Author Archives: David Reiss

Building a Model for Housing Finance

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Following up on Friday’s post, I want to discuss Chambers, Garriga and Schlagenhauf’s draft that they recently posted to SSRN (free here).  It presents some interesting historical analogies to the issues we face as we attempt to chart a new direction for federal housing policy.

They too review the housing subsidies that exist in the financing system and in the tax code.  They attempt to “study the effects of changes in government regulation on individual incentives and relative prices” (4)  They include an interesting Table (2) on page 8 that shows the growing percentage of home mortgages that were insured or guaranteed by the FHA and VA.

What I find most interesting about this article is that it attempts to model the impact of better financing terms on the housing market.  For instance, they argue that their “model suggest that the extension of the FRM contract from 20 to 30 years can explain around 12 percent of the increase in ownership” for a certain period of time. (25)  More generally, they find that the “total impact of mortgage innovation is approximately 21 percent” when combined with “a narrowing mortgage interest rate wedge . . ..” (31) I would love to see more economics articles that model the impact of credit terms on housing prices and homeownership rates.  While this seems fundamental to housing economics, there is less out there about this than there should be.

While their conclusion that “mortgage innovation did make a significant contribution to the increase in homeownership between 1940 and 1960”  is not surprising, their model helps us understand why that is the case. (26)

Goldilocks Homeownership

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It has only been since the housing bust have we had a serious conversation about how much homeownership is just the right amount.  Mostly, the federal government (under both Democrats and Republicans) has pushed for more, more, more without regard to whether more was better.  Principled commentators on the Left (Paul Krugman, for instance) and the Right have rightly criticized this unthinking commitment to more, but it is very politically attractive to push policies that appear to benefit homeowners (read, voters).

Morris Davis has recently posted his Cato Institute policy analysis critique of federal homeownership policy to SSRN, Questioning Homeownership as a Public Policy Goal. Like others, he criticizes the extraordinary subsidization of homeownership through the significant tax benefits (such as the deductibility of mortgage interest on a personal residence) and financing subsidizes (through the FHA, Fannie and Freddie).  But he also attempts to quantify the subsidy.  He comes up with an estimate of $2.5 trillion.

While I agree with Davis that we oversubsidize homeownership, I am not sure that I am so convinced by the price tag he puts on it. This is because the class of homeowners overlaps so much with the class of taxpayers.  It would be very interesting if he could refine his analysis more to see if federal homeownership subsidies effect a transfer from one group to another — that refinement could lead to an interesting fight in Congress.

I was also surprised that Davis did not rely at all on the work by Glaeser and Gyourko regarding the inefficiencies of federal housing subsidies given restrictive local land use policies.  This work would support his overall argument — not only do we oversubsidize, but the subsidies don’t even help homeowners as much as we think they do.

Well, let’s see if Congress takes Krugman and Cato’s views under advisement as we chart a new direction for housing policy . . ..

Borden and Reiss on Dearth of Prosecutions for Mortgage Misrepresentations

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We published Cleaning Up the Financial Crisis of 2008:  Prosecutorial Discretion or Prosecutorial Abdication? (paywall) today in the BNA Criminal Law Reporter.  (You can also get a copy on SSRN or BEPress).  It builds on things we have said here and here.  In short, we argue

When finance professionals play fast and loose, big problems result. Indeed, the 2008 Financial Crisis resulted from people in the real estate finance industry ignoring underwriting criteria for mortgages and structural finance products. That malfeasance filled the financial markets with mortgage-backed securities (MBS) that were worth a small fraction of the amount issuers represented to investors. It also loaded borrowers with liabilities that they never had a chance to satisfy.

Despite all the wrongdoing that caused the financial crisis, prosecutors have been slow to bring charges against individuals who originated bad loans, pooled bad mortgages, and sold bad MBS. Unfortunately, the lack of individual prosecutions signals to participants of the financial industry that wrongdoing not only will go unpunished but will likely even be rewarded financially. Without criminal liability, we risk a repeat of the type of conduct that brought us to the edge of financial ruin.

Seems straightforward to us, but many other lawyers seem to disagree, including the outgoing Assistant Attorney General in charge of the Criminal Division, Lanny Breuer.  He told the NY Times, “I understand and share the public’s outrage about the financial crisis. Of course we want to make these cases. … If there had been a case to make, we would have brought it. I would have wanted nothing more, but it doesn’t work that way.”  More interesting stuff in the article.

A Bransten Trio Join Judicial Chorus on Misrepresentation

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Justice Bransten, a judge in the Commercial Division of the N.Y. S. Supreme (trial) Court, issued three similar decisions last week denying motions to dismiss lawsuits by Allstate over its purchase of hundreds of millions of dollars of MBS. The net result is that various Deutsche Bank, BoA’s Merrill Lynch and Morgan Stanley entities must continue to face allegations of fraud relating to those purchases.

In the Deutsche Bank case, the court rejected “the notion that defendants are immunized from liability because the Offering Materials generally disclosed that the representations were based on information provided by the originators.”  (22)

The court also found that “defendants can be held liable for promoting the securities based upon the high ratings from the credit rating agencies, if, as alleged, thy knew the ratings were based on false information provided to the agencies.” (22)  Finally, the court found that “Defendants’ occasional disclaimers cannot be invoked to excuse the wholesale abandonment of underwriting standards and practices.”  (24-25)

Justice Bransten joins a growing chorus of judges who reject the notion that vague disclosures can protect parties who engage in rampant misrepresentation.  One wonders how this body of law will impact the behavior of Wall Street firms during the next boom.

 

Reiss on CFPB’s New Escrow Rules

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The CFPB Journal interviewed me here about the new five year escrow requirement for Higher-Priced Mortgage Loans (HPMLs):

According to David Reiss, professor of law at Brooklyn Law School, the text of the Dodd-Frank Act itself requires the five-year escrow period be implemented.

