Felix Salmon

What did Wall Street used to be like, before the Securities Act of 1933? Michael Perino’s new book on Ferdiand Pecora, which I reviewed here, reminds us. For instance, there was National City Bank’s Peru deal.

National City’s South American experts had reported that the government’s finances were “positively distressing”, with the treasury “flat on its back and gasping for breath” and the president surrounded by “rascals”. Yet, inevitably, National City decided to underwrite a series of bonds from Peru. Nowhere in the prospectus was there any indication of National City’s view on the country; meanwhile, National City’s ads stated that “when you buy a bond recommended by The National City Company, you may be sure that all the essential facts which justify the Company’s own confidence in that investment are readily available to you”.

Perino continues:

National City kept right on offering Peruvian bonds in 1927 and 1928, even though one of its own South American experts continued to conclude that he had “no great faith in any material betterment of Peru’s economic condition in the near future”. The political situation, he wrote, was “equally uncertain,” with “revolution” a distinct possibility. Would the public have purchased these bonds, Pecora asked, if that information had been included in the prospectus? “I doubt if they would,” Baker replied.

Pecora did something similar with a bond offering for the Brazilian state of Minas Gerais. National City used much of the proceeds to pay off a loan due to itself, without telling telling investors that it was using their money to exit the very credit they were buying into. And that’s not all:

How Minas Gerais would use the proceeds of the bond offering was not the only misrepresentation in the prospectus. Pecora put George Train, the man who originally urged National City to underwrite these bonds, on the stand. Train, it seemed, was willing to play fast and loose with other crucial facts in order to get the deal done. In 1927, analyzing Minas Gerais’s history of bond offerings in Europe, Train was amazed at the shoddy way the government had handled its obligations. The “laxness of the State authorities,” he wrote in an internal company memorandum, “borders on the fantastic”. His review of Minas Gerais’s history “showws the complete ignorance, carelessness and negligence of the former State officials in respect to external long-term borrowing.” It would, he wrote, “be hard to find anywhere a sadder confession of inefficiency and ineptitude than that displayed by various State officials.” Despite those conclusions, Train wrote in the prospectuses for the bond offerings, “Prudent and careful management of the State’s finances has been characteristic of successive administrations in Minas Gerais.”

I’m quoting Perino at length, here, because I’m getting a lot of pushback from various commenters to my assertion that pretty much every major investment bank in the world withheld material nonpublic information when they failed to pass on to investors the results of the due diligence tests that Clayton did on mortgage loan pools.

Kid Dynamite says that we’re not talking about material nonpublic information here. But of course we are: it’s information, it’s nonpublic, and it’s certainly material, since it resulted in the investment banks negotiating down the price of the loan pool in question.

The Securities Act came into law largely in reaction to exactly the kind of behavior that Pecora uncovered with the Peru and Minas Gerais bonds. The banks knew bad stuff about the bonds they were selling, but they didn’t pass on that information to investors. And so the Securities Act was written to put an end to such shenanigans.

The Clayton reports were much more than mere opinion, like the ratings agencies pretend to be. (And in any case, credit ratings are public information.) Clayton did detailed empirical research on the loan pools, and when the banks didn’t like what they saw, they used that information to their own advantage — by asking for a discount on the loans from the originator.

The whole point of the Securities Act was to ensure that information like that was passed on to investors. That’s why bond prospectuses are so long: they include every conceivable piece of information, and every conceivable risk factor, that might possibly be relevant to the price of the bond.

Yet the MBS prospectuses for the loan pools that Clayton examined didn’t include the fact that Clayton had done due diligence on them, didn’t say what Clayton’s results were, and certainly didn’t disclose that those results had allowed the underwriter to buy the loans from the originator at a discount.

If Ferdinand Pecora were alive today, he would recognize all this behavior — and be shaking his head at the way in which banks simply ignored the spirit of the laws which FDR put into place in the wake of the Pecora Commission.

Did the banks behavior violate the letter of the law? I think there’s a good case that they did; they certainly broke the law as it exists today. But let’s find out! Come on, prosecutors — file some suits, here, and see what happens. This crisis has yet to reach the stage at which people start going to jail. And we need to pass through that stage before it’s all over. So let’s get to it.

Joseph Tauke has a monster 5,600-word excoriation of the mortgage industry. It’s a great read, and it includes a lot of information you probably won’t know unless you’re a regular reader of Naked Capitalism and 4closureFraud. But the most important thing about the story is nowhere to be found in the story itself; rather, it’s the fact that it was published by the Daily Caller, Tucker Carlson’s right-wing website.

