The Worsening Foreclosure Crisis: Is It Time to Reconsider Bankruptcy Reform?


Subcommittee Chairman Whitehouse, Ranking Member Sessions, anddistinguished members of the Subcommittee, I thank you for theinvitation to appear at today’s important hearing. I am MarkCalabria, Director of Financial Regulation Studies at the CatoInstitute, a nonprofit, non‐​partisan public policy researchinstitute located here in Washington. Before I begin my testimony,I would like to make clear that my comments are solely my own anddo not represent any official policy positions of the CatoInstitute. In addition, outside of my interest as a citizen and ataxpayer, I have no direct financial interest in the subject matterbefore the subcommittee today, nor do I represent any entities thatdo.

My testimony today will address two specific questions. Thefirst is: why have the Obama and Bush Administration efforts, alongwith those of the mortgage industry, to reduce foreclosures had solittle impact on the overall foreclosure numbers?

The second question is: given what we know about why previousefforts have had such little impact, what are our policyoptions?

In answering both these questions, I rely on an extensive bodyof academic literature, the vast majority of which has beensubjected to peer review, which has examined the determinates ofmortgage delinquency and default. Foremost among this literatureis a series of recent papers written by economists at the FederalReserve Banks of Boston and Atlanta, in particular the work of PaulWillen, Christopher Foote and Kristopher Gerardi. My testimonyowes a considerable intellectual debt to this research.

Why haven’t previous efforts stemmed the foreclosuretide?

The short answer to why previous federal efforts to stem thecurrent tide of foreclosures have largely failed is that suchefforts have grossly misdiagnosed the causes of mortgage defaults. An implicit assumption behind former Treasury Secretary Paulson’sHOPE NOW, FDIC Chair Sheila Bair’s IndyMac model, and the ObamaAdministration’s current foreclosure efforts is that the currentwave of foreclosures is almost exclusively the result of predatorylending practices and “exploding” adjustable rate mortgages, wherelarge payment shocks upon the rate re‐​set cause mortgage payment tobecome “unaffordable.”

The simple truth is that the vast majority of mortgage defaultsare being driven by the same factors that have always drivenmortgage defaults: generally a negative equity position on thepart of the homeowner coupled with a life event that results in asubstantial shock to their income, most often a job loss orreduction in earnings. Until both of these components,negative equity and a negative income shock are addressed,foreclosures will remain at highly elevated levels.

Given that I am challenging the dominant narrative of themortgage crisis, it is reasonable to ask for more than mereassertions. First, if payment shock alone were the dominate driverof defaults then we would observe most defaults occurring aroundthe time of re‐​set, specifically just after the re‐​set. Yet thisis not what has been observed. Analysis by several researchers hasfound that on loans with re‐​set features that have defaulted, thevast majority of defaults occurred long before the re‐​set. Ofcourse some will argue that this is due to such loans being“unaffordable” from the time of origination. Yet according tostatistical analysis done at the Boston Federal Reserve, theborrower’s initial debt‐​to‐​income (DTI) had almost no predictivepower in terms of forecasting subsequent default.

Additionally if payment shock was the driver of default, thefixed rate mortgages without any payment shocks would displaydefault patterns significantly below that of adjustable ratemortgages. When one controls for owner equity and credit score,the differences in performance between these different mortgageproducts largely disappears. To further illustrate this point,consider that those mortgages generally considered among the“safest” — mortgages insured by the Federal Housing Administration(FHA), which are almost exclusively fixed rate with no‐​prepaymentpenalties and substantial borrower protections, perform, on anapples to apples basis, as badly as the subprime market in terms ofdelinquencies.

The important shared characteristic of FHA and most of thesubprime market is the widespread presence of zero or very littleequity in the mortgage at origination. The characteristics of zeroor negative equity also explain the poor performance of mostsubprime adjustable rate mortgages. Many of these loans also hadlittle or no equity upon origination, providing the borrower withlittle equity cushion when prices fell. Recognizing the criticalrole of negative equity of course raises the difficult question asto what exactly it is that homeowners are losing in the event of aforeclosure.

