Double Standard

Recently in class I mentioned that at times it can be a good business decision to default on one’s loan obligations, and that doing so is not necessarily a sign of poor moral character. I recognized that my students–undergraduates all, mostly sophomores–have neither the business nor life experience to truly grasp my point, and even if they did they would not necessarily agree with it.  It’s legalistic, based as it is on non-recourse financing, bankruptcy reorganization, rejection of executory contracts, and other remedies that show a binding promise is not necessarily binding. It was not essential to our discussion and I didn’t belabor the point.

I thought of it again upon read James Surowiecki’s “Living by Default” in the December 19 & 26, 2011 New Yorker. (Keeping current with The New Yorker would require that I cut back on working, working out, sleeping, or other reading.) Surowiecki mentions that American Airlines chose recently to file for bankruptcy:

Declaring bankruptcy will trim American’s debt load and allow it to break its union contracts, so that it can slim down and cut costs. American wasn’t stigmatized for the move. Instead, analysts hailed it as “very smart.” It is now generally accepted that when it’s economically irrational for a company to keep paying its debts it will try to renegotiate them or, failing that, default. For creditors, that’s just the price of business.

Seeing that strategic defaults are an acknowledged business risk dealt with by contract terms, negotiations, and restructured business deals, Surowiecki asks why more homeowners with underwater mortgage debt don’t walk away from their loans?

The bursting of the housing bubble has left millions of homeowners across the country owing more than their homes are worth. In some areas, well over half of mortgages are underwater, many so deeply that people owe forty or fifty per cent more than the value of their homes. In other words, a good percentage of Americans are in much the same position as American Airlines: they can still pay their debts, but doing so is like setting a pile of money on fire every month.

It’s a valid question. Surowiecki provides a few practical answers–dealing with the consequences a loan default is hard work, many homeowners have unrealistic views of the their home’s value–but says the biggest problem is the social stigma of defaulting on one’s home mortgage:

According to one study, eighty-one per cent of Americans think it’s immoral not to pay your mortgage when you can, and the idea of default is shaped by what Brent White, a law professor at the University of Arizona, calls a discourse of “shame, guilt, and fear.”

If you are interested Surowiecki makes the point far better than I made it in class discussion.

“Symbols of Broken Dreams”

This slide show and photographer’s audio document the aftermath of Ireland’s housing boom. In the early 2000’s Irish developers built more housing units than Ireland’s population could fill, banking (literally) on mass home ownership by Irish ex-pats and foreign workers. Believing prices would not decline the Irish bought each other’s real estate in a hothouse of speculation–until the debt crisis tanked the market. Now thousands of housing units stand unfinished or unoccupied–“to rot,” in the words of photographer Kenneth O’Halloran.

Should I Stay or Should I Go?

From As Values Slide, More Walking Away from Mortgages, The New York Times 2 Feb 10:

New research suggests that when a home’s value falls below 75 percent of the amount owed on the mortgage, the owner starts to think hard about walking away, even if he or she has the money to keep paying . . . The number of Americans who owed more than their homes were worth was virtually nil when the real estate collapse began in mid-2006, but by the third quarter of 2009, an estimated 4.5 million homeowners had reached the critical threshold, with their home’s value dropping below 75 percent of the mortgage balance . . . With figures released last week showing that the real estate market was stalling again, their numbers are now projected to climb to a peak of 5.1 million by June — about 10 percent of all Americans with mortgages. “We’re now at the point of maximum vulnerability . . . People’s emotional attachment to their property is melting into the air.”

The article mentions a study of defaulting homeowners that estimated “about 17 percent of owners defaulting in 2008, or 588,000 people, chose [walking away from their mortgage] as a strategic calculation.”  This strategy, known as  deed-in-lieu of foreclosure, is not limited to residential homeowners.  In 2006 Tishman Speyer and BlackRock purchased Manhattan’s 56-building 11,000-unit Peter Cooper Village and Stuyvesant Town apartments for $5.4 billion, which was then “the most expensive [sale] in residential real-estate history.”  (The NYTimes reports debt service reserves and capital improvements made the total project cost $6.3 billion.)  The owners borrowed over $4.4 billion to finance the purchase.

