Credit Slips

The Permanent Foreclosure Crisis and Obama's Refinancing Obsession

2012-02-02T06:27:33-06:00

For the umpteenth time, President Obama has announced that his solution to the foreclosure crisis is to encourage "responsible" homeowners to refinance at lower interest rates. Adopting the Tea Party rhetoric and blaming home buyers who got houses in 2006 for their inability to foresee what few economists foresaw, Obama has steadfastly refused to push for principal reductions and payment suspensions for homeowners behind in payments, lest their luckier neighbors who bought at lower prices become resentful. As a result, he continues to offer help to homeowners who need it least.

Behind the rhetoric is an important policy choice: who will bear the billions of mortgage losses that have yet to be flushed out of the system. Principal reduction modifications for defaulted borrowers would distribute the losses among taxpayers (via Fannie and Freddie), private investors and banks (who hold non-GSE loans), and give underwater homeowners some relief. More importantly, principal modifications mitigate the aggregate losses to the system while accelerating the necessary deleveraging. Refinancing current borrowers does nothing to prevent the huge deadweight losses from continuing foreclosures, at 50% loss severities, on homes whose owners are delinquent. Choosing to do no more for the 7 million or so delinquent mortgage debtors means maximizing losses to those homeowners, but also to taxpayers and investors. It would certainly help to continue driving down home prices, which does benefit new first-time buyers, but at a huge aggregate cost.

In fact, as conservator of the nationalized Fannie Mae and Freddie Mac, the federal government could make the needed modifications of delinquent mortgages happen with a stroke of the pen, more or less. Instead, the Administration proposes the dubious strategy of loading up the FHA portfolio with 4% mortgages at 125% loan-to-value ratios, thus continuing the process of transferring future mortgage losses from banks to taxpayers, and amplifying those losses, while letting the foreclosure crisis continue, just as Mitt Romney proposes. Nothing about the refinancing strategy moves forward the process of realigning mortgage debt to home values. Instead, the strategy relies on the doubtful proposition that home values will soon return to rising at their pre-2007 clip.

Pacta sunt servanda and the housing market and broader economy be damned.

Arbitration Double Standards

2012-01-31T14:01:58-06:00

A case out of the Third Circuit demonstrates the frustration that many of us have with the current state of consumer arbitration law. The consumer had purchased a Dell computer that he alleged had design flaws leading to repeated failure of his motherboard. After Dell refused to fix the computer a third time, he brought a class action against Dell for the alleged design defects.

Dell invoked an arbitration clause which read that any dispute "SHALL BE RESOLVED EXCLUSIVELY AND FINALLY BY BINDING ARBITRATION ADMINISTERED BY THE NATIONAL ARBITRATION FORUM (NAF)." This clause was found in "clickware," that is an agreement to which the consumer agreed by checking a box on Dell's web site when he purchased the computer. The capital letters were in the original agreement, presumably to make this language stand out due to its importance. As many readers of this blog will quickly pick up, there is a problem with this language -- because of abuses the National Arbitration Forum agreed to a consent judgment where it would no longer administer consumer arbitrations.

This case should have been easy. Dell offered its customer a "take it or leave it" form contract that Dell drafted. In that contract, Dell specified an arbitral forum that had to stop doing consumer arbitrations because of its abusive practices toward consumers. In its own contract language, Dell made clear that any dispute had to be resolved "exclusively" by the National Arbitration Forum. Because Dell's own contractual language fails to bind the consumer given the unavailability of the National Arbitration Forum, the consumer is not required to bring his claim in arbitration. In dissent, Judge Sloviter makes similar points. The lower court in this case also came to this conclusion.

The majority of the appellate court, however, sets up an outcome where Dell wins where the coin comes up heads and where the consumer loses when the coin comes up tails. The court notes that the word "exclusively" in the arbitration clause could be read to modify "binding arbitration" rather than the forum where the arbitration occurs. Well, I suppose that language could be read that way, but we normally do not go out of our way to construe an ambiguity in favor of the drafter, especially in a consumer form contract.

