Monday, January 25, 2010

NYT: Underwater, But Will They Leave Pool?


MUCH has been said about the high rate of home foreclosures, but the most interesting question may be this: Why is the mortgage default rate so low?

After all, millions of American homeowners are “underwater,” meaning that they owe more on their mortgages than their homes are worth. In Nevada, nearly two-thirds of homeowners are in this category. Yet most of them are dutifully continuing to pay their mortgages, despite substantial financial incentives for walking away from them.

A family that financed the entire purchase of a $600,000 home in 2006 could now find itself still owing most of that mortgage, even though the home is now worth only $300,000. The family could rent a similar home for much less than its monthly mortgage payment, saving thousands of dollars a year and hundreds of thousands over a decade.

Some homeowners may keep paying because they think it’s immoral to default. This view has been reinforced by government officials like former Treasury Secretary Henry M. Paulson Jr., who while in office said that anyone who walked away from a mortgage would be “simply a speculator — and one who is not honoring his obligation.” (The irony of a former investment banker denouncing speculation seems to have been lost on him.)

But does this really come down to a question of morality?

A provocative paper by Brent White, a law professor at the University of Arizona, makes the case that borrowers are actually suffering from a “norm asymmetry.” In other words, they think they are obligated to repay their loans even if it is not in their financial interest to do so, while their lenders are free to do whatever maximizes profits. It’s as if borrowers are playing in a poker game in which they are the only ones who think bluffing is unethical.

That norm might have been appropriate when the lender was the local banker. More commonly these days, however, the loan was initiated by an aggressive mortgage broker who maximized his fees at the expense of the borrower’s costs, while the debt was packaged and sold to investors who bought mortgage-backed securities in the hope of earning high returns, using models that predicted possible default rates.

The morality argument is especially weak in a state like California or Arizona, where mortgages are so-called nonrecourse loans. That means the mortgage is secured by the home itself; in a default, the lender has no claim on a borrower’s other possessions. Nonrecourse mortgages may be viewed as financial transactions in which the borrower has the explicit option of giving the lender the keys to the house and walking away. Under these circumstances, deciding whether to default might be no more controversial than deciding whether to claim insurance after your house burns down.

In fact, borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed. These fees are not made explicit to the borrower, but if they were, more people might be willing to default, figuring that they had paid for the right to do so.

Morality aside, there are other factors deterring “strategic defaults,” whether in recourse or nonrecourse states. These include the economic and emotional costs of giving up one’s home and moving, the perceived social stigma of defaulting, and a serious hit to a borrower’s credit rating. Still, if they added up these costs, many households might find them to be far less than the cost of paying off an underwater mortgage.

An important implication is that we could be facing another wave of foreclosures, spurred less by spells of unemployment and more by strategic thinking. Research shows that bankruptcies and foreclosures are “contagious.” People are less likely to think it’s immoral to walk away from their home if they know others who have done so. And if enough people do it, the stigma begins to erode.

A spurt of strategic defaults in a neighborhood might also reduce some other psychic costs. For example, defaulting is more attractive if I can rent a nearby house that is much like mine (whose owner has also defaulted) without taking my children away from their friends and their school.

So far, lenders have been reluctant to renegotiate mortgages, and government programs to stimulate renegotiation have not gained much traction.

Eric Posner, a law professor, and Luigi Zingales, an economist, both from the University of Chicago, have made an interesting suggestion: Any homeowner whose mortgage is underwater and who lives in a ZIP code where home prices have fallen at least 20 percent should be eligible for a loan modification. The bank would be required to reduce the mortgage by the average price reduction of homes in the neighborhood. In return, it would get 50 percent of the average gain in neighborhood prices — if there is one — when the house is eventually sold.

Because their homes would no longer be underwater, many people would no longer have a reason to default. And they would be motivated to maintain their homes because, if they later sold for more than the average price increase, they would keep all the extra profit.

Banks are unlikely to endorse this if they think people will keep paying off their mortgages. But if a new wave of foreclosures begins, the banks, too, would be better off under this plan. Rather than getting only the house’s foreclosure value, they would also get part of the eventual upside when the owner voluntarily sold the house.

This plan, which would require Congressional action, would not cost the government anything. It may not be perfect, but something like it may be necessary to head off a tsunami of strategic defaults.

