Benefiting from more foreclosures

BY NOW, it's abundantly clear that the housing bust is having a devastating impact on millions of U.S. families.

Total foreclosures could reach 3 million by the end of 2008, according to real-estate industry estimates. And the core problem--falling housing values--is showing no signs of abating. In fact, during the last three months of 2007, housing values fell faster than in prior periods.

Sub-prime mortgages--housing loans made at higher-than-normal and adjustable interest rates to borrowers with little or poor credit history or an income that wouldn't typically qualify them for a mortgage--lie at the center of the crisis.

These loans were a significant part of the U.S. housing boom of the past decade. Most included a two-year or three-year teaser period, during which the interest rate was low. But now, with each passing month, more of these adjustable rates are resetting--and monthly payments jump by an average of 30 to 50 percent, at which point borrowers fall behind on payments, with many ending up in foreclosure.

According to the Center for Responsible Lending (CRL), 7.2 million families have sub-prime loans worth a total of $1.3 trillion--and of those, 14.4 percent are already in foreclosure. Overall, the CRL predicts that up to $164 billion in housing equity will be lost through foreclosures.

George Bush and Congress have floated numerous piecemeal proposals to deal with the crisis. One is the recently passed $168 billion stimulus package, though it is difficult to see how this will have any real impact on the housing crisis.

A more ambitious proposal, discussed in Congress in February, would have prevented at least 600,000 foreclosures, according to its sponsors, but it was blocked by Senate Republicans. Meanwhile, the Bush administration and Republican lawmakers are using the housing bust as an excuse to try to make Bush's 2001 and 2003 tax cuts permanent.

As it stands, the chief fallback after the defeat of the legislation is a proposal by the Treasury Department--its third different scheme in four months--called Project Lifeline. The centerpiece of the plan is a 30-day moratorium on foreclosures.

But according to CRL President Michael Calhoun, "This is a small step that isn't likely to make a significant difference for the hundreds of thousands of homeowners who are at risk of losing their home."

The CRL points to a report issued by the credit rating agency Standard & Poor's, which found that mortgage servicing staffs are overwhelmed by the sheer magnitude of rising foreclosures. According to the report, the average number of foreclosure files handled by loan servicing employees is nearly 400--"a caseload that virtually guarantees many homeowners will not receive the information or assistance required to save their homes." Thus, 30 days won't provide any sort of cushion.

There are proposals in Washington that would do more. The so-called "cram-down" provisions that were part of the failed Senate bill would have enabled bankruptcy judges to lower the value of a mortgage to match the falling value of homes. This would mean, for example, that a borrower wouldn't be faced with paying back $300,000 for a home now worth $200,000.

Another tactic proposed to cope with the crisis--creating a mechanism for modifying loans to switch from floating interest rates to fixed rates to avoid the problem of exploding monthly payments--would also be a huge help.

Even more effective would be for the government to buy up billions in troubled mortgages at a deep discount, forgive all debt above the current market value of the homes, and use U.S. government loan guarantees to refinance the loans at lower rates.

WHY IS the government failing to push for the most aggressive solutions?

One reason for the failure to act is the question of how mortgage loans are originated and then sold by lenders to investors--which creates competing interests in the event of foreclosures.

Mortgage lenders don't make the loans and then wait for the borrowers to pay them back. They typically sell loans to banks or other companies, which in turn package up large numbers of loans to issue as mortgage-backed securities--bonds sold off to investors, who get a return based on the interest income when the loans are paid off.

At the same time, the banks or mortgage companies get fees for "servicing" the loans--that is, collecting the payments. They make the decision to either work with borrowers who fall behind on payments or push the loans into foreclosure.

On top of the evidence that mortgage servicers aren't equipped to deal with the current volume of foreclosures, studies show that they actually have a vested interest in pushing loans into foreclosure, rather than working out new terms with borrowers.

Why? Because of the proliferation of mortgage-backed bonds, when a foreclosure takes place currently, the pain falls primarily on the borrower and the investors in whatever bond includes the bad loan--not on the servicer. The servicers lose their fees, but doing a workout can be much more costly--sometimes up to 40 percent of the outstanding loan balance.

Thus, loan modifications occur in only a minority of cases. "Servicers are generally dis-incented to do loan modifications," according to Inside B&C Lending, "because they don't get paid for them, but they do get paid for foreclosures."

Or, as the CRL puts it, "Since servicers decide whether to modify, the fact that a modification rather than a foreclosure would be in the interests of investors as a whole is irrelevant." CRL also points to the fact that loan modifications leave servicers vulnerable to lawsuits, whereas with foreclosures, the buck gets passed.

Other interests get served from foreclosures over working out new terms for borrowers. For example, Countrywide Financial, the nation's largest mortgage lender, operates a subsidiary called Recon Trust, a foreclosure trustee. The unit allows Countrywide to make money on fees even when the loans it originated end up in foreclosure.

In fact, during a conference call with investors in October, Countrywide President David Sambol said that increased delinquencies wouldn't affect the company's earnings because those expenses "tend to be fully offset" by "greater fee income from items like late charges and, importantly, from in-sourced vendor functions...such as our business involved in foreclosure trustee and default title services."

In other words, for Countrywide, it's heads, they win; tails, you lose.

Another factor is that because loans are sliced up as part of the securitization process, the ultimate lien-holder--that is, the party that would take control in the event of a foreclosure--isn't always clear. The fact that there are potentially multiple claims on a property makes any loan modifications difficult to hash out.

As a result, during the last three months of 2007, mortgage servicers modified 141,000 distressed loans, but started foreclosures on 458,000. Foreclosures outnumbered loan modifications by a 3-to-1 margin. During the entire year of 2007, according to researchers for the Moody's rating agency, just 3.5 percent of resetting sub-prime loans were modified.

THERE ARE other reasons that legislation which would actually help mortgage borrowers is being fought.

For one thing, mortgage bankers--unlike traditional banks--aren't regulated by the government. And they want to keep it that way. The Mortgage Bankers Association, the industry's trade association and lobbying group, claims no legislation is required because servicers are voluntarily working with borrowers to restructure loans.

The group has also fought hard against "cram-down" legislation because if courts had the power to devalue mortgages, it would damage the mortgage-backed securities business. After all, why would investors buy bonds if there was a possibility that, down the line, a judge could lower the value of the underlying mortgages and thereby wipe out the expected returns?

Lastly, there are the traders benefiting from the downturn. The Wall Street Journal recently profiled John Paulson, the manager of a hedge fund that booked a $15 billion profit in 2007 through betting against the housing market. Paulson alone is believed to have pocketed between $3 billion and $4 billion last year.

Ultimately, the need for more aggressive measures is an indictment of the "free-market" system that puts profits before people's needs--so the barons of Wall Street have an ideological reason for opposing legislation. But because the government is refusing to act, the housing crisis is spreading--and deepening.