The Liberty Papers

The plan coming out of the administration and treasury to prop up the mortgage industry has caused quite an uproar. In particular, there’s been a big debate even within the ranks of contributors to this blog about exactly how smart of an idea this is.

The problem, however, is that we were largely arguing in a vacuum. The particulars of the plan were largely unknown (or not fully understood), even last night as I was writing my own post on the subject. Thus, in a vacuum people are throwing out terms like “bail-out”, and voluntary vs. forced renegotiation (hereafter I will use the term “modify”, as that appears to be the agreed-upon industry term). In general, we were arguing the rhetorical point about government intervention in the market, without really having a handle on what the government was proposing.

Enter a post by Tanta over at Calculated Risk. First, before you continue reading this post, click on the link and read it. Then come back.

As far as I can understand, it boils down to a few key points:

1. Due to the regulatory/contractual structure, lenders did not know whether they could modify loans without violating the contract of the debt instruments they’ve sold to investors.
2. Investor contracts (Pool & Servicing Agreements, or PSA’s) are not uniform, but most are designed such that loans can only be modified under certain circumstances (when in danger of foreclosure). This is due to the fact that the investments are tax-advantaged, and there are very specific rules within the tax code regarding the regulation of such instruments.
3. Lenders and investors wanted a way to modify loans (instead of foreclosing), but they weren’t sure if they could do so, as the typical language in a PSA says “you can follow agreed-upon practices that don’t violate REMIC standards or jeopardize the investment’s Q-status.”
4. The government decided to clarify the meaning of their tax regs and say that such modifications would not violate said standards.

That’s basically it. It looks like lenders and investors were very confused about whether the actions they wanted to take (modifying loans to avoid foreclosures) could legally be done without violating their current contracts. When they’re confused, they often simply don’t act. The government came out and said “yes, what you want to do is legal”, and now the lenders feel more comfortable going forward.

This is why there are three classes of borrowers, and that borrowers capable of refinancing are not eligible for the rate freeze. Those who are capable of refinancing their loan are not considered “in danger of foreclosure”, so they cannot be legally modified within the bounds of the PSA. Their only hope is refinancing. For those with low FICO scores, or other conditions that make refinancing impossible, but are in danger of foreclosure, this gives lenders the ability to modify their loans without fear of legal action under the PSA.

But this isn’t really all about helping borrowers, it’s about letting lenders find a way out of this mess without going belly-up. Which, if you think about it, is entirely consistent with a Bush administration proposal: help the corporations, whether it improves the economy, the housing market, or not. It appears this is a lot more complicated than what fits into a 2-minute sound bite on MSNBC. And like most government actions, between a thin veneer of “public interest”, it’s really about helping out the lenders and investors, not the borrowers.

Of course, the Administration is selling this to the public as if it’s all about helping borrowers. They’re politicians, and they want the public to believe they’re “doing something”. The media isn’t interested in in-depth analysis of the situation, and your average newspaper reader isn’t very interested in getting knee-deep in PSA, REMICs, Q-status, and the like. So only out in the blogosphere does anyone have an incentive to actually call this a non-action, which is what it is.

This isn’t a giveaway to borrowers.
This isn’t a violation of investors’ contracts with lenders.
This isn’t costing the taxpayer money.

This isn’t a bailout.