There's a very interesting new study on mortgage loan modifications out from the Boston Federal Reserve staff. This sort of study is long-overdue and from an academic standpoint, there's a lot I really like about this study. But the study is going to get a lot of policy attention, and I think it's important to point out some of the problems with the study that limit its ability to serve as a policy guide.
Tag: cramdown
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Chrysler and Foreclosures: the Contrast
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Today it's reported that Chrysler has convinced its creditors to agree to modify its debt obligations. Chrysler was able to do this in part because of the leverage it had by threatening to file for bankruptcy. It's instructive to contrast the Chrysler situation to the situation of homeowners. The voluntary home mortgage loan modifications are still not happening on the scale necessary to address the foreclosure crisis. How different would the world look if homeowners had the leverage of bankruptcy to induce voluntary modifications?
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Bankruptcy Bill Passes in the House
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H.R. 1106, the Helping Families Save Their Homes Act of 2009, which will allow modification of all types of mortgages in Chapter 13 bankruptcy, passed the House today by a vote of 234-191.
I haven't found a link yet with the vote breakdown or any other details, but will post more when I do. -
BS Bankruptcy Numbers
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We've already seen a lot of bs numbers in the cramdown debate. The Mortgage Bankers Association keeps pushing its ridiculous figures. And now Todd Zywicki has joined the fray with an op-ed in the Wall Street Journal a couple of weeks ago.
Professor Zywicki that claimed that "A recent staff report by the Federal Reserve Bank of New York estimated a 265 basis-point reduction on average in auto loan terms as a result of the reform."
One little problem. That's not what the Fed staff report found. Professor Zywicki was off by 250 basis points (a doozy of a mistake!), as well inserting a causal link not supported (and arguably contradicted) by the Fed staff's study. The study states that "The decline in the average auto loan spread was 15 basis points lower after BAR for unlimited exemption states, a 5.7 percent decline relative to the mean over all states (265 basis points)." In other words, the average rate spread is 265 bp. The decline in rates, to which Zywicki was referring was only 15bp, and that was only in states with an unlimited homestead exemption. That it was not 265 bp was abundantly clear from the regression tables.
But that's not all. It's not as if Professor Zywicki simply mistook a 15 bp drop for a 265 bp drop. That 15 bp isn't what it appears to be. The study used two statistical specifications and looked at states with limited and states with unlimited homestead exemption to see what impact there was on auto loan rates post-BAPCPA, which enacted an anti-auto cramdown provision (the infamous "hanging paragraph" that says that there's no bifurcation of claims for cars purchased primarily for personal use in the previous 910 days).
In one specification it found nothing with statistical significance regardless of the homestead exemption level, which means that it couldn't rule out the possibility that the change in rates was random.
In the other specification, post-BAPCPA there was a marginally statistically significant 15 bp drop in five-year auto loan rates in states with unlimited homestead exemptions. There was no statistical significance in the drop in other states. What's funny about this is that homestead exemptions have no bearing in Chapter 13–exemptions are only available in Chapter 7. So if the study had aggregated all states for its regression, it seems unlikely that it would have gotten stronger statistical significance.
So we have at best very weak evidence of a 15bp drop in rates. But it doesn't follow that the drop was due to the anti-auto-cramdown provision. The study also found a significant decline in auto-loan delinquencies in the short period after BAPCPA. The most plausible story, I think, is that surge in bankruptcy filings before BAPCPA's effective date cleared out the pipeline of troubled loans so that post-BAPCPA auto loan default rates were lower. My guess is that they've climbed right back up. Notice that this has nothing to do with cramdown. This has to do with moving forward some filings that would have happened later. So we have a 15bp drop that might not even be statistically significant and only in some specifications and only for states with unlimited homestead exemptions, and it probably isn't attributable (or at least most of it) to the anti-cramdown provision, but instead to BAPCPA causing a filing pile-up. So where did Professor Zywicki get this 265 basis point number from? That's the spread that exists between five year auto loans and five year Treasuries. It has nothing to do with bankruptcy.
Sometimes a little common sense is needed when looking at numbers, too. In December 2005, auto loan rates were at around 6.63% (663 bp). If 265 bp was right, it would have been a 40% decrease in auto loan rates! Whatever impact bankruptcy has on credit costs, I don't think there's anyone who could honestly argue that 40% of the cost of auto loans is due to the ability to cram down loans on cars purchased primarily for personal use within the previous 910-days with a purchase money security interest. There just aren't that many folks filing for Chapter 13 bankruptcy, much less who fit into this particular set of circumstances, to have this kind of impact on pricing, regardless of the loss severities.
Yet another case of baloney numbers shaping the bankruptcy debate. I hope the WSJ runs a correction on this. Now there's some fact-checking for you.
[Update 3.6.09:
Based on correspondence with Don Morgan, one of the NY Fed study's authors and Professor Zywicki, a few new points emerge:First, I misread the study too. The 15bp finding is in a regression that measure the "difference-in-differences" in the spread between auto loans and Treasuries pre- and post-BAPCPA for states with and without unlimited homestead exemptions. The study does not report the post-BAPCPA rate drop in auto loan rates. The author, however, tells me that it turns out to be 46-56 bps, and to have strong statistical significance. So let the record stand corrected on this.
Second, regardless of whether the number is 15, 46, 56, or 265bps, the finding of a correlation does not mean there's causation. But that's precisely what Professor Zywicki was pushing in the WSJ. Unfortunately, it's just not a tenable claim.It's possible that BAPCPA resulted in lower auto loan rates. But in order to make a reasonable causation argument, one must first explain the similar or larger rate drops in 2000-2001 and in 2003 and in 2007 that have nothing to do with BAPCPA. Otherwise, the causal argument is reduced to the fallacious post hoc ergo propter hoc variety.
The chart below, taken from the NY Fed study shows with the solid and dotted lines the spread between auto loan rates and Treasury's for states with and states without unlimited homestead exemptions. They move in sync, and they clearly fall after BAPCPA. But they also fall equally sharply before and after BAPCPA. Auto loan rate spreads over Treasury jump around a lot, and the mere fact that they fell after BAPCPA doesn't prove anything.
(fwiw, Chart 5 appears to be incorrectly labelled in the study. The study says that the "Left axis measures interest rate on new automobile loan (5 year) minus rate on government bond (5 year)." If so, then 15bps would appear to be roughly the right measure. Instead, the rate spread must be the right axis in bps, and the left axis must be measuring the difference in the auto-loan-treasury spread between limited and unlimited homestead exemption states.)
The problems with Professor Zywicki's causality argument don't end there. Any causality argument must also distinguish between general impacts of BAPCPA (e.g, delinquency pipeline cleared out) and the auto-cramdown provision. This type of event study cannot provide support for that. The rate drop could be due to the hanging paragraph, but there's no responsible way to make that claim without addressing these other factors, and the NY Fed study doesn't attempt to do that. The fact that Professor Zywicki was off by 209-219 bps, rather than by a full 250 bps (something he couldn't have known from the study) doesn't absolve him of making an untenable causal claim.
The bankruptcy policy debate should happen on the basis of the best possible evidence. If more restrictive bankruptcy laws result in cheaper credit, that's a very important policy consideration, and for the integrity of the policy debate, we need to be working off the best numbers available. I've updated this post to make sure that the correct numbers are clear. I'm still hopeful that Professor Zywicki will make clear that he doesn't stand by either his 265 bp claim or his untenable claim of causality.]
[Updated 3.7.09
Professor Zywicki has corrected on the 265 bp claim. He still seems to be making causal assertions, however, such as that the study finds "the impact of eliminating cramdown was a reduction in
interest rates of 56 or 46 basis points." That's not quite right. The study can't test the elimination of cramdown; it can only test the impact of BAPCPA as a whole. In fairness, Zywicki later refers to the study finding the impact of BAPCPA, rather than the specific cramdown provision. Regardless, Professor Zywicki still has no response to all of the equally large jumps up and down in the auto loan rate to Treasuries before and after BAPCPA, which casts serious doubt on any causal story.] -
Bankruptcy Modification and the Emperor’s New Clothes
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A new argument being advanced against bankruptcy modification is that it will result in trillions of dollars of losses and the collapse of the financial system. This is the "the sky will fall" argument.
Leaving aside the grossly inflated numbers, let's be really clear that these are not losses that would be caused by bankruptcy modification. These losses exist with or without bankruptcy modification. All bankruptcy modification does is force these losses to be recognized now, rather than at some point down the road. Bankruptcy modification doesn't change the underlying insolvency of many financial institutions. One way or another, there are a lot of financial institutions that have to be recapitalized.Financial institutions want to delay loss recognition as long as possible. Maybe they're hoping that the market will magically rebound. Maybe they think that 2006 prices are the "real" prices and "2009" prices are a very short-lived aberration. But here's the crucial point: homeowners bear the cost of delayed loss recognition by financial institutions. Delayed loss recognition means homeowners floundering in unrealistic repayment plans and then losing their homes in foreclosure. Delayed loss recognition means frozen credit markets because no one trusts financial institutions' balance sheets. Delayed loss recognition means magnifying, shifting, and socializing losses. We only make matters worse when we try to pretend that these losses don't exist.We all know the story of the Emperor's New Clothes, and how everybody plays along with the emperor's conceit until a little boy points out that the emperor is stark naked. To suggest that widespread financial institution insolvency would be caused by bankruptcy modification is akin to blaming the little boy for the emperor's nudity. -
Cramdown and Future Mortgage Credit Costs: Evidence and Theory
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I've written extensively (see here, here, e.g.) on why permitting modification of mortgages in bankruptcy would generally not result in higher credit costs or less credit availability. As the debate over bankruptcy reform legislation to help struggling homeowners and stabilize our financial system moves to the fore, it's worth repeating some of the key points and making some new ones.
