Why can’t borrowers buy back their mortgages at a discount?

By Felix Salmon
April 11, 2009

Thornburg Borrowers Unite is a new blog for people with mortgages from now-bankrupt Thornburg. Those mortgages are for sale, at a discount: why can’t the homeowners themselves buy them back? “If Thornburg can be persuaded to give its borrowers right of first refusal,” goes the argument, “it costs taxpayers nothing, and it prevents third parties from profiting from our losses and the demise of Thornburg.”

This is entirely true, and it seems like a perfectly good idea. But there is one small problem with it — the issue of adverse selection, from the point of view of the investor buying up Thornburg’s mortgages.

If I’m putting in a bid on a large number of Thornburg loans, I know that some will perform well, and be worth more than par, while others will perform very badly, result in foreclosure, and be worth maybe 30 or 40 cents on the dollar to me, all told. Net-net, I might be willing to pay 60 or 70 cents on the dollars for those loans.

The borrowers are saying that if Thornburg is willing to sell their loan to an outside investor for 69 cents, it should be even more willing to sell that loan back to the homeowner for 70 cents. But in fact it’s more complicated than that. The homeowners who are willing and able to buy back their own loans for 70 cents on the dollar are generally the most valuable of Thornburg’s borrowers — they’re overwhelmingly likely to be the ones whose loans are worth par, or more. So if Thornburg allows them to buy their own loans back, the value of the remaining mortgages goes down, and the investors aren’t going to be willing to pay 69 cents on the dollar any more.

And it’s also not strictly true that doing this “costs taxpayers nothing”. If I borrow $500,000 from Thornburg and then buy that debt back for $350,000, I’m basically making a $150,000 profit, which would normally be taxed as income. Recently, the government temporarily suspended the laws forcing me to pay income tax on that $150,000. But the more people who buy back their mortgages at a discount, the more income tax is foregone by the Treasury.

All that said, the idea behind the blog is a fundamentally good one: anything which provides a new bid for legacy mortgage assets should be encouraged. I wish these people well, and hope they get somewhere with their campaign.

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