It has never been unusual for borrowers to run into difficulty, and sometimes it becomes clear that a loan will never be repaid in full. The lender's job then is to recover as much money as possible. Because foreclosures are expensive and the eventual recovery is uncertain, it's often a better bet for the lender to restructure the loan--settling for less than they are owed, but more than they'd get in a foreclosure. One of things that has made the subprime debacle go from bad to worse is that loan workout is much tougher when loans are securitized--sold, packaged, diced up, and sold again.

Banks used to have whole departments dedicated to loan workout. (No doubt they still do, but since banks mostly don't hold mortgages any more, their loan workout departments don't get involved when a mortgage goes bad these days.) The structured investment product that mortgages get packaged into these days is a trust, and those trusts are very nearly not in the "workout" game at all.

Packaged loans

One aspect to the packaging of these loans was a division of a package of loans into groups (called tranches, from a French word meaning slice) based on quality. The quality determination, though, isn't made in advance. Rather, they work like this: The first (best) tranche gets all the payments until it's investors have been paid what they're owed. Once they're paid, the second tranche gets all the payments, and so on, until the fifth tranche gets whatever hasn't gone to any of the previous tranches.

Different investors were interested in different tranches. A pension fund might have paid top dollar for the first tranche, which was expected to provide predictable income for many years. The fifth tranche would pay less (starting as soon as the first borrower missed a payment), but would also cost less, and could turn out to be a good investment for a hedge fund that bought it cheaply enough.

It turns out that--and this is the whole point of the thing--because different investors will pay up to get exactly what they want, the selling price for tranches one through five add up to more than the sum of the value of the individual loans that went into the package.

Predictable value

The values of the individual tranches were calculated according to complex mathematical models. Everybody involved in the arrangement--the banks who created the packages, the investors who bought them, and the agencies that gave them credit ratings--had their own models, but all those models depended on predictability. If some loan officer could look at a loan and decide that this or that loan might pay more if a workout kept it from going into foreclosure, that predictability was lost--and once the predictability was lost, the valuation model would become less dependable.

To avert that threat, the trust documents that created these packaged investment vehicles often drastically limit the ability of the trust to modify the terms of the loans.

No more workouts

The upshot is that several of the incentives to workout problem loans no longer exist:

No customer relationship. A local bank knows its borrowers--they are probably depositors, and very possibly future borrowers. In addition, they might have any number of other connections to the bank. For example, they might be a key employee at a local business that is an important customer of the bank.

No incentives. There's real work involved in restructuring a loan. Some fairly smart person needs to look at the collateral, look at the borrower's finances, look at the loan terms, and decide whether the best return to the lender would come from a workout or a foreclosure. And after all that, it often turns out that a foreclosure is still the best plan. Somebody would have to pay people to do all that work, and there's no particular incentive for the trusts that own the loans to do that. They get paid a fee to manage the payments, and it's much simpler for them to just routinely foreclose, even if it brings in less money--after all, it's not their money.

Limited legal options. Since the legal document that creates the trust limits the ability of the trust to modify the terms of the loans (in the name of predictability), there is simply no one with the authority to negotiate a workout agreement.

Fixing the problem

Because of the nature of trusts, there's often no way for the parties involved to solve this problem--there is simply no one who can decide to change the terms of a trust, even if all the interested parties were inclined to agree. The result of that is that the federal government is getting involved. I have a post coming up about government efforts to fix the foreclosure crisis.

(The picture for this post is of a statue of Alexander Hamilton, who architected a restructuring of the revolutionary war debt of the new--and essentially bankrupt--United States of America. His plan established the credit of the new country, which has not missed a payment on its debt since.)