The Tea Party wing of the Republican party has never been a big fan of Wall Street, of course. But at the same time, it has also tended to oppose any Democratic attempts to bring Wall Street into line. And it hasn’t made bank-bashing a central part of its platform at all. (TARP-bashing, yes. But TARP was a government program.)

TARP was a bipartisan deal to save the banks, and its outcome is now regarded as desperately unfair: the rich bankers are now back to making multi-million-dollar bonuses, even as most of the country continues to suffer from a weak economy and high unemployment.

So if the Daily Caller’s story is any indication, there might just be a consensus in Congress to gang up on the banks and dole out a bit of punishment for their fraudulent behavior with respect to respectable homeowners.

The big question mark with regard to foreclosure fraud has always been the willingness, rather than the ability, of authorities to prosecute the banks involved. If the political winds change so that regulators have every incentive to sue, you can be sure that they will do so. Given that any indication of friendliness towards banks constitutes political suicide right now, I’d guess that the banks’ litigation risk is higher than it has ever been.

Which is maybe why JP Morgan Chase set aside $1.3 billion in additional litigation reserves last quarter. At this rate, they might well need all of that — and more.

Clayton isn’t the only company doing due diligence on mortgages: another company doing the same thing is Allonhill. Whose CEO, Sue Allon, has a blog post up today explaining that there’s nothing to get excited about here:

In the run-up to the crisis, there was no rule that issuers had to perform due diligence at all. They obtained diligence for their own purposes, and when they did, no rule dictated that the results be disclosed to rating agencies and investors.

Allon goes on to say that “nobody – not investors, nor the SEC nor the rating agencies” was demanding that the due diligence reports be made public.

But this doesn’t make sense to me: why wouldn’t investors want to see the reports, if they knew they were being conducted?

And then there’s this:

The fact remains that investors still don’t have access to due diligence reports.

Still? How is that even possible? Isn’t the whole point of Section 15E(s)(4)(A) of the Exchange Act — introduced recently as part of Dodd-Frank — to force underwriters to give investors access to due diligence reports?

And as for the SEC not caring about this, I’d point you to to a letter that Clayton sent to the Financial Crisis Inquiry Commission. The idea was to distance itself from its former employees’ testimony, but check out this admission, towards the end:

Clayton began to review prospectuses in the summer and fall of 2007 in response to specific questions from regulators about whether Clayton’s due diligence results were set forth in MBS prospectuses.

Clearly, regulators have known about this issue for three years now; they’ve certainly known about it for long enough to insert Section 15E(s)(4)(A) of the Exchange Act into the Dodd-Frank bill.

So while Allon is right that there might not have been a specific rule requiring disclosure of the diligence results, there were still general rules requiring that underwriters disclose all relevant information when they sold mortgage bonds — or any other kind of security — to investors. That’s where the huge potential liability lies.

Update: Patrick Rucker of Reuters was all over this back in July 2007:

Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in subprime loans to less creditworthy borrowers but did not pass much of the information to credit rating agencies or investors, Wall Street sources said…

“If all the information about these investments was properly disclosed, our client would have made different decisions…and, specifically, not bought these investments,” said Dale Ledbetter, a Florida attorney suing Credit Suisse.

If bankers are good at anything, surely it’s counting money. If there’s a cashflow, anywhere, bankers will surely be able to quantify it and report it. Or, not:

Mortgage-bond buyers are losing faith in the accuracy of remittance reports, and some say the apprehension could soon factor into their investment strategies.

Remittance reports, distributed monthly by securitization trustees, are supposed to provide routine snapshots of the cashflow-collection and distribution activities of servicers. However, investors say there has been a rash of recent instances in which the reported data differed considerably from what actually happened.

Loan servicers, it seems, are so spectacularly incompetent that they can’t even report to bondholders how much money they’re being paid. Especially when a loan has been modified, the servicers don’t seem to be able to report the new cashflows accurately.

Not that this is a bad time to reduce investors’ faith in the transparency and reliability of mortgage-backed securities, or anything.

Just how bad is the mortgage mess right now?

Mike Konczal finds an Andy Kroll piece from January which shows just how unregulated mortgage servicing has been: the OCC, for instance, has never taken action against mortgage servicers. And it’s far from clear that it’s inclined to now:

The OCC, which regulates the nation’s largest banks, has initiated “examinations” of foreclosure and loss-mitigation procedures at big banks, “to be conducted over the next several weeks to confirm compliance and that banks have remedied any identified issues,” an OCC spokesman said.

The point here is that the decision to go after banks and loan servicers is ultimately a political one, and there doesn’t seem to be a huge amount of appetite in Washington to have another huge fight with the banks, so soon after the last one. The OCC could, at any minute, get very tough on the servicers. But will it? That’s very uncertain.