“Unnecessary” foreclosures

Central to the arguments calling for greater governmentinvention in the mortgage market is that many, if not most, of theforeclosures being witnessed are “unnecessary” or avoidable. Generally it is argued that investors and loan servicers do notface the same incentives and that in many cases in would be betterfor the investor if the loan were modified, rather than taken toforeclosure, but still the servicer takes the loan toforeclosure.

The principal flaw in this argument is it ignores the costs tothe lender of modifying loans that would have continued payingotherwise. Ex Ante, a lender has no way of separating the trulytroubled borrowers, who would default, from those that would takeadvantage of the system, if they knew they could get a modificationjust by calling. As long as potentially defaulting borrowersremain a low percentage of all borrowers, as they are today, it isin the best interest of the investor to reject many modificationsthat might make sense ex post. In addition, lenders may institutevarious mechanisms to help distinguish troubled borrowers fromthose looking to game the system.

It is also claimed that the process of securization has driven awedge between the interests of investors and servicers, with theimplication that servicers would be happy to modify, and investorswould prefer modifications, but that the pooling and servicingagreements preclude modifications or that servicers fear being suedby investors. The first fact that should question this assumptionis the finding by Boston Fed researchers that there is littledifference in modification rates between loans held in portfolioversus those held in securitized pools. There is also littleevidence that pooling and servicing agreements preclude positivevalue modifications. According to recent Credit Suisse report,less than 10 percent of agreements disallowed any modifications. While the Congressional Oversight Panel for the TARP has beencritical of industry efforts, even that Panel has found that amongthe sample of pools it examined with a 5‑percent cap on the numberof modifications, none of the pools examined had actually reachedthat cap. If few pools have reached the cap, it would seem obviousthat the 5 percent cap is not a binding constraint onmodifications. In many instances the pooling agreements alsorequire the servicer to act as if the servicer held the whole loanin its portfolio, raising substantial doubts as the validity of the“tranche warfare” theory of modifications.

A careful review of the evidence provides little support for thenotion that high transaction costs or a misalignment of incentivesis driving lenders to make foreclosures that are not in theireconomic interest. Since lenders have no way to separate troubledborrowers from those gaming the system, some positive level ofnegative value foreclosures will be profit‐​maximizing in theaggregate.

Is cramdown the answer?

The high level of foreclosures has left many policymakers andmuch of the public understandably frustrated and searching foranswers. One “solution” that has been regularly presented is toallow bankruptcy judges to reduce the principal balance of amortgage loan to reflect the reduced value of the home, theso‐​called “cramdown.” For a variety of reasons, I believe allowingcramdowns would have adverse market consequences while alsoproviding little real relief to borrowers.

Given the unemployment‐​driven nature of most foreclosures, andthe inability of unemployed individuals to put forth a repaymentplan under Chapter 13 of the bankruptcy code, it appears thatcramdowns would do nothing for those most in need, theunemployed.

As proponents of cramdowns point out, vacation and investmentproperties can currently be subjected to cramdown. This raises thequestion: why aren’t the significant number of foreclosuresinvolving investment properties being resolved via bankruptcyrather than the foreclosure process? The most likely reason isthat property speculators realize that even a reduced mortgagevalue is likely to exceed the home value in the near future. Withhome prices still declining, a crammed down mortgage would beunderwater in few months. The incentive facing most speculators isoften to simply walk away and let the home fall into foreclosure. This would not be a significant problem if investment propertiesdid not constitute approximately 40 percent of currentforeclosures.

At this point, it is worth reflecting on these two points: cramdowns do little or nothing to help the unemployed andspeculators can already pursue that route, but largely choose notto, as it isn’t in their economic interest. With speculatorsmaking up about 40 percent of foreclosures, and the unemployedlikely making up to around 50 percent, it becomes apparent that atminimum cramdowns will do little to help at least 90 percent ofborrowers currently in foreclosure.

