Private Options for Mortgage Recovery Offered

Published January 1, 2009

In an effort to relieve taxpayers of the enormous financial obligations the recent Wall Street bailout involves, economists and other analysts are offering alternatives to government takeovers of troubled loans.

Costly Loan Modifications

Sheila C. Bair, chairman of the Federal Deposit Insurance Corporation, told Congress on October 23, “In recent years, we have seen troubled loan portfolios yield about 32 percent of book value compared to our sales of performing loans, which have yielded over 87 percent.”

Bair hopes a new approach, to be tested at the failed IndyMac Bank, would “serve as a catalyst to promote more loan modifications for troubled borrowers across the country.”

The FDIC plan focuses on achieving “sustainable” loans—those where payments, including insurance and taxes, do not exceed 38 percent of the debtor’s income. Bair said that target would be met on eligible loans through “interest rate reductions, extended amortization, and principal forbearance.”

Less-Risky Alternatives

A number of economists, investment experts, and policy analysts think such costly techniques need to be balanced with financial vehicles offering more risk reduction or upside potential for loan restructuring.

Luigi Zingales, professor of entrepreneurship and finance at The University of Chicago’s Graduate School of Business, favors government-managed rather than government-funded loan restructuring.

“Instead of pouring money to either side,” Zingales said, “the government should provide a standardized way to renegotiate, one that is both fast and fair.”

‘Managed’ vs. ‘Funded’

Zingales proposes a bankruptcy option similar to what is used to reorganize businesses. In bankruptcy, creditors who fear the debtor’s liquidation will bring them less on the dollar than expected will negotiate loan forgiveness in return for equity in the reorganized concern. Zingales suggests importing this concept to residential loan workouts.

In ZIP codes where property values have fallen by 20 percent or more, lenders would have to swap a write-down of this deprecation off the loan in exchange for a 50 percent equity stake in any appreciation.

Zingales points to historic examples of the plan in action. A program at Stanford University, duplicated in style by many institutions, had the university become part-investor in the home purchases of faculty members. Upon sale, Stanford recaptured its principal and a share of the return.

Despite that precedent, Zingales’ colleague at The University of Chicago and longtime editor of the Journal of Law and Economics, Richard Epstein, has doubts.

“The debt-equity swaps are a possibility, but I am not optimistic,” Epstein said. “If the folks wanted that form of business they would have taken it originally. That is why the traditional mortgage interventions were for moratoria. … They had real problems, too, but it had to do with the prolongation of credit risk.”

Debt for Equity

The Ocean State Policy Research Institute, a Rhode Island-based public policy organization, thinks lenders and borrowers might choose debt-for-equity swaps as an efficient workout strategy without a government mandate.

The group has proposed giving upside-down homeowners (those who owe more on their house than it is worth) access to bankruptcy proceedings resembling small claims court, allowing swift mediation or loan modifications by rule that do not undercut the collateral.

“To maintain Constitutional integrity, it is critical that reforms aimed at promoting loan restructuring do not mandate that lenders’ collateral be impaired below its present value,” said Bill Felkner, president of the institute. “Still, where values of collateral have fallen precipitously, this gives policymakers a fair amount of room to maneuver in bankruptcy law.

“We favor ‘debt-for-equity’ swaps in this arena of discretionary policy, because both parties to the contract offer consideration for the benefits they receive from restructuring,” Felkner continued. “The surrender of a portion of equity is a serious disincentive for those who do not need restructuring but would be tempted to join any program that requires givebacks only from lenders.

“As an added benefit, because it is a par-value swap against the homeowner’s base, this technique avoids the IRS treating write-downs as income to borrowers and creating a potentially large tax liability,” Felkner said.

Rent with Option

Dan Alpert, an investment expert at Westwood Capital who has created many innovative financial vehicles, proposes a ‘rent-with-option’ mandate for impaired loans, called the Freedom Recovery Plan.

The plan would require lenders to offer a five-year, market-rate lease to homeowners who surrender their deed in lieu of foreclosure. After five years, the homeowner would have first option to repurchase the house from the bank at market price.

This is a permutation of private mortgage rescue plans that often have been denigrated as equity-stripping, but the key difference is that the mandate for market rent would likely result in a much lower monthly payment than private plans that force a much higher effective rate.

Alpert does not worry about lenders resisting the plan, likening the invasion of their property interest to eminent domain and insisting lenders would be properly compensated by receiving market rents.

Alpert says economic models show his plan would bring returns superior to foreclosure, but it is based on additional proposed changes to tax law reinstating the “passive investment” real estate deduction and accelerating depreciation from 27.5 to 17 years.

Brian Bishop ([email protected]) is the fellow for regulatory policy at the Ocean State Policy Research Institute.

For more information …

Luigi Zingales, Plan B:

Plan to Amortize Impaired Loans (PAIL), Ocean State Policy Research Institute:

Dan Alpert, Freedom Recovery Plan: