May 06, 2010

An oldie but a goodie: If my blog will be remembered for anything, it will be for accurately predicting the collapse of the real estate market back in 2005, and the role that the passage of the 2005 Bankruptcy "reform" act (or BARF, as it has come to be known) in exacerbating the crisis. How badly the GOP-enacted law screwed things up, however, can best be seen in a more scholarly paper recently published by UC Davis, and co-written by Wenli Li, Economic Advisor to the Federal Reserve Bank in Philadelphia. The conclusion:

Before 2005 bankruptcy reform, homeowners in financial distress could use bankruptcy to help save their homes. Homeowners could have their unsecured debts discharged in Chapter 7, thus freeing up funds to make their mortgage payments. Homeowners who were in default on their mortgages could stop foreclosure by filing under Chapter 13 and could use Chapter 13 repayment plans to repay their mortgage arrears over several years. Most homeowners who filed for bankruptcy were not obliged to repay anything to their unsecured creditors.

But the 2005 bankruptcy reform made filing for bankruptcy less useful as a save-your-home procedure. Debtors’ cost of filing increased sharply after the reform. Also the homestead exemption in bankruptcy was capped at $125,000, thus making it impossible for homeowners with high home equity to keep their homes in bankruptcy. A new “means test” increased higher-income debtors’ obligation to repay their unsecured debt in bankruptcy.

Because these changes reduced homeowners’ gain from filing for bankruptcy, they reduce default rates on unsecured debt. And because homeowners’ ability-to-pay is fixedin the short-run, these changes are predicted to increase default rates on mortgages. In the paper, we test whether adoption of the 2005 bankruptcy reform led to higher rates of mortgage default. We use a large dataset of prime and subprime mortgages.

Our main result is that bankruptcy reform caused mortgage default rates to rise. Comparing default rates three months before versus after bankruptcy reform, the increase was 36% for prime mortgages and 11% for subprime mortgages. Using a longer period of one year before versus after the reform, the increase was 50% for prime mortgages and 7% for subprime mortgages. Homeowners subject to the cap on the homestead exemption were 50% more likely to default after the reform, regardless of whether their mortgages were prime or subprime. Homeowners with subprime mortgages were 13% more likely to default if they were subject to the new means test, but default rates of those with prime mortgages did not change.

The study uses a lot of complicated mathematics to make its point, but its well worth browsing through if you have the time.

Perhaps a more devastating land mine, however, is something that was hatched by the lending industry, at roughly the same time they created default swaps and high-risk adjustable rate notes. The Mortgage Electronic Registration Systems, or MERS, was invented by Big Banking as a way to cut costs on the production of legal documents, specifically recording deeds. In real property transactions, ownership is usually shown through the public recordation of deeds, which create a chain of title proving that the person who claims to be the owner has a legitimate case, based on a series of orderly transactions dating back to Adam for all to see. At the same time, any party that has a lien on property, whether it be from a mortgage or some other debt, can also record, thereby establishing a priority based on when the lien was recorded.

Of course, recording anything with the county costs money. The almost-entirely unregulated process of lending money to prospective homeowners, the fruits of which we have seen in the insane rise and precipitous fall of the market in the last five years, generated increasingly complicated arrangements by which trusts involving multiple investors financed these high-risk notes, which would then be bought and sold to other investors. A very complicated system, indeed, which was how MERS came to be.

The idea behind MERS was that rather than generating a new document every time a loan was transfered, and thereby having to repeatedly record (and repeatedly pay fees) mortgages, an entity would be created that would take on the role of "holder of the lien" as a "nominee" of the actual note holder. The lender would collect money from the homeowner, but if the borrower ever fell behind, MERS would step in, and initiate the foreclosure process. MERS, however, is never actually the note holder, has no right to collect money on debts, and has no privity of contract whatsover with the parties to the homeloan.

Which is problematic, since MERS does not otherwise have anything resembling a right to participate in foreclosures, and courts are increasingly rejecting their attempts to proceed on the sixty million mortgages to which they "hold title." In Kansas, for example, the state supreme court recently held that MERS had no standing to pursue foreclosures, and courts in that state have effectively given a free pass to homeowners whose loans were originally held in the name of MERS. It's a slip-up that has effectively put the brakes on foreclosures based on loans generated after 2005, since the right by MERS to foreclose can be challenged even after a sale has occurred; even in states where MERS' claim for standing has been upheld, the threat of litigation challenging it's right to foreclose has suddenly made the option of modifying the underlying loan to terms that better suit the borrower more palatable, and certainly better than anything dreamed up by the Obama Administration.