MBS Moral Hazard and Flexibility

Robert Waldmann

I don’t have a very positive view of innovative financial products, or rather, of financial products invented in the past 20 years or so. However, I love mortgage bonds (MBSs). I think they are an excellent way of diversifying and eliminating risk.

However, I have to admit that they create a problem. Since the mortgage initiator is not bearing all of the risk, the mortgage initiator and the debtor can profit at the expense of the investors who bought the MBSs. To reduce this problem (which can’t be eliminated) mortgage initiators sign contracts which require them to do everything they can to get every penny owed by the debtor.

This makes it difficult to restructure mortgage contracts even in cases where a restructured contract is better than foreclosure for the debtor, the innitiator and the investors. I wonder if there is another way to handle the moral hazard problem which doesn’t involve such unfortunate rigidity ?

I had a thought which is probably stupid. It seems to me that there might be something good about non-bank mortgage initiators. What if they promise that they will have no revenues except a multiple of money that they send on to MBS investors (and agree to open their books so the promise can be enforced) ? Oh and that the owners and employees will have no compensation from any source but that revenue scheme (this is as hard to enforce as laws banning public officials from taking bribes, that is not quite impossible).

That seems to reduce the moral hazard problem doesn’t it ? Currently they get fees and points and stuff, that is cream of cash immediately before packaging the risky flow and selling it.

Compared to issuing debt and initiating mortgages, this is still a sane business plan.

A no revenues but x% of what we send to you gives strictly positive revenues to the firm. Now obviously employees will want a salary, so the shareholders of the mortgae initiator will have to bear quite a lot of risk.

It seems to me that purchasers of MBS would be protected much more thoroughly than they are now and that firms with such a rule have a viable business plan.

What am I missing ?

Hilzoy finds a fascinating story about the Pareto improving wonders of renegotiation of mortgage contracts.

“Patricia Greenberg’s townhouse in Irvine, California, was losing about $10,000 a month in value when she received a letter in February 2008 that looked too good to be true: An investor was offering to cut her $472,000 mortgage by 26 percent and her monthly payment by a third.

“I didn’t want to get involved in a scam,” says Greenberg, a cosmetics saleswoman for Orlane Inc., who had bought the house with no money down eight months earlier.

It was no ruse. New York hedge fund manager Ralph DellaCamera Jr. says he’d purchased the mortgage for 60 cents on the dollar and forced the originator, MLSG Home Loans of Reno, Nevada, to eat the loss. Protecting his investment, DellaCamera lowered Greenberg’s debt to keep her in the home. She now pays $2,400 a month instead of $3,800 and plows some of her savings into upgrading the Cape Cod-style residence.”

She asks why it doesn’t happen more often. I comment

So why doesn’t this happen more often ?

I think the problem is that most mortgages don’t have one owner anymore. The firm which lent Greenberg the money hadn’t packaged the money she sent them into a mortgage bond (MBS) and sold it … yet.

Many homeowners in trouble don’t owe more than they can pay to a bank or mortgage company. They owe more than they can pay to investors who don’t even know who they are.

To renegotiate such loans DellaCamera would have to buy up all the mortgage bonds. The owners of the MBS aren’t organized to bargain with him. The person who owned the last bond with a claim on income from Greenberg would be able to block the whole deal unless DellaCamera paid him, her or it whatever he she or it demanded.

MBS by diversifying risk have created a collective action problem.

My solution is to set up the Big Bad Asset Bank BBAB (aka shitibank) and requisition all the MBS in the world in exchange for shares of the BBAB. At this point all mortgages would be in, at most, 2 pieces, the part the initiator kept and the BBAB. DellaCamera and other people as smart as he would make out like bandits and people would keep their homes. The shares of BBAB would be worth more than the requisitioned MBSs).

The key is the word “requisition” that is take not buy so BBAB gets all of the toxic sludge not just the worst it.

Not gonna happen, but I think it would work.