Meanwhile, the incredibly low rate of existing home sales looks like it’s going to plunge still further:

New buyers have stepped back from the market for distressed property, which now accounts for more than 30% of new transactions, according to RealtyTrac. New owners are worried they don’t have a legal right to their homes. Title insurers are worried about their exposure to faulty documents and unwilling to stand behind new purchases. Since title insurance is required for most mortgages, the market is essentially at a standstill.

In other words, the housing market, which was broken before, is even more broken now.

What’s this all going to cost? Nelson Schwartz is throwing around numbers less than $10 billion, which is decidedly manageable, but that’s just the cost to banks, and crucially it assumes that the problem is merely one of paperwork. Hire a few new people, be a bit more diligent, and things will be able to sort themselves out.

If you start looking at the mortgage market, the potential cost gets much, much higher:

An alarming report on Bank of America, compiled by Branch Hill Capital, a San Francisco hedge fund, circulated widely on Wall Street on Thursday. Branch Hill suggested that the bank, the nation’s largest, could be facing more than $70 billion in losses from mortgage securities that it may have to repurchase from Fannie Mae and Freddie Mac, as well as private investors.

“We think this is a very important issue, and the liability will be substantial,” said Manal Mehta, a partner at Branch Hill. “There has been pervasive bad behavior throughout the system.”

The problem is hardly confined to Bank of America, of course. All investment banks did this, which means they all have enormous potential liabilities.

And then the costs to the broader housing market are higher still. The longer that market fails to properly clear, and the longer that the overhang of unsold houses continues to grow, the less it makes sense to talk about what any given house is “worth” — and the more it makes sense for homeowners to default on their mortgages. They’re very unlikely to get thrown out of their homes for at least a year and possibly much longer, and there’s a pretty good chance, if they’re underwater, that at the end of this mess they’ll be able to negotiate some kind of principal reduction.

So what are the mortgage originators and investors doing about this huge problem? It looks as though they’re sticking their heads in the sand:

The Executive Director of the American Securitization Forum, Tom Deutsch, released the following statement regarding misinformation circulating within the financial markets that transfers of residential mortgage loans to securitization trusts were not valid.

“In the last few days, concerns have been raised as to whether the standard industry methods of transferring ownership of residential mortgage loans to securitization trusts are sufficient and appropriate. These concerns are without merit and our membership is confident that these methods of transfer are sound and based on a well-established body of law governing a multi-trillion dollar secondary mortgage market.”

Apparently the Forum is going to release a white paper “over the course of the next two weeks” designed to put our minds to rest. Needless to say, it won’t. Even if the narrow question of the transfer of ownership to the securitization trust is cleared up, there are still numerous enormous concerns surrounding mortgage bonds, including whether the banks misled investors, whether investors might be able to force the banks to buy the bonds back, and whether the bonds themselves are going to plunge in value as house prices fall, defaults rise, and the ability to foreclose on notes in default slowly evaporates.

And what happens if and when the homeowners who have already been foreclosed upon start filing class action suits against various parts of the financial-services industry, saying that the banks had no right to do that? If the verdicts of kangaroo courts start being overturned, things could start getting really messy.

What’s desperately needed here — and what isn’t going to happen — is someone to come in and take ownership of the whole mess, and cobble together a roadmap for getting out of it. But that would take more political will than seems to exist in the White House. So this is going to drag on, painfully, state by state, quite possibly for years. And while it’s doing so, the chances of any kind of robust economic recovery — at least outside the world of high-priced legal firms — seem slim indeed.

Update: Thanks to Economics of Contempt. This turns out not to be the cut-and-dried breaking of the law that it looks like. Because it turns out that Section 15E(s)(4)(A) of the Exchange Act is very new: it was only inserted into the Act by Dodd-Frank (page 1,376, if you’re following along at home). So it wasn’t in force when these bonds were issued. You couldn’t do this kind of thing any more — it would be illegal. But Section 15E(s)(4)(A) isn’t enforceable retroactively.

After my post yesterday on the mortgage bond scandal, a lot of commenters said that it looked like a violation of Rule 10b5-1 of the Exchange Act — the bit that prohibits trading on material nonpublic information. Well, it may or may not be a violation of 10b5-1. But that might be beside the point, because this looks like an absolutely textbook violation of Section 15E(s)(4)(A).

This rule is not dense legalese at all. In fact Section 15E(s)(4)(A) is written in very plain English. Here it is in full (see page 231 of the PDF):

The issuer or underwriter of any asset-backed security shall make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.

I can’t for the life of me work out how every single mortgage bond that Clayton taste-tested didn’t violate this rule.