Richard H. Thaler is a professor of economics and behavioral science at the Booth School of Business at the University of Chicago.

Copyright 2010 The New York Times Company. All rights reserved.

Friday, January 22, 2010

NYT: Basking In Islands of Legalisms


The Cook Islands have a smaller population — about 20,000 — than one apartment complex in Manhattan, and an economy with little to offer except tourism and pearl exports. The country contracts out its national defense to New Zealand, which is four hours away by plane.

But sand and sun are not the attractions for some Americans who have sent their money to the Cook Islands.

Under Cook Islands law, foreign court orders are generally disregarded, which is helpful for someone trying to keep assets away from creditors.

In fact, getting an American court order can make it harder to get money out of the Cook Islands. If someone who stashed funds in a Cook Islands trust asks for the money back because a court ordered him to do so, Cook Islands law says that person is acting under duress, and the local trustee can refuse to return the money.

Over the years, a number of less-than-upstanding Americans have found the islands attractive for that reason, among them former corporate raiders, penny stock promoters and telemarketers who defrauded customers.

The latest to use that tactic is the wife of Jamie L. Solow, a former broker in Florida who evidently has a silver tongue and certainly has a lot of angry former customers. In one year, he earned more than $3 million in commissions selling a form of collateralized debt obligations known as “inverse floaters” to individual investors who claim he never warned them of the risks.

The investments proved to be disastrous, and the Securities and Exchange Commission persuaded a jury in West Palm Beach, Fla., that he had committed securities fraud.

Now a federal judge has ordered Mr. Solow to go to prison on Monday for civil contempt for failing to come up with a large part of the $6 million he was ordered to pay in disgorgement, interest and penalties.

Mr. Solow claimed he had virtually no assets, since his wife owned everything in the family and had put most of it in a Cook Islands trust. A couple of months after the jury verdict, but before the final judgment was issued, she put an undisclosed amount of cash and jewelry in a safe deposit box in a Swiss bank in Zurich.

Mr. Solow did sell all the assets he acknowledged owning — an old pickup truck and some office furniture — and sent $2,639 to the court. The family Rolls Royce was also sold, for $205,000, but the Solows say it was actually owned by Mrs. Solow, even though her husband had put up the money to buy it and signed the sale documents.

This week, Mr. Solow asked that his incarceration be delayed, on the grounds that he and his wife were now willing to ask the Cook Islands trustee to return the money. They have not actually made that request, and in the past, Cook Islands trustees have refused to honor such requests. In ordering Mr. Solow to prison, Judge Donald M. Middlebrooks, of the United States District Court for the Southern District of Florida, said his inability to pay was self-created, and thus no excuse.

Nor was the judge impressed by Mr. Solow’s contention that the S.E.C. itself was to blame for his inability to pay, since it had won an order barring him from the securities industry, and thus prevented him from working.

“Mr. Solow’s ‘chosen profession’ consisted of committing fraud against his investors,” the judge wrote. “That being the case, an opportunity to do different work, outside his ‘chosen field,’ may better serve his ability to satisfy the disgorgement order.”

In setting up the trust, Mr. Solow’s wife, Gina, followed a blueprint laid out in a 2005 article in an accounting publication, written by Howard D. Rosen, a lawyer in Florida whom she hired a few days after the jury verdict in early 2008.

The Solows own a waterfront home in Hillsboro Beach, Fla., which they view as their permanent residence even though they have not lived in it for several years because of hurricane damage. “It has been condemned due to the roof falling in,” Mr. Solow’s attorney, Carl F. Schoeppl, said Thursday, adding that he did not know how much repairs would cost.

The house was already encumbered by $2.4 million in mortgages, but a Cook Islands bank lent $5.2 million more secured by the house. The money from that was immediately placed in a Cook Islands trust to benefit only Mrs. Solow.

The judge noted that the mortgage could not have been taken out without Mr. Solow’s consent.

The house is now listed for sale for $6.1 million, far less than the combined mortgages, but the bank in the Cook Islands was taking no real risk. The proceeds from the mortgage were deposited in the Cook Islands, and the interest earned is used to pay the interest on the mortgage.

