On January 19, 2009, Eric Posner from the Volokh Conspiracy cited to the Subprime Shakeout in his article entitled “Why should the government buy toxic assets?” The post addressed the idea of an “Aggregator Bank” that would acquire the mortgage-backed securities that banks can’t or won’t sell–the original and much-debated purpose of TARP (the original government bailout plan).
In discussing the benefits and potential drawbacks of an Aggregator Bank, the article asked:
What is gained by this exercise? Not increased certainty or the discovery of the “real” value of the MBS’s. It would have to be—if the intervention were to make sense at all—that the MBS’s are worth more aggregated in the hands of the Aggregator than they are in the hands of banks and other investors scattered around the world. How could this be the case?
To see how, consider some of the litigation that has erupted as a consequence of the subprime crisis. This excellent blog, by Isaac Gradman, provides some examples. Debtors and attorneys general are suing loan originators like Countrywide for predatory lending practices, and winning settlements. Under the terms of these settlements, the mortgage loans are modified, with principal and interest reduced. The problem is that Countrywide is now the loan servicer for these loans, so if it agrees to lower payments, as it has, the holders of MBS’s, not Countrywide, incur the loss. Can it do this? A definite maybe! Everything depends on the terms of the contracts between the loan servicer and the MBS holders.
Posner is correct that in the particular case of Countrywide, which settled with the Attorneys General of over a dozen states for upwards of $8 billion in what was widely-hailed as the largest predatory lending settlement in U.S. history (see prior post here), the question of who bears the cost of loan modifications comes down to the terms of the contracts between Countrywide and the investors. The settlement itself does not appear to provide for Countrywide to bear the cost of modifications, but does require some consultation with investors. If the contracts likewise do not provide for Countrywide to bear these costs, the great victory claimed by the Attorneys General for engineering this settlement would be rendered ethereal, as investors would bear the entire cost of the poor underwriting and predatory lending practices that led to the suits against Countrywide in the first place. Indeed, how could this be called the largest predatory lending settlement in U.S. history and a “model for other lenders” if the alleged predatory lender was able to shift the cost burden of its modifications onto investors?
The mere fact that this important issue of cost was not addressed by the terms of the settlement agreement is either a horrendous oversight on the part of the Attorneys General, or reveals that the settlement was mere political window-dressing that was never intended to actually punish Countrywide, but only to make it appear that the company was being chastised. This lends even more credence to the lawsuit brought by Greenwich Financial CEO William Frey against Countrywide, discussed in previous posts gathered here.
Loan modifications are ordinarily structured such that the expected value to investors from modifying the loan (in net present value terms) is greater than the expected return from immediate foreclosure. For example, by lowering a borrower’s interest rate to something he or she can afford, but extending the term of the loan or increasing the principal balance, a borrower may be able to continue making payments that will benefit investors in the long run compared to an immediate foreclosure (which, as Posner points out, typically results in a fifty percent drop in the value of the home). However, when loan modifications are being conducted, not for the benefit of the investor, but because the loan was originated in a predatory or otherwise improper manner, the cost of such a modification should obviously be borne by the party responsible for such negligent or predatory practices. Instead, when the $8 billion plus expected loss is born under the terms of the settlement agreement by largely innocent investors, it should be no surprise when massive litigation follows. Thank you to the Volokh Conspiracy for continuing to highlight this important issue.