And in fact, the SEC has now proposed its own additional rule, which would mandate this kind of due diligence, and would also mandate that the issuer disclose the nature, findings and conclusions of any such taste test.

Up until now, underwriters have not been obliged to do this kind of due diligence. But the fact is that they did it, and that Clayton, in particular, made good money from performing such due diligence for just about every major investment bank in the world. As far as I know, not a single one of those banks disclosed Clayton’s results when they sold their bonds. And that looks to me like a blatant violation of Section 15E(s)(4)(A).

Or is there something I’m missing here? (Obviously, yes, there was.)

Update 2: If Section 15E(s)(4)(A) doesn’t do the job, what are we left with? Well, there’s still 10b5-1, of course. That prohibits the sale of any security on the basis of material nonpublic information. And there’s also Section 17 of the Securities Act:

It shall be unlawful for any person in the offer or sale of any securities… to obtain money… by means of any untrue statement of a material fact or any omission to state a material fact.

Which still does the job, I think.

Politico has the transcript of Tim Geithner’s appearance on Charlie Rose last night:

I think it’s important to recognize, Charlie, that if you — a national moratorium would be very damaging to exactly the kind of people we’re trying to protect, because the consequence of that would be in neighborhoods that have been most affected by the foreclosure crisis, where you see lots of houses on the block empty, unoccupied, what it means is those communities will be living longer with houses unoccupied, with more pressure on their house price with the people still in their houses. That would be very damaging.

I don’t follow this logic at all. Geithner is absolutely right that empty houses are a Bad Thing. But he seems to think that a foreclosure moratorium would cause empty houses. Isn’t it foreclosures which cause empty houses?

I feel I’m missing something obvious here — but as I understand it, when a bank forecloses on a house and sells that house, it evicts the previous owners as part of that process. One the old owners are evicted, the house is empty — until the bank manages to sell it. If the foreclosure doesn’t happen, the eviction doesn’t happen, and the house isn’t empty.

Is Geithner implying that banks will continue to evict homeowners even without foreclosing on those properties? Is that even possible?

Update: Treasury responds, via email.

First, at least 40 % of all homes in foreclosure are vacant.  Delaying conveyance of title and resale has devastating impacts on neighborhood values
and increases demand for municipal services.

Also, a blanket moratorium equally impacts the banks that are acting in accordance with the law increasing costs for servicers and investors.
This threatens the safety and soundness of smaller community banks that are not part of the document problem and ultimately limits market
liquidity preventing low and moderate income borrowers from refinancing or buying a house as investors are ever more hesitant to lend to all
but the most pristine credit borrowers.

You thought the foreclosure mess was bad? You’re right about that. But it gets so much worse once you start adding in a whole bunch of parallel messes in the world of mortgage bonds. For instance, as Tracy Alloway says, mortgage-bond documentation generally says that if more than a minuscule proportion of notes in a mortgage pool weren’t properly transferred, then the trustee for the bondholders can force the investment bank who put the deal together to repurchase the mortgages. And it’s looking very much as though none of the notes were properly transferred.

But that’s not even the biggest potential problem facing the investment banks who put these deals together. It also turns out that there’s a pretty strong case that they lied to the investors in many if not most of these deals.

I mentioned this back in September, and I’ve been doing a bit more digging since then. And I’m increasingly convinced that the risk to investment banks isn’t only one of dodgy paperwork; there’s also a serious risk of massive lawsuits from the SEC or other prosecutors, as well as suits from individual mortgage investors.

The key firm here is Clayton Holdings, a company which was hired by various investment banks — Goldman Sachs, Bear Stearns, Citigroup, Merrill Lynch, Lehman Brothers, Morgan Stanley, Deutsche Bank, everyone — to taste-test the mortgage pools they were buying from originators.

Here’s how it would work:

First, the bank would put in a winning bid for the pool of mortgages, with the intention of slicing it up into mortgage bonds and selling those bonds off to investors at a profit.

After submitting the winning bid, the bank would commission Clayton to take a closer look at a representative sample of loans in the pool. Clayton controlled as much as 70% of the market for this service, which is known as third-party due diligence. But Clayton’s not at fault here, and the problem is likely to apply no matter who performed this service.

The size of the representative sample would vary according to the size of the loan pool; it could be anywhere between 5% and 35% of the loans in the pool. Essentially, Clayton would go back to the loans, one by one, and re-underwrite them after the fact, checking that the originator’s underwriting standards were in fact being upheld.

Clayton would either accept or reject the loans it was looking at, according to whether or not they met underwriting standards. Here’s the results of what it found for one bank, Citigroup; the chart comes from this document filed with the Financial Crisis Inquiry Commission. I’m just using Citi as an example, here; all banks behaved in basically exactly the same way.

Look at the first line. Clayton reviewed 1,280 loans on behalf of Citigroup in the first quarter of 2006. Of those, it accepted 554 outright: they lived up to the originator’s underwriting standards. It also waived another 144, on the grounds that there were mitigating factors (a large downpayment, say). And it rejected 582 for a rejection rate of 45%.

This kind of information was valuable to Citigroup: it showed them that the quality of the loan pool was much lower than you’d think just by looking at the ostensible underwriting standards.

Armed with this information, Citigroup would do two things. First of all, it would take those 582 rejects and put most of them back to the underwriter. Essentially, they said, the loans weren’t as advertised, and they didn’t want them. But Citi would still keep some of them in the pool.

But remember that Clayton had tested only a small portion of the loans in the pool. So Citi knew that if there were a bunch of bad loans among the loans that Clayton tested, there were bound to be even more bad loans among the loans that Clayton had not tested. And those loans it couldn’t put back to the originator, because Citi didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of Clayton’s test. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

I talked to one underwriting bank — not Citi — which claimed that investors were told that the due diligence had been done: on page 48 of the prospectus, there’s language about how the underwriter had done an “underwriting guideline review”, although there’s nothing specifically about hiring a company to re-underwrite a large chunk of the loans in the pool, and report back on whether they met the originator’s standards.

In any case, it’s clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool. That’s a lie of omission, and if I was one of the investors in one of these pools, I’d be inclined to sue for my money back. Prosecutors, too, are reportedly looking at these deals, and I can’t imagine they’ll like what they find.

The bank I talked to didn’t even attempt to excuse its behavior. It just said that Clayton’s taste-testing was being done by the bank — the buyer of the loan portfolio — rather than being done on behalf of bond investors. Well, yes. That’s the whole problem. The bank was essentially trading on inside information about the loan pool: buying it low (negotiating for a discount from the originator) and then selling it high to people who didn’t have that crucial information.

This whole scandal has nothing to do with the foreclosure mess, but it certainly complicates matters. It’s going to be a very long time, I think, before the banking system is going to be free and clear of the nightmare it created during the boom.

Update: KidDynamite asks a good question in the comments: were the bond investors able to do their own due diligence on the loan pool? The answer is no, they weren’t — the prospectus did not include the kind of loan-level information which would enable them to do that.

Sifma CEO Tim Ryan released this statement today:

“It would be catastrophic to impose a system wide moratorium on all foreclosures and such actions could do damage to the housing market and the economy. It must be recognized that the mortgage market, investors and the health of the economy are all inter-related. Investors in the housing market—including American workers with pension funds, 401k plans, and mutual funds—would unjustly suffer losses in their savings from these actions. Increased uncertainty in the securitization market would further constrain consumer credit and spending, dampening our already unhealthy economic situation. If mistakes have been made in relation to foreclosure processing, SIFMA firmly believes such mistakes should be corrected. It is imperative, however, that care be taken in addressing these issues to ensure that no unnecessary damage is done to an already weak housing market and, in turn, that there is no further negative impact on the economy.”

It’s worth going through this slowly to see just how bizarre it is.

Firstly, it’s Sifma’s own members — with Bank of America taking the lead — who are imposing “a system wide moratorium on all foreclosures”. No one’s suggesting that the government could or should do such a thing: a foreclosure is, after all, a legal action brought by one private entity against another. It makes sense, if you’re going to sue somebody, that you make sure in advance that you have the your legal ducks in a row. Right now it’s abundantly clear that most loan servicers don’t have their legal ducks in a row, so it makes sense for them to stop foreclosing on homeowners, at least for the time being. (In Bank of America’s case, it has even tried to foreclose on houses which don’t have a mortgage at all.)

Secondly, it’s not foreclosure moratoriums which damage the housing market, it’s badly-documented mortgages. A healthy market is one in which title and ownership are clear and legally watertight; in which assets change hands at market-clearing prices; and in which value and market price are generally understood to be one and the same thing. Using these criteria, it’s pretty obvious that the housing market is not healthy now, and that the longer this foreclosure crisis drags on, the less healthy it’s going to be.

Crucially, you can’t judge the health of the market by house prices alone, especially when home sales are plunging and foreclosure sales often take place a good 35% below market values. And what goes for the housing market also goes, mutatis mutandis, for the mortgage market. It’s entirely possible that secondary-market RMBS prices will fall if housing prices drop. But in the medium to long term, what’s really necessary is for investors in mortgage-backed securities to have faith that they really own what they think they own. And the only way to do that is to bite the bullet and fix the mortgage mess.

In any case, it’s far from clear that a foreclosure moratorium would hurt house prices — or even RMBS prices — at all; indeed, it’s pretty hard to see exactly what Ryan and Sifma are worried about. They say that they firmly believe that the mistakes made in relation to foreclosure processing should be corrected, but they don’t bother to tell us how that’s meant to happen.

It would be great if Sifma were to take the lead on this issue, and come up with constructive solutions to a serious problem. Instead, they’re just delivering an inchoate and unhelpful blast of opposition. Sad.

As people like Mike Konczal and Annie Lowery try and explain the foreclosure mess, it’s worth stopping to think about a possible long-term solution to the crisis. And given the sheer quantity of insufficiently-documented loans, the only sensible and scalable solution I can think of is to swap out those bad loans for good new ones.

There are three main ways this can be done. The first is to refinance the current loan, possibly through HAMP. The second is for the banks and the homeowners to negotiate a principal reduction. And the third is to allow a short sale of the house.

So long as the banks make sure they get their paperwork right this time, any one of those three actions would solve the problem at a stroke. Even better, any one of those three actions should actually be preferable, from the bank’s point of view, to a foreclosure in any event. As RealtyTrac’s Rick Sharga told Chris Isidore, short sales typically take place at a 15% discount to the value of the mortgage, while foreclosure sales normally take place at a 35% discount. That’s a big difference.

For homes which are in the foreclosure process right now, it’s probably too late to attempt a HAMP modification, so the banks will have to switch to either a principal reduction or a short sale. But for performing loans, or those which are delinquent but not yet in foreclosure, all three options should be aggressively pursued. The good news is that mortgage rates are very low right now, so a refinance is generally in the homeowner’s interest anyway.

Logistically, replacing all those old mortgages with new mortgages will be expensive and time-consuming; certainly the loans in or near foreclosure should get priority. But it seems to me a market-based and transparent solution to a very large problem for which there is no legislative fix. (Or rather, the one legislative fix that’s needed has already happened, and will remain in force through 2012.) And if it ends up hurting banks’ balance sheets, well, that’s condign punishment for their failure to keep their paperwork in order during the boom.

Paul Jackson reckons that the idiotic way in which GMAC/Ally is handling its defaulted loans is partially a function of the thankless nature of the work:

The loan servicing shop is its own world, with its own management – and none of this management typically has anything to do with the upper management within the banking institution itself…

The talent gap between the front office and the back end of a mortgage operation can be substantial – the most talented financial minds, and the best trained and most experienced managers, don’t typically find themselves falling into default management as a career. The pay scale simply isn’t there. Banks don’t require future managers to spend time working a turn in default management, either. The Harvard MBAs go elsewhere, and don’t bother themselves with getting their hands dirty on the default side of the business…

Now, it’s the same management-talent gap that is wreaking havoc for the biggest of banks and their servicers.

The implicit assumption here is that if the Harvard MBAs had gone into default management, the outcome would be better than what we’re seeing now, rather than worse. Does Jackson really believe that? I certainly don’t.

Yes, the situation we have right now is pretty gruesome. But I suspect it’s not a function of incompetent staffers in default management, so much as it’s a function of those Harvard MBAs higher up the org chart systematically depriving the default-management operations of the staff and funds they need to do their jobs properly.

Default management is not rocket science. It requires conscientious and diligent work; it doesn’t require talent. The kind of people who are good at such things also tend to be good at hiring their successors and generally doing their job perfectly well without much if any oversight. The problem isn’t that senior management is divorced from default management, it’s that senior management thinks it can squeeze costs and the people actually doing the work, without worrying about the far-reaching potential consequences.

So Jackson is absolutely right about this:

At what point does it behoove senior management at the board level of a bank to sit “Chainsaw Al” down and explain to him that “streamlining” operations at all costs is actually counterproductive? At what point does a bank’s board decide that default operations are important enough to merit a more substantial investment in people and process, rather than continuing to push default management under the proverbial rug and being content to play whack-a-mole when problems inevitably pop up from below?

Go follow that link to a classic Tanta post, and you’ll see something approaching the platonic ideal of how a loan servicer should do her job. And obviously Tanta was an exceptional person in many ways: no bank can just decide overnight to hire lots of people like her. But it seems to me that the best thing to do here is simply empower the managers in that arm of the organization to spend what they think necessary, even if they’re not on the management fast-track. Budgets will go up in the short term. But tail risk will come down enormously.

Carrick Mollenkamp writes today about Talcott Franklin, a lawyer in Dallas who has taken it upon himself to wage war against trustees — those impossible-to-find people buried deep within big banks who technically work on behalf of bondholders but who in practice do absolutely nothing.