Mrs. Solow also took out a $1.2 million mortgage on the Fort Lauderdale condominium she owns, and in which the couple live.

Mr. Rosen, the lawyer who set up the trust, said in the article that it was a challenge to protect real estate from American courts, since the property obviously could not be moved overseas.

“The only effective method available to protect an immovable asset,” he wrote, “is to make the asset unattractive to a creditor by removing its value — make the asset not worth going after. (Think about it: Would you spend your time and money to sue someone if all they had was a piece of real property worth $1 million encumbered by a $950,000 mortgage?) This technique is implemented by pledging the asset as collateral for a loan and by then protecting the loan proceeds with the client’s other liquid assets in the offshore trust.”

In a telephone interview, Mr. Rosen, who had testified in the case on behalf of Mr. Solow, told me that Judge Middlebrooks “simply does not understand the laws of the United States” and voiced confidence that an appeals court would overturn the ruling.

In an e-mail message, he compared the use of an offshore trust to a company’s decision to incorporate in Delaware rather than some other state. “Establishing a trust in the Cook Islands or other suitable asset protection jurisdiction in order to gain a protective advantage is no different,” he wrote. “It is a choice-of-law matter.”

Of course, Delaware law does not say companies can ignore judgments issued by judges in other states.

Even if Judge Middlebrooks’s order is upheld on appeal, the S.E.C. could be in for a long battle to get the money. More than a decade ago, the Federal Trade Commission persuaded a federal court to jail a married couple, Michael and Denyse Anderson, for civil contempt after they violated a court order to return funds to the United States that had been put into a Cook Islands trust. The commission said the two were involved in a telemarketing Ponzi scheme.

After several months, Mr. and Mrs. Anderson agreed to direct the trustee to release the money, and were released from jail. But the trustee refused, citing the United States court order as a form of duress, and the Cook Island courts upheld that decision.

Eventually, the F.T.C. was able to recover most of the money, which went to a fund to repay victims of the fraud, because the trustee agreed to settle. That happened after the commission threatened to file contempt charges against ANZ, the Australian bank in which the Cook Islands bank had deposited the money. ANZ, which has offices in the United States, evidently persuaded the trustee to agree to a settlement.

Promoters of Cook Island trusts learned from that case, and now make sure to use banks that have no American operations. It seems likely that a request from Mrs. Solow now would be similarly refused by the trustee.

It is worth noting that nearly all of the asset-moving activities in this case came after the S.E.C. notified Mr. Solow that it intended to file suit, and many of them came after the jury rendered its verdict. Perhaps it could have been avoided if there had been an asset protection freeze in place.

The S.E.C. says it has been seeking more such freezes. Mary L. Schapiro, the commission’s chairwoman, said last week that the commission “sought 82 asset freezes to preserve assets for the benefit of investors” in fiscal year 2009, “an increase of 78 percent compared to 46” in the previous year.

But it did not seek such an order in the Solow case, and probably would have had a difficult time getting one. It most often does so in insider trading cases, where it is preserving the apparently ill-gotten gains from being sent abroad, and in cases where it can persuade a judge that there is reason to fear the defendant would move assets and that it is highly likely the S.E.C. will win the case.

The S.E.C. has now filed a follow-up case against Mrs. Solow, who was not a defendant in the original case, and is seeking to garnish any bank accounts she has. But the money is long gone.

Copyright 2010 The New York Times Company. all rights reserved.

Tuesday, January 05, 2010

NYT: U.S. Loan Effort Is Seen as Adding to Housing Woes


The Obama administration’s $75 billion program to protect homeowners from foreclosure has been widely pronounced a disappointment, and some economists and real estate experts now contend it has done more harm than good.

Since President Obama announced the program in February, it has lowered mortgage payments on a trial basis for hundreds of thousands of people but has largely failed to provide permanent relief. Critics increasingly argue that the program, Making Home Affordable, has raised false hopes among people who simply cannot afford their homes.

As a result, desperate homeowners have sent payments to banks in often-futile efforts to keep their homes, which some see as wasting dollars they could have saved in preparation for moving to cheaper rental residences. Some borrowers have seen their credit tarnished while falsely assuming that loan modifications involved no negative reports to credit agencies.