The majority also makes much of section 5 of the Federal Arbitration Act, but it makes the same mistake that many of my students make coming out of a first-year law school curriculum that is heavy in case analysis. The majority spends a lot of time talking about what courts say about section 5, literally relegating the actual language of section 5 to a footnote (the underlining is mine):

If in the agreement provision be made for a method of naming or appointing an arbitrator or arbitrators or an umpire, such method shall be followed; but if no method be provided therein, or if a method be provided and any party thereto shall fail to avail himself of such method, or if for any other reason there shall be a lapse in the naming of an arbitrator, or arbitrators or umpire, or in filling a vacancy, then upon the application of either party to the controversy the court shall designate and appoint an arbitrator or arbitrators or umpire, as the case may require, who shall act under the said agreement with the same force and effect as if he or they had been specifically named therein; and unless otherwise provided in the agreement the arbitration shall be by a single arbitrator.

Section 5 could be read to allow the court to name an arbitrator on these sorts of facts which, in fairness to the court majority, some courts have done. But, there are at least two questions raised by such an interpretation. On the facts of this case, is there a "lapse in the naming of an arbitrator?" Second, is the National Arbitration Forum even an "arbitrator" within the meaning of the statute. The NAF is an arbitral forum, and the language of the statute as a whole suggests that, where it says "arbitrator," it means the actual human being who will conduct the arbitration. Here, the problem was not a lapse in naming an "arbitrator" but the unavailability of the organization designated to administer the arbitration as chosen by the parties to the contract.

Fair-minded people might see contractual and statutory arguments going both ways, and the majority admits as much. Thus, the majority rests heavily on what we might call a "tie breaker," and it is here where my frustration lies. In reaching its decision, the majority makes six references to the "federal policy favoring arbitration." This seemingly high-minded policy is not exactly a neutral principle. A policy "favoring arbitration" necessarily favors big corporate interests over consumers. It is a policy that is hostile to consumer claims and to class actions. Maybe the court wants to be hostile to such claims, but it is dishonest to dress it up as a neutral appeal to preferring arbitration. One also might wonder where this "policy" comes from such that the court would not be wiser sticking to the "policy" articulated by Congress in the words of the statute.

The application of this so-called policy becomes a "heads I win, tails you lose" rule. When companies get the arbitration clause correct, they can ask the courts to enforce the clause as written. When companies overreach and offer arbitration clauses with enforceabillity issues, they can ask the courts to fix their mistake, construing the clause or law to require arbitration nonetheless. In their extreme application, these principles can undermine public confidence in the courts to treat all parties equally.

Private Equity Works on Its Image Problem

2012-01-31T09:03:56-06:00

Bloomberg out with an interesting story about how private equity firms are buying single family homes at foreclosure to rent out. It surprises me that there is real interest in what remains a relatively small scale, highly heterogeneous asset. Previous attempts to achieve economies of scale in this area have been disastrous -- see Bank of America.

Consumer Friendly Forms for Bankruptcy

2012-01-30T05:21:00-06:00

In many respects, bankruptcy is a one-size-fits-all legal process. Yes, there are ample differences in the law (and a world of difference in practice) between the bankruptcy of a large corporation and a typical consumer. But the Bankruptcy Code itself contains plenty of provisions of general applicability. A major example of the one-size-fits-all approach to bankruptcy is the official forms for filing a case. The basic petition and schedules are the same forms for Big Airline Co. and Mr. Joe Blow. The information on the forms is wildly different, with Big Airline Co. listing hundreds or even thousands of creditors, with many more digits in their debts, than Joe Blow. But the form for those debts--Schedule F--is the same form. That may all be changing soon.

The Bankruptcy Rules Committee began a Forms Modernization Project a few years ago, and one of its top agenda items has been creating new forms just for use in consumer bankruptcy cases. Although few people seem to be aware of the effort, a draft version of those new forms is available to the public and to my mind, well worth a look. To see the forms, go here, then click on September 2011, download the file, and look at pp. 189-315 of the PDF (or tab 7.1 if you use the PDF index.) One thing that is obvious from the page numbers in the prior sentence is that the new forms are really long--way longer than the current forms as completed in the typical consumer case. The added length results in part from the development of extensive instructions for each form. Below is an example of a new form with some commentary on its notable new features.

