One thing the $700 billion Emergency Economic Stabilization Act rescue plan should buy is a commanding seat at the table in the restructuring of this country's mortgage debt. Intelligent lenders know that, at times, deferrals of principal and interest, as well as discounts and conversions of debt into equity, are not just compassionate but simply good business for all concerned.
A national housing workout is already under way, under the rescue plan and otherwise. On Oct. 6, Bank of America Corp. agreed with state attorneys general to reduce homeowner principal and exploding interest payments by as much as $8.4 billion. In the Oct. 7 presidential campaign debate, John McCain made what he said was a new proposal: buying up mortgages on the open market and giving homeowners new mortgages based on the new, lower value of their homes. Barack Obama noted that under the Troubled Asset Relief Program in the rescue legislation, the secretary of the Treasury already has the power to do this.
If the national housing workout is to be more than an empty promise, policymakers at all levels need to recognize the implications of the securitization process. Individual mortgages have been pooled by the thousands, with their revenue shared by the different classes of securities issued from the pools. The mortgage pools mean that one-on-one workouts on an individualized basis are next to impossible. But if the voting mechanics of the pools are properly understood and utilized, they could be a key to solving the problem on the same mass basis as we created it.
You might have thought that for $700 billion in purchases to be made under TARP, plus the mortgage-backed securities already owned by American International Group Inc., Fannie Mae, Freddie Mac and the Federal Reserve, we'd now be well on the way to gaining voting control of a significant number of the mortgage pools. And maybe Congress and the candidates think so, too, if only because Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke implied as much in their brief testimony. But think again. Because of the structure of mortgage-backed securities, unless the Treasury adopts the right regulations and policies from the get-go, it may well find itself buying mostly non-voting classes of securities, and leaving the very institutions it helps with a blocking position in future workout negotiations.
Bank of America can't implement much of its own settlement without the votes of institutional holders of the mortgage pools that now hold the loans originated by Countrywide Financial Corp.
TARP already directs Fannie Mae, Freddie Mac and the Federal Housing Administration to consent to loan modifications, including term extensions, rate reductions and principal write-downs, and directs the Treasury secretary to do so as well “where appropriate” and “considering the net present value to taxpayers.” Another TARP provision protects mortgage-pool servicers who agree to “a modification or workout plan” that increases anticipated net recovery to all investors over what they would get in foreclosure, even if particular groups of investors (i.e., holders of particular classes) might be harmed.
These provisions embody the wisdom of lenders acting in their own enlightened self-interest. But the mortgage-pool servicers to which TARP refers unfortunately aren't the ones who hold the right to agree or disagree with workout plans: Only the holders of the requisite majorities of the voting classes of securities can do that. Mortgage-backed securities typically give the voting power to the most senior classes of securities issued from a given mortgage pool, the classes that, by definition and design, are the last to suffer losses as default rates climb, and the last to trade below par. The toxic, hard-to-value, or valueless, classes that the institutions will be most eager to sell to the Treasury, and which Treasury appears to be mandated to buy, in most cases carry with them no voting rights at all on restructuring the underlying mortgage pools.
Control of the voting structure of the mortgage pools is essential to reconciling TARP's competing mandates of assisting homeowners, financial institutions and the housing market. Once we have found and agreed upon a restructuring solution that makes the best of the current situation, we can't afford to allow anyone who has benefited from the rescue to take blocking positions in key mortgage pools and use them as leverage for their own narrow gain.
Participating institutions should be required to give the Treasury a permanent proxy over the voting rights they retain or acquire in the secondary market. If Treasury doesn't think to make this simple request, we won't get what we're bargaining for in the rescue effort, and the promise made by both presidential candidates in the debate — that the Treasury will use the powers granted by the mortgages it buys to help homeowners stay in their homes — will remain beyond our reach. Either that, or we'll wind up paying twice, because the institutions will use the senior securities to block a salutary workout — or to sell them to someone who will.
With thousands of mortgages in each pool, a national housing workout becomes thousands of times easier to implement than would an individualized program, one household at a time. Admittedly, conditioning participation in the TARP rescue plan on an agreement to consent to future restructurings could discourage participation in the plan or raise prices; the same is true of the limits on executive compensation and the requirement for equity participation that are already part of TARP. But locking in the votes of participating institutions in favor of any future workout plan is too important to leave to the future, when the price could be far greater.
The proponents of TARP are right in supposing that a national housing workout can be a win-win-win scenario for taxpayers, homeowners and institutions. Indeed, a sharp reduction of the mortgage-debt burden in interest or principal of the insolvent household sector (along with a recapitalization of solvent institutions) is economist Nouriel Roubini's prescription for making the TARP plan effective. Treasury must act with foresight on the voting issue from the beginning of its distressed asset purchase program, or it may find itself powerless to approve the workout plan that may be our best hope.
Bruce Kraus is a partner in the New York-based law firm Willkie Farr & Gallagher LLP.