On March 5, 2009, the U.S. House of Representatives passed H.R. 1106, also known as the “Helping Families Save Their Homes Act of 2009,” which threatens to override the contract rights of bondholders who invested in mortgage-backed securities (MBS). A version of the bill has been referred to the Senate Committee on Banking, Housing and Urban Affairs, but the Senate has not yet voted on the legislation. You can follow the progress of this bill here at govtrack.us or here at thomas.loc.gov.
In its current form, H.R. 1106 contains several provisions that would undermine investors’ contract rights and could result in a significant shifting of economic losses to bondholders. First, the bill will allow judicial modification of primary residential mortgages in borrowers’ bankruptcy proceedings (also known as “bankruptcy cramdowns”). This means that judges can now forgive principal on the debtor’s primary residential mortgage, just as they already could for other types of debt. This change in the bankruptcy codes, part of President Obama’s economic plan, has been anticipated for some time, especially since banks began relaxing their opposition to this idea (see prior posting regarding Citigroup here).
However, the troubling aspect of H.R. 1106 for investors is Section 124, which renders unenforceable, as against public policy, any provisions of investment contracts between servicers and securitization vehicles that require excess bankruptcy losses over a certain dollar amount to be borne by all classes of certificates on a pro rata basis. What that means is that instead of having bankruptcy losses hit every bond in the capital structure proportionately, the losses from bankruptcy cramdowns will now “trickle up” from the most junior bonds before hitting senior bonds (the traditional way losses are treated).
Yet, such pro-rata loss provisions in securitization contracts were put in place specifically to attract investors for the junior classes of securities and assuage their concerns that they would be disproportionately exposed to excess bankruptcy losses. Currently, many of the senior classes of bonds in these securitizations are held by major lending institutions who fear that downgrades will put significant pressure on the amount of capital they’re required to hold by law. The practical impact of Section 124 is thus to shift the the loss burden from banks to bondholders. I’ll discuss the constitutionality concerns raised by such a shift in a later posting, but query whether, from a purely equitable standpoint, the risk that borrowers would not be able to make their mortgage payments should be born by banks that often underwrote and issued these loans, or by the outside investors who specifically contracted against bearing that risk.
The second provision raising equitable concerns is the so-called “Servicer Safe Harbor.” This provision will have a direct impact on who will bear the losses for loan modifications, another important issue for the financial well-being of banks, and one that has been discussed at length in prior postings
on this blog. Again, many contracts governing securitizations contained provisions mandating that servicers bear the costs of any loans they modify, such as by lowering a borrower’s interest rate, extending the duration of the loan, or reducing the borrower’s principal balance. This is the precise issue being litigated in a suit by Greenwich Financial Services against Countrywide (see prior postings here
The Servicer Safe Harbor provision of H.R. 1106 threatens to cause a sea change in the loan modification landscape. Pursuant to this provision, servicers will not be obligated to repurchase loans or make payments to the securitization vehicle because of loan modifications or other loss mitigation plans, so long as the loans subject to modification are in default or default is reasonable foreseeable (which is the case for most loans eligible for modification). As if this shift in liability wasn’t dramatic enough, the bill also provides cash incentives
($1000 per loan) for servicers to modify loans, in an attempt to help defray origination costs. Keep in mind that these will apply more often than not to the same servicers who originated
the loans and were often grossly negligent in underwriting the loans to determine if the borrower actually had the ability to repay. Not only would this bill let such servicers off the hook for their irresponsible lending practices (see, e.g., prior postings here
on Countrywide passing off the costs of its settlement with Attorneys General), but servicers will now get handouts from the Government for correcting their mistakes! With the current political climate so supportive of “Helping Families Save Their Homes” and easing the rates of foreclosure, it seems that the goal of allocating losses fairly to the parties who contributed most to this mess has been utterly forgotten.
Check back soon for an analysis of the potential constitutional challenges to H.R. 1106 if, as expected, the bill is passed by the Senate in the coming weeks…