This is the first page of the draft new form for consumer debtors to report their unsecured debts; this would replace the existing Schedule F. From an aesthetic perspective, note that the form has a larger typeface than the existing form and makes much more use of font characteristics such as bold, underline, boxes, etc. to differentiate content. This is all part of the art of making a form "readable." It also contains lots of little checkboxes rather than columns to hold information like the current form. From a substantive perspective, and before someone makes a comment that I have made a mistake, note that this first page of the form starts by asking the debtor to list priority debts. The form combines Schedules E and F, into a single form for Unsecured Claims. It also lists only the three most common kinds of priority debts in consumer cases--domestic support, taxes, and drunk driving--on the form and uses an "other" box where the debtor could list the kinds of priority debts in Section 507 of the Bankruptcy Code that rarely apply in consumer cases, but frequently come up in businesses cases. This is a great example of how the form departs from one-size-fits-all forms that match where bankruptcy law takes a one-size-fits-all approach in the Bankruptcy Code.

The period for public comment on these forms has not yet begun, and the Bankruptcy Rules Committee may well make changes before then. In future posts, I will say more about what kinds of changes I hope to see and offer some thoughts on whether this initiative is a positive development for the system.

The GM & Chrysler Success

2012-01-28T20:17:16-06:00

During the State of the Union address, the President crowed about the success of the GM/Chrysler bailouts, noting that these companies were thriving again. An NPR program this evening was holding up GM/Chrysler as a beacon of hope for Kodak, as if bankruptcy were now the fountain of corporate youth.

But this just begs the question of why did the GM/Chrysler bankruptcies work? What made these bankruptcies success stories? NPR raised the question, but had some lame answers, namely that it forced management to make decisions it hadn't wanted to do like cutting loser brands (Saturn, Pontiac). It might have helped focus management decision-making, but that alone can't be the answer, I think. I'm curious to hear readers' thoughts. A few thoughts of my own below the break.

(1) Deleveraging. This one should be obvious. A lot of GM/Chrysler creditors got paid very little, but the 363 sales enabled the firms' good assets to be reployed to companies that were not weighed down with tons of financial leverage and legacy liabilities (CBA terms, retiree benefits, dealerships). Deleveraging, however, only helps if the underlying business is competitive. Apparently it is.

I'm not a car afficianado, but I've got to say that this surprises me. I was not under the impression that GM/Chrysler were turning out particularly great cars in 2007-2008, and I don't have the sense that they're boasting radically different product lines now (I'll find out soon, however, at the DC Auto Show...). But maybe the answer is that they were producing reasonably good cars and now they're able to price them more competitively. Thoughts anyone?

(2) How much of a management shake-up did bankruptcy entail? Perhaps bankruptcy revitalized management. Still, I suspect that what management can do with firms of this size is fairly constrained.

(3) GM/Chrysler did manage to avoid major layoffs of their own employees. But they also closed down a lot of dealerships. In other words, there was major job loss as a result of their bankruptcies. Not as bad as it might have been, but it wasn't a bloodless operation. The job loss from the dealerships, however, was spread out geographically, rather than concentrated in the Rust Belt. So this was akin to amputating a toe to prevent gangrene from spreading. I'd be curious if anyone knows of any figures on the actual job loss.

(4) Did it help to have the government as DIP lender? That is, does public DIP financing actually facilitate reorganizations because the DIP lender's goal is reorganization, rather than maximization of its economic return?

Again, I really am interested in hearing thoughts on this.

Vee Haf Vays Uf Making You Pay!

2012-01-28T09:41:12-06:00

Anna Gelpern's Gunboat Diplomacy post pretty much sums out the leaked German term sheet on Greece. I would only note one other thing--the highly idiosyncratic use of "absolute priority." The Germans seem to have taken the language of Chapter 11 and repurposed it, with absolute priority meaning foreign unsecured creditors get paid in full before anyone else sees a cent. Of course, maybe the Germans really do know how to get blood out of a stone. But in the meantime, I think this is best referred to as Teutonic priority.

Greek Gunboat Diplomacy Eupdate and More ECB/EFSF

2012-01-28T00:48:41-06:00

Someone who wanted to be very mean to the Germans just leaked this document, where they manage to come off as both desperate and inept. The proposal purports to address Greek failure to meet program targets by installing an EU overlord, whose job it would be among other things to pay off the foreign bondholders before funding public services in Greece.

The strategy goes back to the days when imperial gunboats took over debtors' customs houses to pay foreign bondholders, but has been considered impolite in creditor country circles for a century or so. Now it is back as an EU institutional innovation. As for the business of "absolute priority" for foreign creditors, the statement is nonsensical on its face: Greece will enact a law that would make creditors feel "de facto" senior. At best, this would be "de jure," and without a shred of credibility. The actual phrase used--"De facto elimination of the possibility of a default"--surely qualifies for an Oscar nomination.

