Mortgage “Cram Downs” Quickest Route to CDO & MBS Price Discovery

There is a lot of rhetoric to strip away from this debate. “Cram downs” imply that bankruptcy judges have total free reign to modify mortgages to suit the interests of borrowers without any regard to the interests of the lenders. Bankruptcy judges will automatically lower principal to the current value of the underlying homes or the borrowers’ ability to pay, again without regard to a net present value (NPV) comparison with foreclosure. The sanctity of contracts and the effect of cram downs on mortgage costs in the future are arguments that have been endlessly reiterated. And finally JP Morgan (JPM) CEO Jamie Dimon does not want to write down any principal that he is entitled to get back.

Now for some truth: Congress is only opening mortgage contract modification to a limited portion of the bankruptcy code and judges would be obligated to consider modifications versus foreclosure in a way that mitigates losses to the lenders. The threat of cram downs should lead to more conservative lending. Also, Congress has been considering implementing judicial mortgage modification for only a limited time period.

Everything I have read says that mortgage servicers are supposed to decide mortgage modifications based on a NPV comparison with foreclosure. The trouble is they are risk adverse in interpreting their on contracts with the securitization trusts, and they don’t have the incentives to step out on the limb. The numbers to plug into the NPV calculations and risk of re-default are open to endless argument. Therefore all parties will actually benefit from having bankruptcy judges as their arbitrator.

Once the judge decides that modification is more beneficial to creditors than foreclosure, he or she will have to determine how to move the various mortgage levers to make the mortgage sustainable. The judge will have to arbitrate the borrower’s and lender’s proposals for the most sustainable combination of interest, principal, term, deferrals and fees. Most modifications have failed to date because lenders and servicers have not taken a realistic approach to sustainability.

Former Treasury Secretary Paulson and Federal Reserve Chairman Bernanke have told us endlessly that we need price discovery to unclog the movement of toxic assets. Forget the mark-to-market CDO and MBS prices based on models, indexes, and credit default swaps. Each of these is used for the benefit of individual players, and the self-interests of these players negate a transaction price.

My guess is that bankruptcy judges will only hear borrowers with the least desirable collateral and that are the deepest under water. Banks will eagerly use the bankruptcy threat to facilitate short sales for their better collateral. This combination will quickly bring real price discovery from the bottom up. Once loans are made current (with sustainable payments) their value can be uniformly calculated, and trading of CDO and MBS easily facilitated.

Valuing mortgages based on the greater value of foreclosure or the borrowers’ ability to pay is the true free-market price. Have the Treasury or Fed determine the value of mortgages if held to maturity or the value booked at financial institutions is arbitrary and will not facilitate free-market transactions.

I would even take it one step further. The government should create a temporary mortgage court that would rapidly arbitrate all delinquent mortgages based on standardized filings. Parties unsatisfied with the judge’s ruling would then be able to appeal in a regular bankruptcy proceeding.

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