statute” that has employed a lower burden of proof and long statute of limitations to exact large tribute from the mortgage industry, according to Marjorie Peerce of the Ballard Spahr law firm.

*     *    *

Brooklyn Law School Professor David Reiss agrees. He added that throughout President Obama’s term, the White House at the highest level has set an agenda for corporate accountability so it’s likely that one of the chief mandates of Holder’s successor will be the continuation of the DOJ’s vigorous use of tools such as FIRREA.

During a speech last month prior to announcing his resignation, Holder called for making the FIRREA statute even stronger, with whistleblower bounties raised to induce more testimony. However, Reiss noted it’s unlikely the White House would be keen to encourage lawmakers to take another look at FIRREA given that Congress next year will likely be in Republican hands.

However, Reiss called attention to a part of Holder’s speech where the AG expressed frustration with the DOJ’s inability to hold financial services executives criminally liable for alleged misconduct. Holder suggested several ways for the DOJ to do so, including extending the “responsible corporate officer doctrine” to the financial services industry.

Under this doctrine, an individual may be prosecuted criminally under the Food, Drug and Cosmetic Act even absent culpable intent or knowledge of wrongdoing if the executive was in a position to prevent the wrongdoing and failed to do so.

“Focusing on individual culpability could be a new charge of the new attorney general,” said Reiss. “Given the events of the last 10 years, [a significant number of] people think that fewer individuals were held accountable for the financial crisis than should have been, so I think the Department of Justice may have heard that message as well.”

The Other GSE Conservatorship Lawsuit

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While there has been a lot of attention over Judge Lamberth’s ruling on the shareholders’ cases regarding Fannie and Freddie’s conservatorships, much less has been given to Judge Cooke’s dismissal of Samuels v. FHFA (No. 13-22399 S.D. Fla. ) (Sept. 29, 2014 ). The low-income and organizational plaintiffs in Samuels challenged the FHFA’s decision to suspend Fannie and Freddie’s obligation to fund the Housing Trust Fund after they entered into conservatorship. The Housing Trust Fund was to be funded by contributions by that were based on Fannie and Freddie’s annual purchases. The FHFA took the position that they GSEs need not pay into the fund while they themselves were in such a precarious financial position. Judge Cooke held that “The Individual and Organizational Plaintiffs lack Article III standing because their alleged injuries are too remote from and not fairly traceable to the Defendants’ allegedly unlawful conduct.” (13)

I found the dicta in the case to be the most interesting. The court found that the relevant provision from the Housing and Economic Recovery Act of 2008

provides no meaningful standards for determining when “an enterprise” is financially instable, undercapitalized, or in jeopardy of unsuccessfully completing a capital restoration plan. Considering the history of Fannie Mae and Freddie Mac; the government’s placing Fannie Mae and Freddie Mac in conservatorship; the Treasury Department providing liquidity to Fannie Mae and Freddie Mac through preferred stock purchase agreements, the mortgage backed securities purchase program, and an emergency credit facility; it is not for this Court to judicially review Defendants’ statutorily mandated suspension of payments into the Housing Trust Fund. (13)

My takeaway from this opinion is that we  now have another federal judge finding that the federal government is to be given great deference in its handling of the financial crisis. And this deference derives not just from the text of the relevant statute but also from the particular historical events that led to its adoption and that followed it. This seems like an important trend, as far as I am concerned.