Now the complex is estimated to be worth only $1.8 billion, and  [in January] the owners began defaulting on debt payments. “It has become clear to us through this process that the only viable alternative to bankruptcy would be to transfer control and operation of the property, in an orderly manner, to the lenders and their representatives,” the owners told the [Wall Street] Journal.

The Journal reports the project’s equity investors include CALPERS and the Church of England.  Its debtholders include the Government of Singapore Investment Corp. and Hartford Financial Services Group.  They will, as workout folks say, “take a haircut.”  According to the New York Times CALPERS has written off its $500 million investment.  Don’t weep for Tishman Speyer and BlackRock.  Each had about $112 million, 2% of the purchase price, of  their own money in the deal.  $112 million is real money.  Two percent equity is a walking-away down payment.

It almost makes me miss being in the workout business.

Missing Notes

Real estate mortgage foreclosure is pretty simple.  The borrower gives a promissory note to the lender to evidence the loan, the borrower fails to pay debt service when due, the lender accelerates the outstanding principal balance of the mortgage loan, obtains a court order to sell the real estate securing the loan, and auctions the property to the highest bidder.  The process rests on two plain-vanilla legal instruments, a promissory note and a mortgage.

Simple.  But take that mortgage loan, bundle it with 10,000 mortgage loans, sell the bundle to an investment bank, securitize the 10,000 debt service obligations, create A, B, and C tranches, and through financial alchemy you have new investment securities.  These securities can be an essential cog in the generation of capital for new mortgage loans or they can contribute to and exacerbate financial free-fall.  About 15 years ago I helped put together the first-of-its-kind (and, as far as I know, last of its kind) securitized pool of defaulted non-rated tax-exempt multifamily housing bonds. It was innovative, created a high tax-exempt yield for its purchaser, and worked.  Securitization can be a valuable tool.

Valuable, if the financial risks are handled properly and the mundane details don’t get lost in the shuffle.  Securitizing those 10,000 mortgage loans requires that the mortgage loan originator–a bank or mortgage company–assign the 10,000 promissory notes and related mortgage loans to whoever purchases the bundle.  Whoever securitizes the loans must place the notes and mortgages in a vault and track which set of legal instruments goes with which mortgaged property.  When Joe the Debtor defaults and the loan servicer hired to oversee the loans files for foreclosure it must present the original promissory note and mortgage to the court to prove that it owns the loan and is owed debt service payments.  No original promissory note and, usually, no right to foreclose.

It is distressing and depressing, but not surprising, to learn that keeping track of the notes and mortgages was not a Wall Street priority.  Bookkeeping is not sexy or lucrative.  Yet it is often the mundane details, the faulty O-ring, the failed anchor bolt, that brings down complicated machines.  The NY Times reported on Sunday “bankruptcy judges are finding that institutions claiming to hold the notes that back specific mortgages often cannot prove it.”  When this happen the court should hold the lender has no right to foreclose the loan.

Like everything else economic these days, no one knows how big a problem missing loan documentation might be.  The Times reports-

as messes go, this one has, ahem, potential. According to Inside Mortgage Finance, some eight million nonprime mortgages were put into securities pools in 2005 and 2006 and sold to investors. The value of these loans was $797 billion in 2005 and $815 billion in 2006.  If notes underlying even some of these mortgages were improperly assigned or lost, that will surely complicate pending legislation intended to allow bankruptcy judges to modify mortgage terms for troubled borrowers. A so-called cram-down provision in the law would let judges reduce the size of a loan, forcing whoever holds the security interest in it to take a loss. But if the holder of the note is in doubt, how can these loans be modified?

One more thing to watch.