Publié par : crise2007 | décembre 2, 2007

Finally moving from a case-by-case to an across-the-board approach to mortgage restructuring

Finally moving from a case-by-case to an across-the-board approach to mortgage restructuring

Nouriel Roubini

This author spent a few years of policy wonkdom working on financial crises in emerging market economies and how to resolve them; and eventually he wrote – with Brad Setser – a book about it. The crisis resolution issues faced by emerging markets (Mexico, East Asia, Russia, Brazil, Argentina, Turkey, Uruguay, etc.) were similar to those presented today by the need to resolve the sub-prime crisis and the risk that millions of households will default on their mortgages.  In any debt crisis there are two main issues:

1. Should you take a “case-by-case” approach to debt restructuring (where each individual debtor’s liabilities are restructured in court or out-of-court on a one to one basis) or should you take an “across-the-board” approach where some a priori rules are used to restructure the debts of all debtors in particular group? 

2. Is the borrower illiquid or insolvent? I.e. if you re-stretch the maturity and/or debt payments path of an illiquid borrower would such borrower be eventually able to pay its debt?

The answer to the first question, coming from the experiences with a dozen financial crises in emerging market economies, is that when millions of small agents (households with foreign currency denominated mortgages whose real value has sharply increased following a currency devaluation, small and medium sized enterprises with foreign currency debts, and even larger corporate firms when you have a systemic corporate crisis) are financially distressed it is altogether impossible to follow a case-by-case approach as neither the bankruptcy court system nor the creditors are able to expeditiously restructure on an individual basis millions of separate debt contracts.

Thus, while an across the board approach is not totally fair – as some debtors who could pay and don’t deserve debt relief do receive it – this approach is the only feasible way to deal with the need to rapidly restructure millions of separate debt contracts. Thus, while some market fundamentalists were always pushing for a case-by-case approach and wanted to avoid the IMF supporting an across-the-board approach to debt restructuring it became clear to all that, with the exception of very large corporations or financial institutions, the across-the-board approach was the only feasible one to deal with such debt crises.  

This simple lesson, that has been known for ages now, has been finally learned – after a long year of subprime meltdown – by the US Treasury and major mortgage lenders as they are now planning an across-the-board approach to the restructuring of the mortgages of some categories of sub-prime borrowers. As reported by the WSJ:

 The Bush administration and major financial institutions are close to agreeing on a plan that would temporarily freeze interest rates on certain troubled subprime home loans, according to people familiar with the negotiations.

 An accord could reassure investors and strapped homeowners, both of whom are anxious as interest rates on more than two million adjustable mortgages are scheduled to jump over the next two years. It could also give a boost to the Bush administration, which is facing criticism for inaction amid the recent housing turmoil.

 The plan is being negotiated between regulators including the Treasury Department and a coalition of mortgage-related companies including Citigroup Inc., Wells Fargo & Co., Washington Mutual Inc. and Countrywide Financial Corp. People familiar with the talks say the individual members have agreed to follow any agreement reached by the coalition, which is called the Hope Now Alliance.

Details of the plan, which could be announced as early as next week, are still being worked out. In general, the government and the coalition have largely agreed to extend the lower introductory rate on home loans for certain borrowers who will have trouble making payments once their mortgages increase.

Many subprime loans carry a low « teaser » interest rate for the first two or three years, then reset to a higher rate for the remainder of the term, which is typically 30 years in total. In a typical case, the rate would rise to around 9.5% to 11% from 7% or 8%. That would boost an average borrower’s payment by several hundred dollars a month….

Mr. Paulson, who is philosophically opposed to federal meddling in markets, at first rejected a sweeping approach to loan modifications when the idea was floated by Federal Deposit Insurance Corp. Chairwoman Sheila Bair. But he shifted his position recently. He told The Wall Street Journal last week that it would be impossible to « process the number of workouts and modifications that are going to be necessary doing it just sort of one-off. »

So after wasting almost a year in supporting  a case-by-case approach to loan modification and realizing that only a paltry 1% of such mortgages had been modified as lenders and servicers did not have either the skills or the human resources or the physical resources to modify one by one millions of loans after a dragged out negotiating process with the debtor, both the mortgage lenders and the US Treasury have now gotten religion and accepted an approach that they had vehemently opposed before: i.e. move from a case-by-case to an across-the-board approach to loan modification.  Even Paulson finally got it that – as reported by the WSJ – it would be impossible to « process the number of workouts and modifications that are going to be necessary doing it just sort of one-off. »

The answer to the first question is also pretty obvious from the experience with emerging markets financial crises: if the borrower is illiquid re-stretching maturities (if the principal on the debt was coming due soon) with no reduction in the face value of the debt and at the same time freezing the interest rate on the debt at below market rates can allow an illiquid but solvent debtor to eventually repay the face value of the debt. But if the debtor is insolvent and a maturity re-stretching will not affect its eventual ability to repay its debts it is better to allow default and debt write-downs.  Note that even in the case of maturity re-stretching with no face value reduction the lender suffer of a NPV loss as the interest on the re-stretched debt is set a below market rates. So while no face value reduction occurs there is still an NPV loss for the creditor and a form of debt relief for the borrowers (under the assumption that the lower interest rate is not capitalized).