Last year, I wrote about US Bancorp as being one of the worst of these trustees, and it’s no surprise to see them on Mollenkamp’s list. Here’s what they’re meant to do:

If a trustee, for example, discovers that a borrower lied when getting a loan, the trustee or loan servicer is responsible for forcing the originating bank to repurchase the loan on behalf of mortgage investors. Trustees enforce warranties made by loan originators when they sell loans to a trust, and oversee loan-servicing firms.

In practice, you won’t be surprised to hear, the trustees ended up doing little or nothing, despite their obligation to protect the rights of bondholders:

In the past, complaints by mortgage-security investors went unheeded. But because Mr. Franklin now represents enough investors to meet certain legal thresholds—he, for example, represents 50% or more of the voting rights of 900 mortgage securities—his clients could fire a trustee, demand changes in the way a mortgage bond is managed or ultimately file a suit on behalf of a huge group of bondholders.

In the letter, Mr. Franklin said that in some trusts where the lender and servicer sit inside the same bank, the number of recent repurchases by the lender is zero, even though the default rate for the loan pool is 25%.

Things have come to a pretty pass when bondholders need to group together to sue their own trustee. But it’s been clear for a while that almost nobody has been looking out for bondholders’ rights; certainly the government has been much more interested in keeping the banks solvent. Good for Mr Franklin for fighting this fight; I hope he gets results.

Yves Smith has been doing a fabulous job covering the latest fiasco at Ally Financial, the state-owned bank which used to be called GMAC. But to get a quick idea of how dysfunctional the situation is, all you need to do first is read the official GMAC memo to its agents in 23 states around the country, and then read the official GMAC press release on the subject.

The memo could hardly be any clearer. “Do not proceed with evictions, cash for keys transactions, or lockouts,” it says. “All files should be placed on hold, regardless of occupant type. Do not proceed with REO sale closings.”

Yet here’s how the press release begins:

Recent reports have stated that GMAC Mortgage instituted a moratorium on all residential foreclosures in 23 states. This is not true. In fact, all new residential foreclosures are continuing in the ordinary course of business with no interruption in our usual practice.

There’s no good reason for this kind of misdirection and mendacity. Ally is meant to be the friendly, transparent bank; instead, at the first sign of trouble, it retreats into Clintonian language (didja spot that “new” in the press release?) which only serves to reinforce the impression that no banks, including Ally, can ever be trusted.

The substantive problem here seems to be a series of affidavits — tens of thousands of them — signed by Jeffrey Stephan of GMAC Mortgage/Homecomings Financial. The states where GMAC has put its evictions on hold are the ones where you need to go to court to get an eviction. And when you go to court, you need to provide an affidavit signed by someone with personal knowledge of the case in question. Stephan, it seems, had no such personal knowledge: rather, he was something of a “robo-signer”, who would put his name to affidavits without even reading them.

As Smith details, this problem is just as likely to get much bigger as it is to quietly get sorted out in the coming weeks. GMAC was not the only mortgage lender using robo-signers. And during the housing boom, all manner of legal corners were cut when mortgages were written, which can make them very hard to legally enforce.

And although the GMAC moratorium is so far only in 23 states (including Florida, but excluding California), the legal issues are surely substantively the same in the 27 other states as well. Just because you don’t need to go to court to get an eviction doesn’t mean you can toss someone out of their home without your legal i’s dotted and t’s crossed.

All of this is complicated, too, by the fact that the US Treasury owns 56.3% of Ally. At most banks, it’s generally assumed that the shareholders just want to see the maximum possible returns, over the long run. That’s not a safe assumption, however, when your shareholder is Treasury, which has been ploughing billions of dollars into schemes designed to prevent evictions.

It would be wonderful if GMAC could take the high road here, and act with full transparency in a manner consistent with the best possible practices that Treasury would like to see in the mortgage market. Judging by its press release, there’s not much indication that’s happening yet. But maybe a couple of phone calls from Washington might change its mind. I wonder how Elizabeth Warren is settling in to her new job.

Remember Fannie Mae’s National Housing Survey? Well, Fannie has repeated the exercise, just six months later, and chief economist Doug Duncan tells me it might even become more frequent than that, in future.

The general upshot is that Americans might still be delusional when it comes to housing, but they’re less delusional than they were six months ago, which is a good sign.

Although 67% of Americans think buying a house is a safe investment, this is down 3 points from January 2010 and 16 points from 2003 – the largest declines among all tracked alternatives over both timeframes.

It’s also good news that 80% of renters think they would have to make a financial sacrifice in order to own a home, and that fully 90% of owners think that they’re making a financial sacrifice to own their home. Given that expectations for house-price appreciation are realistically modest, one can conclude that people buying houses today are doing so for pretty good reasons.

