Thursday, November 27, 2008

Would ADR have helped mitigate the financial crisis

The financial crisis which stemmed from the mortgage crisis seems to count among the foremost enemies of humanity today (we give terrorism, heart disease, cancer etc. their due too). At least one person on LSC (me, for example) wonders whether ADR methods, if they had been used at the right time would have helped mitigate the financial crisis significantly.

What caused me to think along these lines was this post on the freakonomics blog which says inter alia that

Back in the old days, banks didn’t package and resell the mortgages they wrote. So when a homeowner got into trouble, they could go down and talk with the bank about working out some solution other than foreclosure. For instance, the bank could allow the borrower to pay back the loan over 30 years instead of 15 years, reducing the monthly payment".
Well that is ADR at its simplest really. The same blog also says that a typical foreclosure costs the lender about $60,000 (these people are not the India Today Sex Survey, they are friends of Krugman, you can believe their stats.)

One major roadblock in using these good ole ADR methods this time round that the banks had repackaged the mortgages and sold them off as securities so the bank did not have the full liability anymore and it they were left with no rights to renegotiate. Further, the repackaging of the mortgages as securities meant that the mortgages were not held as units and renegotiation for the end lender (the person who purchased the security, or the person who purchased a repackaged security from a person who purchased the security....) was not really an option because -
a) the disconnect between him and the mortgage (was he even aware that it was a repackaged mortgage?). He has no means of assessing whether modifying the amortization schedule or something will mean he gets his money back.
b) he wasn't the only person holding any given single mortgage, it was distributed across many securities possibly held by many different people
c) he has small pieces of too many mortgages to bother with renegotiation

There is also the question of to what extent ADR could have saved the day.

Even if it was able to come into play, it would have not been able to anything in cases which are now popularly known as Ninja loans. No humanly possible alternative payment arrangement would have been practicable in these cases. (Where there is an impossibility, there is a crooked way around it - They could renegotiate it such that they postponed foreclosure, speculated when the next real estate bubble would come around and wait till then. This is precisely the kind of hoodwinking that brought it about in the first place)

Can you think of other crises that could have been prevented or mellowed by the timely use of ADR?