And indeed last March when this author suggested abandoning a case-by-case approach and moving to an across-the-board approach to the looming sub-prime crisis this distinction between illiquid and insolvent debtors was at the center of the proposed approach to loan modifications. As I put it then:

[Here are] some principles for the coming financial support that will be given with public funds to clean up the unfolding mortgage disaster. First, distinguish between true victims of predatory lending and deadbeat borrowers who were into early strategic default. Early payments default is a clear way to distinguish between inability to pay and unwillingness to pay. Also, means testing for financial support is crucial: low income and low asset households who were pursuing the American Dream and were deceived by lenders may deserve support. But subprime borrowers with higher incomes and/or assets do not deserve support and should be pushed into foreclosure if they are unable or unwilling to service their mortgages. Also, condo-flippers and other individuals who bought homes for speculative purposes such as speculating on price increases (i.e. folks who were not first time homeowners who lived in their homes) would get no financial relief at all and will be forced to foreclose if they are unable or unwilling to service their mortgage.  Second, financial support to households who were victims of predatory lending (and owners of overvalued homes whose value was incorrectly assessed as much higher than equilibrium) should take the form of reduced debt servicing (as in some recent proposals) rather than subsidies to borrowers; this to prevent the support of the borrowing victims from indirectly bailing out the culprits of reckless or predatory lending.


For example, suppose that the value of a home (with zero down-payment) has fallen 10% (following the current housing bust) and that the borrower cannot now pay the full value of the mortgage debt servicing payments that are now being reset at much higher interest rates. Then, if the borrower can afford a lower string of service payments  that, in NPV terms, is 10% lower than the initial terms of the mortgage (and equal to the true value of the home), the solution will be to allow a reduction of 10% (in NPV terms) of the debt-servicing payments for the borrower. Instead, a public subsidy to the borrower in the same amount would have the same effect on the borrower while bailing out a reckless or predatory lender. 


Suppose instead that the home value has fallen 10% but the household cannot afford even a 10% NPV reduction of the stream of debt payments associated with the initial mortgage (say at zero initial down-payment). Then, the household – duped or not – was buying a home with a bundle of housing services that was too large relative to its ability to afford it even after the value of the mortgage has been adjusted to the lower market value of the home. In this case if it takes more than a 10% reduction in the NPV of the debt payments to allow the household to be able (or equivalently willing) to afford the home. Thus, it make sense to foreclose the home and not provide financial support to the household: duped or not the household had bought a home whose real housing services were too large relative to even its ability to afford it at a reduced market value. Thus, financial support of the household is not warranted and foreclosure is a socially efficient solution. The bank should take the loss of a mortgage with a home value lower than the mortgage. And such household should rent a lower amount of housing services by renting a smaller home/apartment rather than own a home with a bundle of housing services that it cannot afford.

In that analysis of mine the first type of  borrower is illiquid but solvent; the latter is both illiquid and insolvent.  And those who could afford or were strategic defaulters would not receive debt relief. 

The proposal for mortgage modification now supported by Treasury and the coalition of lenders takes a similar approach with three groups of borrowers. First, interest rate resets will be frozen for a while (possibly up to seven years) while face value of the loan will be maintained for selected group of sub-prime borrowers who are illiquid but otherwise solvent.  Second, those who can afford to keep on paying their mortgages would not receive the interest rate relief. Third, those who cannot afford to service their mortgages even at frozen reset rates should not receive the relief but should be allowed to default.  As the WSJ put it:

Treasury officials say financial institutions are likely to set criteria that divide subprime borrowers into three groups: those who can continue to make their payments even if rates rise, those who can’t afford their mortgages even if rates stay steady, and those who could keep their homes if the maturity date of their mortgages were extended or the interest rates remained at the teaser rates. Only the third group would be eligible for help.

Notice that, even in the case of illiquid borrowers, it is essential the maintaining the face value of the debt with frozen – rather than reset – interest rate works as long as the difference between the implied reset rate and the frozen teaser rate is not capitalized. Otherwise the face value of the debt increases over time and eventually the loan modification is bound to trigger a likely default. I.e. freezing the teaser rates works only if you provide true NPV reduction of the debt claim. So, even with no face value reduction the debtor gets some debt relief in net present value terms. Also note that a variety of combinations of debt payment streams can be equivalent in NPV terms: you can keep face value and freeze interest rate payment; you can reduce face value and allow resets at higher rates; or you can taka a combination of face value reduction and some partial resetting of rates. All those can be equivalent on a NPV basis and all of them imply some reduction in the NPV of the claim and some effective debt reduction for the borrower. So while the Treasury proposal does not touch – for now – the face value of the mortgage claim it still represents a form of debt reduction – on a NPV basis  – for the borrower (unless the banks push for capitalizing the difference between the reset rate and the frozen initial rate).

As a final observation one can say: better late than never. After wasting a year on a mission impossible quest to deal with the sub-prime problem on a case-by-case basis and avoiding debt relief to the borrowers the Treasury and the banks saw the light and realized that only an across-the-board approach would work even if this approach implies an indirect government interference – via moral suasion – with the “free market” process and an effective debt relief to the borrowers rather than a bailout of reckless lenders. And this type of government interference with the market mechanism is – based on initial information – sounder than the other half-baked proposal pushed by Treasury to deal with the SIVs mess, i.e. the super-shell game “Super-Conduit”. Having botched the latter mess, Paulson legacy may – hopefully – remain with a sounder proposal to deal with a systematic and across-the-board partial resolution of the sub-prime mess.


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