There are weirdnesses in the survey: 91% of underwater borrowers, for instance, say they’re satisfied with their current mortgage.

And in the Fannie Mae survey, underwater homeowners are significantly less tolerant of the idea of walking away from a mortgage than their more solvent peers: just 6% of them say it’s OK to stop paying their mortgage, compared to 10% of the population as a whole. That’s in contrast to the latest Pew survey, in which 18% of underwater borrowers — and 19% of the general population — say that walking away is acceptable.

That said, half of the population think that mortgage lenders are likely to pursue other assets, rather than just the home in question, if the borrower walks away. Americans think they’re living in a recourse world, and they’re wrong about that: statistically speaking, lenders almost never chase personal assets in such situations. This attitude is good news for lenders, since it gives borrowers more of a reason to keep on making their mortgage payments. But if borrowers ever waken up to reality, the consequences for banks could be brutal.

There are also interesting divergences between buyers and renters. The proportion of buyers who think that homeownership is important to the overall economy, for instance, rose two points to 82% in this survey, while the proportion of renters thinking the same thing fell a full five points to 72%. And more generally, says Duncan, there’s a divide between renters and delinquent homeowners, on the one hand — who are more pessimistic than the general population, and becoming more pessimistic still — and owners who not delinquent. They are not only optimistic, but becoming more so.

Duncan reckons, after spending a lot of time with the survey results, that a lot of people are putting off buying a home because they’re worried about the future direction of the economy. It’s not so much that they think house prices are going to fall, but rather that they don’t want to take on the huge commitment of making mortgage payments every month for the next 30 years, given the uncertainty surrounding their own personal financial situation.

That bespeaks a lot more financial common sense and responsibility than we saw during the housing market. And so while America is by no means a nation of would-be renters, it’s moving in the right direction.

Gretchen Morgenson is absolutely right, in the words of her headline, that “Housing Doesn’t Need a Crash. It Needs Bold Ideas.” The problem is that the bold idea she’s pushing is not the kind of bold idea that housing needs. Meanwhile, she sidles up to a genuinely good, if not particularly bold, idea, but fails to connect her own dots:

Many lenders and some government agencies bar borrowers who sold their homes for less than the outstanding loan balance — known as a “short sale” — from receiving a new mortgage within a certain period, sometimes a few years.

For example, delinquent borrowers who conducted a short sale are ineligible for a new mortgage insured by the Federal Housing Administration for three years; Fannie Mae blocks such borrowers for at least two years. Private lenders have similar guidelines…

68 percent of properties in Nevada are worth less than the outstanding mortgage, CoreLogic said, while half in Arizona and 46 percent in Florida are underwater.

So, the first, easy thing to do is to get rid of the blunt restrictions on lending to people with a short sale in their recent past: the housing market needs all the potential buyers it can get, right now. Once upon a time, it might have made sense to think that people with recent short sales would be such bad credits that no bank should think about selling them a mortgage. But not now, when the presence of a short sale on your credit report is likely to say much more about the broader housing market in your region than it does about you.

Of course, lenders can always refuse any individual for any reason, after doing their underwriting. But there’s no point in having a blanket restriction on lending to people who have done a short sale.

But that’s not Morgenson’s bold idea. Instead, she reckons that Fannie and Freddie should happily step in and refinance — at par — any and all performing subprime mortgages that they can find.

The problem with this is the same as the problem with HAMP: there’s no principal reduction. Without principal reduction, these borrowers will remain underwater on their mortgages, and therefore will remain at very high risk of defaulting.

Think about it this way: the subprime mortgage crisis came about because banks were blindly and happily lending 100% of a home’s value. Now Gretchen Morgenson wants the U.S. government — through Fannie and Freddie — to lend out much more than that: maybe 150%, maybe more. That’s idiotic.

Here’s how the Congressional Oversight Panel characterizes such schemes:

Lack of principal forgiveness means that homeowners will continue to be underwater. It also means that more of each payment will be going to interest, rather than paying down principal, and it may mean that some borrowers have to pay for a longer period of time. All of these factors increase the re-default risk on modified mortgages, and to the extent that a permanent modification is not sustainable, it merely delays a foreclosure and the stabilization of the housing market.

The main beneficiary of Morgenson’s scheme would be the investors and lenders who would jump at any opportunity to take mortgages worth much less than par and sell them at 100 cents on the dollar to Uncle Sam. It’s a bailout of bondholders, primarily, and as such it stinks. These investors, when they lent to subprime borrowers, knew they were taking credit risk. They should suffer some kind of loss now that the market has crashed, and any idea which takes them out at par is fundamentally ugly.