(1) The key comparison is bankruptcy modification versus foreclosure. Opponents of bankruptcy modification often misframe the issue, whether deliberately or ignorantly. It is not a question of bankruptcy losses versus no losses, but bankruptcy losses versus foreclosure losses. If bankruptcy losses are less than foreclosure losses, the market will not price against bankruptcy modification. This is an empirical question, and to date, my work with Joshua Goodman is the only evidence on it. Opponents of bankruptcy modification have only been able to respond with plain-out concocted numbers (e.g., the Mortgage Bankers Association) or insistence on applying economic theory that looks at the wrong question.
(2) Economic theory tells us that cramdown is unlikely to have much impact on mortgage credit costs going forward. The ability to cramdown a mortgage (reduce the secured debt to the value of the property) is essentially an option borrowers hold to protect themselves from negative equity. It is a costly option to exercise–it requires filing for bankruptcy, and that has serious costs and consequences. More importantly, though, cramdown is typically an out-of-the-money option. It is only in-the-money when (1) property values are falling enough that there's negative equity and (2) likely to remain depressed in the long-term. Long-term declining residential property values have been the historical exception. What this means is going forward there really isn't much for creditors to worry about with cramdown–homeowners can't exercise an out-of-the-money option.
Moreover, because the likelihood of the cramdown option being in the money is Instead, it is an option that is more likely to be valuable when default is imminent, at which point the loan is in the secondary market. So to the extent that the cramdown option does cost creditors, it is the secondary market, and the effects on credit availability and cost to homeowners would be diffused.
(3) Arguments about bankruptcy court capacity and bankruptcy transaction costs are made by people who have no experience with the actual bankruptcy system. A serious misconception about bankruptcy modification is the belief that the bankruptcy judge would decide how to rewrite the mortgage. That's not how bankruptcy works. The debtor (and debtor's counsel) would propose a repayment plan that includes a mortgage modification. The judge either confirms or denies the plan, depending on whether it meets the necessary statutory requirements. This means that bankruptcy judges can actually handle significant consumer bankruptcy case volume. If you want proof that the bankruptcy courts can handle a huge surge in filings, look at what happened in the fall of 2005, before BAPCPA went effective. The courts survived that flood of filings. Today the bankruptcy courts are better prepared; there are more bankruptcy judges (thank you BAPCPA) than in fall 2005. Nor would there be tremendous time and money lost in valuation disputes. After there are a handful of cases decided in a district, all the attorneys know what the likely outcomes would be in future cases and settle on valuations consensually. Court capacity and excessive transaction cost arguments are made by people who have never stepped foot into bankruptcy court.
(4) There's no other serious option on the table. Permitting bankruptcy modification of mortgages will not by itself solve the finance crisis. It will not stop all foreclosures. But it will help stop some uneconomic foreclosures, which benefits homeowners, investors, communities, and the financial system. And, more importantly, whatever imperfections bankruptcy modification has as a solution, it's the only real option on the table.
There is no other detailed legislative proposal. There are various economist pipedream proposals around, but even the best of them fail, either because they are politically unrealistic or because they are too rooted to a belief that the private market can solve problems with a tweak here and there. I believe that people and institutions respond to incentives, but market-based solutions haven't worked to date. How many times do we have to be burned by "market-based" solutions before we try something else? The unfortunate truth is that no one understands enough about various mortgage market players' incentives to properly align them. We can't follow all the trails of servicing contracts, insurance, reinsurance, credit derivatives, overhead, and litigation risk and know what incentives look like. Even if we did, it would take serious time for the market to correct itself and start doing large-scale loan modification. That's time that families don't have, and I don't think that anyone who is advocating a market-based solution is also pushing a foreclosure moratorium to allow the market to get its act together. Bankruptcy modification is the only game in town, and to pretend otherwise is disingenuous cover for opposing it in the name of "studying all the options."
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House Judiciary Cramdown Hearing
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A great thing about teaching in Washington, D.C., is the ability to drop in on legislative hearings. Today I went to a House Judiciary subcommittee hearing on the cramdown bill, also known as the Emergency Home Ownership and Mortgage Equity Protection Act of 2007(HR 3609). A report is below the break.
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More Bogus Numbers from the Mortgage Industry
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The past few months have seen story after story about fraud in the mortgage industry. Now we’re seeing a new type of fraud–mortgage lobbying fraud. The Mortgage Bankers Association has been claiming the proposed bankruptcy reform legislation that would significantly roll back the special treatment given to mortgage lenders in chapter 13 bankruptcies would result in residential mortgage interest rates rising 1.5 to 2 percent. (Somehow this number started at 2% and has drifted down to 1.5% without any explanation.) The MBA’s number is pure and demonstrable hokum. As Joshua Goodman, a Columbia University economist and I show in a new working paper, permitting bankruptcy modification is likely to have little or no impact on mortgage interest rates or origination volumes. Keep reading below the break for the proof.