Some experts argue the program has impeded economic recovery by delaying a wrenching yet cleansing process through which borrowers give up unaffordable homes and banks fully reckon with their disastrous bets on real estate, enabling money to flow more freely through the financial system.

“The choice we appear to be making is trying to modify our way out of this, which has the effect of lengthening the crisis,” said Kevin Katari, managing member of Watershed Asset Management, a San Francisco-based hedge fund. “We have simply slowed the foreclosure pipeline, with people staying in houses they are ultimately not going to be able to afford anyway.”

Mr. Katari contends that banks have been using temporary loan modifications under the Obama plan as justification to avoid an honest accounting of the mortgage losses still on their books. Only after banks are forced to acknowledge losses and the real estate market absorbs a now pent-up surge of foreclosed properties will housing prices drop to levels at which enough Americans can afford to buy, he argues.

“Then the carpenters can go back to work,” Mr. Katari said. “The roofers can go back to work, and we start building housing again. If this drips out over the next few years, that whole sector of the economy isn’t going to recover.”

The Treasury Department publicly maintains that its program is on track. “The program is meeting its intended goal of providing immediate relief to homeowners across the country,” a department spokeswoman, Meg Reilly, wrote in an e-mail message.

But behind the scenes, Treasury officials appear to have concluded that growing numbers of delinquent borrowers simply lack enough income to afford their homes and must be eased out.

In late November, with scant public disclosure, the Treasury Department started the Foreclosure Alternatives Program, through which it will encourage arrangements that result in distressed borrowers surrendering their homes. The program will pay incentives to mortgage companies that allow homeowners to sell properties for less than they owe on their mortgages — short sales, in real estate parlance. The government will also pay incentives to mortgage companies that allow delinquent borrowers to hand over their deeds in lieu of foreclosing.

Ms. Reilly, the Treasury spokeswoman, said the foreclosure alternatives program did not represent a new policy. “We have said from the start that modifications will not be the solution for all homeowners and will not solve the housing crisis alone,” Ms. Reilly said by e-mail. “This has always been a multi-pronged effort.”

Whatever the merits of its plans, the administration has clearly failed to reverse the foreclosure crisis.

In 2008, more than 1.7 million homes were “lost” through foreclosures, short sales or deeds in lieu of foreclosure, according to Moody’s Last year, more than two million homes were lost, and expects that this year’s number will swell to 2.4 million.

“I don’t think there’s any way for Treasury to tweak their plan, or to cajole, pressure or entice servicers to do more to address the crisis,” said Mark Zandi, chief economist at Moody’s “For some folks, it is doing more harm than good, because ultimately, at the end of the day, they are going back into the foreclosure morass.”

Mr. Zandi argues that the administration needs a new initiative that attacks a primary source of foreclosures: the roughly 15 million American homeowners who are underwater, meaning they owe the bank more than their home is worth.

Increasingly, such borrowers are inclined to walk away and accept foreclosure, rather than continuing to make payments on properties in which they own no equity. A paper by researchers at the Amherst Securities Group suggests that being underwater “is a far more important predictor of defaults than unemployment.”

From its inception, the Obama plan has drawn criticism for failing to compel banks to write down the size of outstanding mortgage balances, which would restore equity for underwater borrowers, giving them greater incentive to make payments. A vast majority of modifications merely decrease monthly payments by lowering the interest rate.

Mr. Zandi proposes that the Treasury Department push banks to write down some loan balances by reimbursing the companies for their losses. He pointedly rejects the notion that government ought to get out of the way and let foreclosures work their way through the market, saying that course risks a surge of foreclosures and declining house prices that could pull the economy back into recession.

“We want to overwhelm this problem,” he said. “If we do go back into recession, it will be very difficult to get out.”

Under the current program, the government provides cash incentives to mortgage companies that lower monthly payments for borrowers facing hardships. The Treasury Department set a goal of three to four million permanent loan modifications by 2012.

“That’s overly optimistic at this stage,” said Richard H. Neiman, the superintendent of banks for New York State and an appointee to the Congressional Oversight Panel, a body created to keep tabs on taxpayer bailout funds. “There’s a great deal of frustration and disappointment.”

As of mid-December, some 759,000 homeowners had received loan modifications on a trial basis typically lasting three to five months. But only about 31,000 had received permanent modifications — a step that requires borrowers to make timely trial payments and submit paperwork verifying their financial situation.

