Forget Political Rhetoric: Bailout will not save the economy – Part 1

Confirming the worst fears of middle class homeowners, the $700B Wall Street Bailout will do virtually nothing to help homeowners.  Democrats, as usual, fail to seize upon their power as majority and give in to Republican demands that bankruptcy reform be stricken from the deal.

In the end, the failure to include language allowing bankruptcy judges to modify primary residential mortgages means the bailout will fail because it does not adequately address the underlying cause of the economic crisis: the collapsing housing market.

Under the terms of the bailout, the United States government will purchase billions upon billions of “home mortgage related assets.”  The government will purchase toxic investment vehicles known as mortgage-backed securities (MBS), which is not the same thing as purchasing the mortgages themselves. 

A MBS is an ownership interest, known as a certificate, in a special tax-free company, known as a trust, which owns thousands of mortgages.  A certificate holder is akin to a bond holder, virtually powerless to control the management decisions of the trust.  This is a big distinction which essentially renders any “foreclosure prevention” provision of the plan worthless because a certificate holder cannot direct the trust to stop foreclosures or modify the terms of the underlying mortgages that make up the trust.

When pools of mortgage notes are sold to a trust, the seller, Countrywide for instance, retains the right to service these loans.  There is a very complex agreement, known as the Pooling and Servicing Agreement (PSA), which governs the formation and operation of the trust as well as the servicing of the loans.  The servicer is the entity with the authority to modify mortgages, but that authority is governed by the PSA, which dictates whether loans in the trust can be modified and, if so, how they can be modified.

 As Adam J. Levitin, associate professor at Georgetown University Law Center, explains,

PSAs frequently place restrictions on servicers’ ability to modify mortgages. Sometimes the modification is forbidden outright, sometimes only certain types of modifications are permitted, and sometimes the total number of loans that can be modified is capped (typically at 5% of the pool). Additionally, servicers are frequently required to purchase any loans they modify at par (100 cents on the dollar). This functions as an anti-modification provision. Moreover, all PSAs prohibit the servicer from undertaking any action, including many modifications, that would threaten the MBS’s pass-thru tax status.

If a servicer ignores the PSA, the tax-free status of the trust can be destroyed, exposing the trust to a tremendous tax liability and exposing the servicer to a lawsuit brought by the trust.  Therefore, servicers can only modify loans if the PSA is amended to allow it, and the PSA typically cannot be amended to allow such wholesale modifications without becoming a taxable entity.

Related posts:

1. Forget Political Rhetoric: Bailout will not save the economy – Part 2
2. Wall Street Bailout Won’t Stop Home Foreclosures
3. Bailout Should Save Homes From Foreclosure