I have already commented before on why an across-the-board (like in the Treasury/banks plan) rather than a case-by-case approach to sub-prime mortgage restructurings makes sense. Moreover, the attempt to distinguish between those who are insolvent and would default anyhow (even after a freeze of the reset rate), those who can pay and don’t need debt relief and those who are illiquid but solvent (i.e. can likely keep on servicing their mortgages if the teaser rate is frozen for a while) also makes sense. Of course, the Treasury plan may or may not provide enough relief to enough homeowners depending on how it is implemented. But its basic conceptual approach is sound.
 

What one should thus clarify is a lot of the nonsense that one has heard in the last few days about this proposal. This nonsense takes many forms but here are some variants of it:
 

“It is an illegal breach of contracts to modify such contractual agreements”;
 

“Investors in RMBS and CDOs will suffer sharp loss given this forced mortgage modifications”;
 

“Domestic and foreign investors will be wary of buying such assets in the future given this ‘forced’ modification of the contracts that inflicted losses on them”.
 

All these statements are utter nonsense and betray basic ignorance of the process and substance of bankruptcy. One thing should be clear at the outset: investors in these assets will be much better off (i.e. the value of their claims will be higher than otherwise) with this proposal rather than the alternative of letting millions of homeowners default on their mortgages.
 

The crucial financial issue here is not whether investors in RMBS and CDO will experience losses or not: they bought risky instruments that paid a premium for the expected ex-ante default probability and the expected loss-given-default. Any bond is a contingent claim that, in some states of the world (debtor’s distress or insolvency) leads to losses; talking about the sanctity of contracts is baloney as any bond – corporate, sovereign or otherwise – can default in some states of the world and there are procedures for orderly reducing the debt of insolvent agents. Defaults on bonds and other claims occur every day and investors get ex-ante premia relative to riskless assets for buying such risky claims.
 

In the specific, the benchmark of losses against which this Treasury/banks proposal should be judged is what would happen if this proposal is not implemented: and that benchmark is one where in the absence of loan modifications millions of households will default, end up in foreclosures and the losses to holders of mortgages, RMBS and mortgage related CDOs would be massive. So, the benchmark for investors is not one of being paid in full and in time but rather one of massive bankruptcies and severe financial losses.
 

Against that benchmark we can ask the question: do loan modifications of the sort proposed in the Treasury plan make the losses bigger or smaller for these investors?  And the answer to that question is simple: losses will be lower and the reduced value of these ABS claims will be greater than under the alternative of massive defaults (cum case-by-case slow restructuring of the claims). The reason why the losses will be lower and the value of the ABS assets larger than otherwise is simple: you avoid liquidation costs of avoidable defaults and foreclosure and you allow illiquid but solvent borrowers not to default.  Saying that investors will lose money because you prevent teaser rates – averaging 7% now – from being reset to an average 10% is nonsense; the alternative is for investors is not getting a higher 10%; the alternative is rather that at 10% hundreds of thousands of homeowners will pay 0%, i.e. they will stop paying both interest and principal on mortgages that often have a value above the one of the underlying asset.  On in expected terms, investors are worse off in a world where most of these borrowers default compared to a world where the teaser rate is maintained for another five years. So investors should be cheering this proposal rather than opposing it.
 

The logic here is the same of Chapter 7 versus Chapter 11; if a firm is insolvent creditors are better off liquidating the firm and selling the remaining assets (Chapter 7); but if the firm is illiquid but solvent (given financial and operational restructuring) the continuation value of the firm to its creditors is larger than the alternative of liquidation; thus, while restructuring (Chapter 11) provides debt relief to the debtor it provides a larger value to creditors too, including the bondholders, than liquidation.  The same holds for mortgage restructuring: default and foreclosure implies larger costs and losses to creditors – in situations when the borrower is illiquid but solvent conditional on the provision of some debt relief (the NPV reduction in the burden of the mortgage that freezing the teaser rates implies) – than the alternative of an orderly restructuring and debt relief to the borrower.
 

So investors are much better off under this proposal than under the alternative of defaults and/or endlessly slow case-by-case loan modifications.  Basic economic and finance reasoning that is familiar to anyone who has a bare knowledge of the economics of bankruptcy suggests that. 
 

As for the across-the-board approach versus the case-by-case approach to the mortgage restructuring again the claims that the former approach is an unfair – or substantially illegal - process are wrong.  As I discussed before the experiences with a dozen financial crises in emerging market economies, is that when millions of small agents (households with foreign currency denominated mortgages whose real value has sharply increased following a currency devaluation, small and medium sized enterprises with foreign currency debts, and even larger corporate firms when you have a systemic corporate crisis) are financially distressed it is altogether impossible to follow a case-by-case approach as neither the bankruptcy court system nor the creditors are able to expeditiously restructure on an individual basis millions of separate debt contracts.
 

