Investors vs Distressed Homeowners

In response to my post yesterday about Countrywide's court loss that will make mortgage modifications harder, one commenter, newdealanne, wrote:

I hate to be a simpleton about this, but am I missing something? The investors took a risk. It didn't go in their favor, or in ours. They toppled our economy. And now the best way out of the mess they helped caused is if we allow the modification and they have to eat their losses. What's the problem here?

I wanted to address this, because she's probably not alone in her belief. I have a few comments.

First, let me explain what I'm talking about in case you didn't read the original post. Countrywide was trying to modify mortgages in compliance with the Treasury's foreclosure prevention program. But mortgage-backed securities (MBS) investors who owned a part of those mortgages sued the bank, because they did not give permission for those mortgages to be modified -- as the MBS legal documents require. Newdealanne appears to believe that the investors should be forced to accept these modifications.

In this case, investors are still going to eventually, one way or another, be on the hook for a loss associated with these MBS. The question really is whether that loss should be controlled by modifying the mortgage -- which remember might still result in redefault -- or through the distressed homeowner not obtaining a modification and foreclosing immediately. These investors appear to prefer the latter option, which is why they brought suit against Countrywide.

Next, let me try to provide just a little bit of sympathy for the investors. They definitely made a bad investment decision. However, I think it's a bit of a stretch to say they caused the problem. The real cause of the problem was when mortgage companies originated mortgages that ended up going sour. Investors did help to facilitate this origination through purchasing of MBS, consequently providing further funding to originate more mortgages. But I think it's a stretch to really place the mess on the shoulders of investors alone.

Moreover, investors would probably choose to place some of the blame on the distressed homeowners who are requesting modifications to avoid foreclosure. These investors probably believe that those borrowers should have been more responsible in signing a mortgage that they could afford. Indeed, the investors are likely angry that the borrowers took these mortgages in the first place, because that's why the MBS market now faces significant losses.

I would counter that with the argument that investors probably should have done better due diligence before purchasing the bad MBS. They should have anticipated the possibility that that these borrowers couldn't afford the mortgages they were signing. That might have led them to think twice about purchasing the securities.

So does that mean that investors really are to blame and should be forced to take even greater losses at the benefit of those distressed homeowners? I'm not sure. Both made mistakes. Each party would be better off if they'd thought a little bit harder about their actions. That's why I think this is a difficult situation.

The reason why I would lean slightly to the side of the investors is because legal precedent backs up their side of the argument. The underlying legal documents for the MBS say that they must approve any mortgage modifications. That means that they did, in a sense, do their due diligence in regard to potential modifications. They did not expect to have their contractual rights superseded by an act of Congress that showed preference to distressed homeowners.

Which option is better for the economy? It depends. If the mortgage modifications really work in preventing foreclosures, that might help the housing market. Though high redefault rates would cast doubt on that assertion. But if investors have more certainty about the strength of the contracts that they enter in when purchasing securities, then that would help eliminate some risk from the market. That would also help the economy to stabilize. Don't forget, the financial crisis was caused by uncertainty regarding these toxic securities, so additional political risk resulting from the foreclosure legislation trampling investor rights could be a big deal. Again, it's a mixed bag of sorts.

Finally, some would argue that forcing these homeowners into foreclosure sooner would actually be a more conservative approach. The housing market would find a real bottom faster. The economy can't truly recover until that happens. Investors would also be forced to realize their losses sooner, as foreclosure-related losses would hit their payment streams sooner than they would via redefaults. Mortgage modifications could just be prolonging the inevitable for many of these struggling homeowners who have mortgages that are too underwater for them to ever afford.

Everyone is entitled to his or her own opinion on this one, and mine is still a little mixed. I just find this is a complicated issue, without either side seeming obviously more righteous than the other. On balance, however, I think the economy on a whole might be better off as a result of this court decision.