The government has pressured mortgage companies to move faster. Still, it argues that trial modifications are themselves a considerable help.

“Almost three-quarters of a million Americans now are benefiting from modification programs that reduce their monthly payments dramatically, on average $550 a month,” Treasury Secretary Timothy F. Geithner said last month at a hearing before the Congressional Oversight Panel. “That is a meaningful amount of support.”

But mortgage experts and lawyers who represent borrowers facing foreclosure argue that recipients of trial loan modifications often wind up worse off.

In Lakeland, Fla., Jaimie S. Smith, 29, called her mortgage company, then Washington Mutual, in October 2008, when she realized she would get a smaller bonus from her employer, a furniture company, threatening her ability to continue the $1,250 monthly mortgage payments on her three-bedroom house.

In April, Chase, which had taken over Washington Mutual, lowered her payment to $1,033.62 in a trial that was supposed to last three months.

Ms. Smith made all three payments on time and submitted required documents, Chase confirms. She called the bank almost weekly to inquire about a permanent loan modification. Each time, she says, Chase told her to continue making trial payments and await word on a permanent modification.

Then, in October, a startling legal notice arrived in the mail: Chase had foreclosed on her house and sold it at auction for $100. (The purchaser? Chase.)

“I cried,” she said. “I was hysterical. I bawled my eyes out.”

Later that week came another letter from Chase: “Congratulations on qualifying for a Making Home Affordable loan modification!”

When Ms. Smith frantically called the bank to try to overturn the sale, she was told that the house was no longer hers. Chase would not tell her how long she could remain there, she says. She feared the sheriff would show up at her door with eviction papers, or that she would return home to find her belongings piled on the curb. So Ms. Smith anxiously set about looking for a new place to live.

She had been planning to continue an online graduate school program in supply chain management, and she had about $4,000 in borrowed funds to pay tuition. She scrapped her studies and used the money to pay the security deposit and first month’s rent on an apartment.

Later, she hired a lawyer, who is seeking compensation from Chase. A judge later vacated the sale. Chase is still offering to make her loan modification permanent, but Ms. Smith has already moved out and is conflicted about what to do.

“I could have just walked away,” said Ms. Smith. “If they had said, ‘We can’t work with you,’ I’d have said: ‘What are my options? Short sale?’ None of this would have happened. God knows, I never would have wanted to go through this. I’d still be in grad school. I would not have paid all that money to them. I could have saved that money.”

A Chase spokeswoman, Christine Holevas, confirmed that the bank mistakenly foreclosed on Ms. Smith’s house and sold it at the same time it was extending the loan modification offer.

“There was a systems glitch,” Ms. Holevas said. “We are sorry that an error happened. We’re trying very hard to do what we can to keep folks in their homes. We are dealing with many, many individuals.”

Many borrowers complain they were told by mortgage companies their credit would not be damaged by accepting a loan modification, only to discover otherwise.

In a telephone conference with reporters, Jack Schakett, Bank of America’s credit loss mitigation executive, confirmed that even borrowers who were current before agreeing to loan modifications and who then made timely payments were reported to credit rating agencies as making only partial payments.

The biggest source of concern remains the growing numbers of underwater borrowers — now about one-third of all American homeowners with mortgages, according to The Obama administration clearly grasped the threat as it created its program, yet opted not to focus on writing down loan balances.

“This is a conscious choice we made, not to start with principal reduction,” Mr. Geithner told the Congressional Oversight Panel. “We thought it would be dramatically more expensive for the American taxpayer, harder to justify, create much greater risk of unfairness.”

Mr. Geithner’s explanation did not satisfy the panel’s chairwoman, Elizabeth Warren.

“Are we creating a program in which we’re talking about potentially spending $75 billion to try to modify people into mortgages that will reduce the number of foreclosures in the short term, but just kick the can down the road?” she asked, raising the prospect “that we’ll be looking at an economy with elevated mortgage foreclosures not just for a year or two, but for many years. How do you deal with that problem, Mr. Secretary?”

A good question, Mr. Geithner conceded.

“What to do about it,” he said. “That’s a hard thing.”

Copyright 2010 The New York Times Company. All rights reserved.