All this innovating does follow a pattern: take a program that does not work, double down on it, and ratchet up enforcement to the point where no one would ever dream of it. Genius.

And further to my last post, it looks like Richard Barley and Felix Salmon took sides on the EFSF swap possibility a couple of days ago, except that they seem to operate on the assumption (which I shared last May) that EFSF would have to take the loss up front. Now I think that the swap would be worth it even if it only captured the discount for Greece. Phase Two happens when it does.

The Crisis of Fake Constraints: Greek Denouement Eupdate

2012-01-27T23:50:50-06:00

Unless Greece and its creditors reach a deal in the next few days, Greece has no money to pay €15 Billion or so due to its bondholders in March.

From the start, this has been a crisis of fake legal and economic constraints masking very real political constraints. In 2010, Greece could have restructured its debt quicker than most sovereigns in modern memory -- or it might have been bailed out, had Europe chosen to go the route of fiscal transfers. Neither of these paths was taken because the European Central Bank was unwilling to countenance the sin of debt restructuring, but member states with money were unwilling to pay for the appearance of collective virtue.

Now that the restructuring is inevitable and the virtue bill unpayable, the fake constraints are back. The ECB holds about €50 of Greek debt, which must go into the restructuring to get enough debt and cashflow relief. But the central bank would not take losses, and remains allergic to triggering credit default swaps (which is more likely to happen if it sits out). Worse, its votes might be needed to (credibly threaten to) amend Greek bonds using retrofit Collective Action Clauses. (See latest from Gulati-Zettelmeyer here.)

There seems to be a simple fix: swap the Greek bonds held by the ECB for bonds of the European Financial Stability Facility at a price that does not cause ECB losses. Then have the EFSF go into the exchange and vote the bonds if it needs to. At a minimum, this captures for Greece the discount at which the ECB bought its bonds. If Europe is unwilling to see the EFSF take a loss from the ECB's purchase price, Greece could conceivably make up the difference with a special bond issue for the EFSF on terms that reflect the specialness of the vehicle and the circumstances.

Freshly downgraded, EFSF debt is not exactly in high demand. An ECB swap would not require it to raise money in the markets. Having a fiscal vehicle take the risk (if not the loss) from a Greek restructuring is more honest and institutionally sensible than leaving it with the monetary authority. At a minimum, it would stop the chatter about monetizing the debt--without the optics of a big new package for Greece.

As precedent, the operation might be healthy for all involved. An EFSF swap would signal the parameters for any future deals involving ECB-held debt: on the one hand, it is not fully preferred, on the other hand, there is a built-in limit to the haircut. There is even a whiff of harnessing the market. (I once heard a story that Latin American debt managers in pre-Brady days had made up "Capture the Discount" t-shirts.)

More broadly there is a decent argument that the EFSF is sui generis--an ad hoc crisis vehicle that can do what no one else can be expected to do. For example, it has never been encumbered by feckless claims of preferred creditor status, unlike the new treaty-based European Stability Mechanism, due out this summer. This is as close as it gets to a credible "just this once".

There is an argument that under some version of best market practice for CACs, EFSF should not be allowed to vote its Greek bonds in an exchange, because Greece is among its shareholders. I think this objection is surmountable, to the extent the EFSF is not controlled by and does not answer to Greece. Here is some analogous reasoning.

All this to say, wait for the next fake constraint to derail what could be a palatable solution to a horrible situation, followed by more suffering for all.

Break up Bank of America?

2012-01-25T17:31:20-06:00

Steve's title was subtle, so in case anyone missed it, here are the materials on Public Citizen's website. The petition calls on the Federal Reserve and the Financial Stability Oversight Commission to use their authority under Dodd-Frank to break up Bank of America. (But still check out Steve's analysis on Dealbook!).

And Now Featuring Melissa Jacoby

2012-01-25T14:46:14-06:00

On behalf of all the Credit Slips bloggers, it is my pleasure to announce the permanent return of Professor Melissa Jacoby as one of our "Occasionals." For the past several weeks, she had doing some guest posts, but we are very happy that she has agreed to stick around. Melissa is a professor at the University of North Carolina School of Law and a leading expert on bankruptcy law with a number of prominent studies on medical debt as well as housing issues. As one of the founding members of Credit Slips, Melissa is one of the reasons we're here at all. Welcome back.