As first reported by Bloomberg yesterday, bond king Pacific Investment Management Co. (PIMCO) has quit the American Securitization Forum (ASF) after the trade group refused to issue a statement reflecting investors’ views of the announced settlement between the five largest servicers and 49 state Attorneys General. As I discussed when the deal was announced, there are several reasons why bondholders may have wanted ASF to sound the alarm about the settlement, as much of the pact’s announced value of $26 billion may come out of investors’ pockets rather than those of the banks responsible for the questionable foreclosure practices at issue.
But wouldn’t you like to have been a fly on the wall during one particularly inflammatory incident in which ASF’s Executive Director was taken to the wood shed over its conflicts of interest, precipitating PIMCO’s departure? Now you can, thanks to an exclusive conversation with bondholder advocate Bill Frey, who was a central figure in this incident and discussed with The Subprime Shakeout how these issues came to a head.
To set the stage: though the official terms of the settlement have still not been released in the two weeks since it was announced, statements made by public officials in connection with the settlement have suggested that investors will not be adequately protected, causing an outcry from such organizations as PIMCO and the Association of Mortgage Investors (AMI). In particular, investors are upset about two major issues: 1) how banks will be incentivized to modify loans held in portfolio versus those held by investors through residential mortgage backed securities (MBS) and 2) whether lien priority will be respected for second liens where the underlying first lien is modified.
Though investors’ distrust of ASF has been fomenting for some time now, since ASF represents both banks and institutional investors (see Yves Smith’s post today on Naked Capitalism for more background), it appears that one incident surrounding the group’s stance on the second lien issue confirmed these suspicious and provided a flashpoint for PIMCO’s split. On February 1, 2012, the second lien issue was brought to the forefront during an exchange between ASF Executive Director Tom Deutsch and Frey, of Greenwich Financial Services, at a roundtable in Washington, D.C. organized by the office of Rep. Scott Garrett (R-NJ). According to Frey and several sources in attendance at the meeting, Deutsch was called to task by Frey over the handling of second lien loans held on bank balance sheets.
Approximately 30 congressional staffers and several congressmen were allegedly in attendance at the closed-door meeting, as well as three speakers: Deutsch, Frey and a representative from Redwood Trust. According to Frey, the fireworks began shortly after Deutsch began characterizing the issues surrounding second lien loans and how to handle them as “confusing.”
“I jumped in at that point because I wanted Deutsch to explain what was so confusing, ” Frey said. “Pursuant to their contracts, second liens are subordinate to first liens, plain and simple. I offered an analogy from the commercial mortgage backed securities context in which second liens are wiped out if the first lien can’t be satisfied.” Deutsch allegedly responded that residential MBS were different from CMBS and that there were “extenuating circumstances,” but couldn’t offer any specifics.
According to sources, Frey then pointed to Section 3 of pooling and servicing agreements, which require the servicer to service loans in the interests of the first lienholders. “I asked him what would happen if the Big Four banks had to mark their $400 billion of second liens to market,” Frey said. “He had no answer. At that point, I asked him if the ‘extenuating circumstances’ he was referring to included the fact that the banks would be insolvent if their second liens were to be written down.”
Calls to Deutsch and ASF Managing Director of Public Policy, Jim Johnson, requesting comment were not returned. However, Debtwire has quoted Deutsch as saying, when confronted about the exchange, “what you are describing is flat wrong… and sounds like it came from sources who couldn’t possibly know what was said because they weren’t in the room.” Unfortunately for him, Bill Frey was in the room, and he begs to differ.
That servicers have conflicts of interest resulting from their holdings in second lien loans on properties in which they service the first liens for others has been well documented, and is discussed at length in Frey’s book, Way Too Big to Fail, and in several articles on the Subprime Shakeout. However, it is regulators’ failure to recognize this conflict or uphold contractually-designated lien priority that has investors up in arms.
The AG settlement is reported to require that second lien loans be modified in pari passu (on equal footing) with first liens, and only requires them to be wiped out if they’re 180 days delinquent (in which case they should have been written off already). This plainly conflicts with the contractual lien priority assigned to second liens – that they sit behind firsts and may only be satisfied out of liquidation proceeds after the first liens have been satisfied completely.
PIMCO, for its part, told Debtwire that the firm’s decision to defect from ASF was “in the best interest of our investors” and a result of ASF’s failure to advocate for bondholders. But whatever the ultimate reason for the split, one thing is for sure: servicer conflicts of interest are showing more clearly than ever, and the second lien issue simply won’t go away.