The main function of a cramdown would be to serve as reductionin outstanding principal, thereby lowering the monthly payment. Even significant payment reductions may not offer long‐​termsolutions. According to the most recent OTS/OCC mortgage metricsreport, of those delinquent borrowers seeing a payment reduction of20 percent or more 37.6 percent were again delinquent twelve monthslater. Continuingly re‐​modifying the same loan is not a solutionfor the borrower, investor, or lender.

We often use the term “speculator” to refer to purchasers thatdo not intend to live in the home and often quickly “flip” the hometo make a quick profit. That definition is useful, but far toonarrow. Many borrowers purchasing a home for occupancy did not doso solely for the consumption benefits of homeownership, but alsofor the investment returns. They were both consumers andspeculators. As these speculators were generally not offering toshare potential gains with their lenders, it is not clear why theyshould be allowed to share their losses.

Of the remaining borrowers, who were neither pure speculatorsnor unemployed, many of these borrowers invested little of theirown cash in the home purchase. Once again, the empirical evidencedemonstrates that minimal or zero downpayments on the part ofborrowers are the leading mortgage characteristic in terms ofpredicting default. If borrowers, who have placed no money oftheir own at risk, are allowed to reduce their losses via cramdown,while also reaping any future appreciation, we are only encouragingfuture speculation in our housing markets. We should not actsurprised if the next housing cycle of bubble and bust is evenworst than the most recent.

Proponents of cramdown have also misrepresented the treatment ofvacation homes and investor properties during a Chapter 13bankruptcy. While the current Bankruptcy Code does allows secureddebts other than those secured by a principal residence to becrammed down; if they are crammed down, the debtor is required topay off the entire amount of the secured claim within thethree‐​to‐​five year duration of the Chapter 13 plan. The debtordoes not have 30 years to pay off a modified mortgage as theoriginal loan term may provide. The borrower in these instances isrequired to pay the entire amount of the secured mortgage by theend of their payment plan. This is one of the reasons many ownersof investment choose to walk way rather than seek bankruptcyprotection.

Cramdown is often presented as simply a way to put pressure onlenders to negotiate, or to “bring them to the table.” It is nomore appropriate, in a free society, to use the coercive stick ofthe state to bring lenders to the table, than it would be to usethat stick to bring borrowers to the table. A government focusedon the common good, the general welfare, does not choose sides inprivate disputes.

Less tangible, but perhaps more important in the cramdown debateis the message it sends to market participants, particularlyinvestors. It has long been established in law, and in commonsense for that matter, that the body of law relevant to andexisting at the time of a contract enters into and comprises partof that contract. To change by legislative fiat the terms ofcontracts that have already been agreed to is to change thecontract itself. I fear if the cramdown were to become law, wesend a signal that any private agreement is subject to beingre‐​written depending on which way the political winds are blowing. This is a sure recipe to reduce investment and the overall relianceof market participants on contract. In order to rebuild publictrust in both our markets and our government, I believe Congressshould affirm its own trust in the voluntary decisions of privateparties. To do otherwise is to weaken the very bonds that make afree and civilized society possible.

In speaking of investors, it is also important to remember thatcramdown is not simply an issue of taking from lenders and givingto borrowers. As bad as that would be, it is made all the worse asthe ultimate investors in mortgage related assets that will sufferlosses rather than the largest banks. As the largest banks aremostly just servicers and not the ultimate investor, they will passalong any losses from cramdown to investors. As we have seen inthe recent auto restructuring, often these investors are not largecorporations or wealthy individuals; they are pension fundsrepresenting the retirement savings of millions, usually retiredstate and local government employees. I have yet to hear acompelling reason why retired teachers and firefighters should beforced to bear the burden of irresponsible borrowing andlending.

Non‐​coercive solutions

At its core, the cramdown proposal is little more than a coercedtaking of wealth from one group of citizens and transferring thatwealth to another group. We should reject any proposed “solutions“that are based upon applying coercion to parties in what isessentially a private contract. I urge Congress to look for onlythose solutions that are truly voluntary.