Thus, while an across the board approach may be not totally fair – as some debtors who could pay and don’t deserve debt relief do receive it – this approach is the only feasible way to deal with the need to rapidly restructure millions of separate debt contracts. Thus, while some market fundamentalists were always pushing for a case-by-case approach and wanted to avoid the IMF supporting an across-the-board approach to debt restructuring it became clear to all that, with the exception of very large corporations or financial institutions, the across-the-board approach was the only feasible one to deal with such debt crises.   Systemic banking crises always require systemic across-the-board solution and eventually are resolved with such systemic approaches; there is nothing new here compared to any other past banking crisis. A case-by-case approach - either in court or out of court - is just “mission impossible” when millions of contracts are at stake.

Also the actual legal challenges to these loans modifications – that a number of authors have expressed concerns about - are also way overstated: leaving aside technical legal issues litigation will be very limited only because investors in these instruments are better off under this plan than the nightmarish alternative of massive defaults and foreclosure; investors are not stupid and will find out on their own that they are better off in a world where mortgage are orderly and massively restructured. Certainly legal threat is larger from investors who were short in RMBS, CDOs, ABX and may thus lose from loan modifications that reduce their gains from such short positions; they will not come from investors – the mass of them – who bought trillions of dollars of RMBS and mortgage related CDOs.
 

The Treasury plan also does not involve – so far - any use of public money; thus, it does not represent a “bailout” of either borrowers or lenders/investors; investors are not bailed out as there is no transfer of public resources to them; if anything they have to accept a haircut – in NPV terms – on the initial value of their claims; but such investors are also better off under this scheme as – under the alternative of massive defaults – the losses and NPV haircuts would have been much larger; debtors are not really bailed out either as many of them would have defaulted anyhow on their mortgages and would have thus obtained eventually greater relief by defaulting than by keep on servicing their mortgages at the lower frozen teaser rates.
 

All this does not mean that the Treasury plan is ideal: the housing recession is the worst in US history and will get worse regardless of this plan; and a US hard landing is now unavoidable regardless of any debt relief plan. And how this plan will be implemented will determine whether it provides enough debt relief to enough households; so the devil is in the details. Most likely much more relief should be given to more borrowers than this plan provides as only a small subset of subprime borrowers will qualify for such debt relief compared to those who need it and deserve it. So the problem with this plan is that it does too little, not too much, in terms of extent and coverage and size of the debt relief; not enough deserving borrowers will qualify for the relief under this plan.  But the alternative of doing nothing would be much worse than a positive step in the right direction, i.e. providing relief to those borrowers – not all borrowers but only those - that were victims of reckless and predatory lending practices.

Is this a plan that pospones the pain and will lead to larger and bigger defaults down the lines, as argued by some critics? Not necessarily. If you provide debt relief to illiquid and insolvent borrowers - by stretching the maturity of their claims and letting them to refinance at below market rates - you just pospne the problem and cause bigger damage down the line. And indeed in past housing crises voluntary loan mitigation procedures that allowed insolvent borrowers to refinance eventually lead to default anyhow. Thus, loan modificatios that allow insolvent borrrowers to avoid default for a while are always sellf-defeating. But if you provide debt relief to illiquid but solvent borrowers you actually reduce eventual losses for both the borrowers and the lenders by allowing refinancing easing debt servicing payments to those who can eventually afford to pay. Thus, conceptually the Treasury plan is correct in trying to distinguish among insolvent and illiquid borrowers. Of course, the success of such a distinction will depend on how the plan is implemented.

Finally, like in any Chapter 11 restructuring case, investors with different formal ex-ante seniority will be treated – in the actual restructuring – somewhat differently from what formal seniority would have implied in a true liquidation – Chapter 7 – process. Some more junior creditors may be better off than they would have been – in the absence of this plan – compared to some senior creditors. But Chapter 11 experience suggest that this inter-creditors redistribution of losses occurs all the time and is a well accepted principle and practice of any form of  in-court restructuring process. So while some holders of different tranches of CDOs may – in relative terms – be better off or worse off – on net this plan makes all of these groups – even the holders of senior AAA or AA tranches  - better off than an alternative where millions of borrowers default and the loss of value of AAA and AA tranches – that is already large as it is given the massive expected defaults  and losses -  would be even larger than in this orderly restructurings.
 

Thus only folks who are so blinded by their free markets fundamentalism and opposition to any government intervention in market failures would be so obfuscated by their ideological blinders that they would realize that this plan –however modest and partially faulty and incomplete – implies a better market-oriented resolution and much lower losses to private investors than a disorderly and “mission impossible” case-by-case workout of millions of actual or threatened mortgage defaults. Systemic market failures and crises require systemic response where governement resolve the collective action problems of individual creditors rushing to the exits and causing a disorderly workout of severe debt problems. This mortgage disaster is a case where sound public intervention is necessary and desirable.