Specifically, the CFPB’s rule implements sections 1461 and 1462 of the Dodd Frank Act, which amends the requirements for maintaining escrow accounts in connection with higher-priced mortgage loans.

“CFPB has indicated that it is trying to have a coordinated roll out of new mortgage regulations and this is part of that roll out,” Reiss says. “Creditors will benefit from the float on the aggregate escrow accounts—a small amount for each individual homeowner but potentially a meaningful amount for creditors, particularly if interest rates rise to their historic average or higher in coming years.”

Per the rule, a creditor may not cancel escrow accounts required under the rule except with the termination of the loan or the receipt of a consumer’s request to cancel the escrow account no sooner than five years after it was established, whichever happens first.  The CFPB’s rule also states that the creditor may not cancel the escrow account unless the unpaid principal balance is less than 80 percent of the property’s original value and the consumer is not delinquent or in default on the loan at the time of the request.

One key aspect of the rule involves the exempting small creditors who operate primarily in rural or underserved areas. According to the CFPB, to qualify for the exemption, a creditor must:

  • Make more than half of its first-lien mortgages on properties located in counties that are designated either “rural” or “underserved” by the CFPB
  •  Have had assets of less than $2 billion at the end of the preceding calendar year
  •  Have originated, together with its affiliates, 500 or fewer covered, first-lien transactions during the preceding calendar year
  • Together with its affiliates, not maintain escrows for property taxes or insurance for any mortgage it or its affiliate currently services, except when the escrow account was established for a first-lien, higher-priced mortgage loan between April 1, 2010 and before June 1, 2013
  • Escrow accounts established after consummation as an accommodation to assist distressed consumers in avoiding default or foreclosure

One outcome of the escrow requirement as it pertains to creditors is the marginal cost of maintaining escrows for five years instead of one. “To some extent, creditors may be able to pass along the increased cost of the longer escrow term to homeowners,” Reiss says. “This is a rule that is probably good for homeowners and creditors in the aggregate.”

Reiss on Future of the FHFA

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Law360 wrote a story (here, behind a paywall) on the Obama Administration’s plans for the Federal Housing Finance Agency.  It reads in part

Although the Obama administration has dealt aggressively with congressional Republicans in some areas, it’s unlikely to make a recess appointment before the U.S. Supreme Court rules on the NLRB case, or chooses not to take it.

“The notion of a recess appointment is even harder to fathom,” said Brooklyn Law School professor David Reiss.

Still, despite those challenges, there are whispers that DeMarco could be replaced within the next few weeks. The names of some potential replacements, including Rep. Mel Watt, D-N.C., have been publicly floated.

A second part of DeMarco’s job is to help figure out just what to do with Fannie and Freddie, and how to bring more private money into the mortgage market.

Currently, Fannie and Freddie own or guarantee around 75 percent of all residential mortgages. Combined with the mortgages owned by the FHFA and the U.S. Department of Veterans Affairs, more than 90 percent of mortgages have some sort of federal backing.

DeMarco in October laid out a five-year plan for winding down Fannie and Freddie, including a common securitization platform for the two companies.

The Obama administration may well be on board with those plans and DeMarco provides convenient cover, Reiss said.

“It’s hard to imagine that Ed DeMarco is taking big positions like that without the administration’s at least tacit approval,” he said.

Unhampered and HAMPered Mortgage Modifications

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The National Consumer Law Center has issued a thorough report, At a Crossroads:  Lessons from the Home Affordable Modification Program  (HAMP), which also provides some guidance for the way forward after we get past the foreclosure crisis.  The authors summarize their findings as follows:

The government’s Home Affordable Modification Program (HAMP) is our starting point. HAMP has reached more homeowners, and successfully modified more home loans, than any program in history. Created by the federal government in early 2009 as a temporary program in response to the foreclosure crisis, HAMP provided additional financial incentives to servicers and investors to modify mortgages at risk of ending in foreclosure. The result has been affordable, sustainable loan modifications that keep borrowers in their homes and maximize returns to investors. But HAMP fell short of its goals, which were inadequate to the scope of the crisis. HAMP has been justly criticized for its lack of transparency and its failure to provide for effective enforcement. (3)

Not pulling punches, the report squarely places responsibility for its failure on “one root cause: massive servicer noncompliance. Almost every official evaluation of HAMP has noted widespread servicer noncompliance and the concurrent failure of the U.S. Department of the Treasury (Treasury) to engage in meaningful enforcement.” (4)  Given that millions more foreclosures are on the horizon, this failure must be rooted out.

The report identifies five principles for effective loan modification standards:

  1. Loan modification evaluations should be standardized, universally applicable to all loans and servicers, and mandatory for all loans before the foreclosure process can go forward.
  2. Loan modification terms must be affordable, fair, and sustainable.
  3. Hardship must be defined to reflect the range of challenges homeowners face.
  4. Transparency and accountability throughout the loan modification process are essential.
  5. Homeowners must be protected from servicers’ noncompliance. Good rules on paper are not enough. (4)

I am intrigued by some of the particular proposals, although I am not sure how they actually work in practice.  For instance, the report states that “Provisions Must Be Made for Homeowners with Junior Liens and Others for Whom a Thirty-One Percent Monthly Mortgage Payment Is Not Affordable.” (58) At what point must we say that a particular situation is untenable?  The report also proposes that “A Servicer’s Violation of Servicing Standards Should Constitute a Defense to a Foreclosure.” (63) While this would no doubt be great for current homeowners, it would also be a radical role change for the foreclosure process.  If this idea gets any traction, it will be interesting to see the industry critique.