Some voluntary alternatives to consider: encouraging bankregulators to give lenders more flexibility to lease out foreclosedhomes to the current residents. Typically banks come underconsiderable pressure from their regulators not to engage in longterm property leasing or management, as that activity is notconsidered a core function of banks. I believe we can avoid thelarger debate of banks being property managers by giving banksgreater flexibility in retaining properties with non‐​performingmortgages as rentals, preferably to current residents.

In order to separate out deserving borrowers, who are trying toget back on their feet, from those simply walking away from a badinvestment, Federal lending entities, such as FHA and the GSEs,should engage in aggressive recourse against delinquent borrowerswho have the ability to pay, but simply choose not too. We shouldmake every effort to turn away from becoming a society wherelegally incurred debts are no longer obligations to be honored butsimply options to be exercised.


In concluding my testimony, I again wish to strongly state: thecurrent foreclosure relief efforts have largely been unsuccessfulbecause they have misidentified the underlying causes of mortgagedefault. It is not exploding ARMs or predatory lending that drivesthe current wave of foreclosures, but negative equity driven byhouse prices declines coupled with adverse income shocks that arethe main driver of defaults on primary residences. Defaults onspeculative properties continue to represent a large share offoreclosures. Accordingly for any plan to be successful it mustaddress both negative equity and reductions in earnings. Cramdownfails on both accounts. I thank you for your attention and welcomeyour questions.

Primary References:

Foote, Gerardi, Goette and Willen (2009) “Reducing Foreclosures: No Easy Answers,” National Bureau of Economic Research workingpaper 15063.

Cordell, L., K. Dynan, A. Lehnert, N. Liang, and E. Mauskopf(2008). The Incentives of
Mortgage Servicers: Myths and Realities. Finance and EconomicsDiscussion Series,
Federal Reserve Board 46.

Foote, C., K. Gerardi, L. Goette, and P. S. Willen (2008). Justthe facts: An initial
analysis of subprime’s role in the housing crisis. Journal ofHousing Economics 17 (4).

Foote, C., K. Gerardi, and P. Willen (2008). Negative equity andforeclosure: Theory and
evidence. Journal of Urban Economics 6 (2), 234 – 245.

Gerardi, K., A. Shapiro, and P. Willen (2007). Subprimeoutcomes: Risky mortgages,
homeownership experiences, and foreclosures. Federal Reserve Bankof Boston Work‐
ing Paper 07 – 15.

Hunt, J. (2009). What do subprime securitization contractsactually say about loan mod‐
ification. Berkeley Center for Law, Business and the Economy.

Kau, J. B., D. C. Keenan, and T. Kim (1994). Defaultprobabilities for mortgages. Journal
of Urban Economics 35 (3), 278 – 296.

Sherlund, S. (2008). The past, present, and future of subprimemortgages. Finance and
Economics Discussion Series 2008 – 63, Federal Reserve Board.

Mark A. Calabria,Ph.D. is Director of Financial Regulation Studies at the CatoInstitute. Before joining Cato in 2009, he spent six years as amember of the senior professional staff of the U.S. SenateCommittee on Banking, Housing and Urban Affairs. In that position,he handled issues related to housing, mortgage finance, economics,banking and insurance for Ranking Member Richard Shelby (R‑AL).Prior to his service on Capitol Hill, Calabria served as DeputyAssistant Secretary for Regulatory Affairs at the U.S. Departmentof Housing and Urban Development, and also held a variety ofpositions at Harvard University’s Joint Center for Housing Studies,the National Association of Home Builders and the NationalAssociation of Realtors. Calabria has also been a ResearchAssociate with the U.S. Census Bureau’s Center for EconomicStudies. He has extensive experience evaluating the impacts oflegislative and regulatory proposals on financial and real estatemarkets, with particular emphasis on how policy changes inWashington affect low and moderate income households. He holds adoctorate in economics from George Mason University.

Mark A. Calabria

Subcommittee on Administrative Oversight and the Courts
Committee on the Judiciary
The United States Senate