Bondholders Considering Plan to Tell Servicers: "You’re Fired!"

Posted on January 6, 2010 by Isaac Gradman

With lawsuits against servicers grinding a slow path through the court system, investors are looking to make an end-run around the intransigent banks who are refusing to service mortgages in accordance with bondholder wishes. Their solution to break through the gridlock surrounding so-called “toxic” mortgage-backed securities? Use the mechanisms in their pooling and servicing agreements (PSAs)–the agreements that govern the creation, maintenance and payment streams of mortgage-backed securities–to remove conflicted servicers from their roles and insert friendly institutions willing to service the loans consistent with the best interests of the investors.

According to one group of prominent investors (hereinafter the “Securitization Syndicate”), who asked to remain anonymous because the plan is still in the works, investors with large holdings in mortgage-backed securities (MBS) are beginning to join forces to petition securitization Trustees to relieve Master Servicers from their posts. Under the terms of most PSAs (which tend to vary little from trust to trust), the Master Servicer is required to service loans in such a way as to maximize investor returns. However, due to recognized conflicts of interest (such as significant holdings in junior mortgages and an interest in accumulating fees from delinquent loans), servicers instead have frequently breached these obligations and refused to liquidate or modify loans that borrowers are incapable of repaying.

The problem is that, under the terms of most PSAs, the only party with the power to do anything about a breach of an obligation by a Master Servicer is the Trustee. Trustees are generally large financial institutions that are paid a fee to oversee the flow of money through the securitization waterfall and to carry out certain administrative tasks. Though the Trustee may remove a Master Servicer, because the Trustee was designed to play a fairly passive role, it is not required to enforce servicer breaches on its own initiative.

Instead, bondholders must petition the Trustee to take action. In this regard, most PSAs require that at least 25% of the Voting Rights (evidenced by beneficial ownership of 25% of the bonds) give notice to the Trustee of a breach by the Master Servicer before triggering any obligations by the Trustee. Only when the Trustee fails to remedy the breach within 60 days after such a petition may the bondholders bring legal action on behalf of the Trust.

However, most PSAs also provide the following: “The Holders of Certificates entitled to at least 51% of the Voting Rights may at any time remove the Trustee and appoint a successor trustee.” (quoted from the representative PSA for Countrywide Alternative Loan Trust 2005-35CB) Anticipating that the Trustee will not take action against the Master Servicer, and reluctant to engage in yet another protracted legal battle to enforce servicers’ obligations, the Securitization Syndicate is shooting for a more ambitious goal: amass a 51% interest in one securitization so that they may remove the Trustee, appoint a friendly successor, and get that successor to fire the Master Servicer.

Sound difficult? It will be. Most prudent investors seek to diversify their holdings so that they do not hold too high a percentage in any one securitization, let alone any one asset class. Finding a few investors with large enough holdings in one particular securitization to obtain 51% might be a challenge. However, it turns out that several large institutional investors, drawn by mortgage-backed securities promising double-digit returns from an investment-grade rated product, acquired substantial holdings in single MBS trusts. Thus, it may be the case that by encouraging just two or three of these large funds to join forces, the Securitization Syndicate may be able to hit the 51% hurdle.

According to one member of the Securitization Syndicate, “all it takes is one or two funds that get it. What do you think will happen if we tell a Trustee or a Master Servicer, ‘you’re fired’? What will happen the next time we notify a Trustee that we’ve caught a servicer breaching its obligations? I think you’ll find they begin to sit up and take notice.”

I would tend to agree that a single firing would cause a sea change in loan servicing policies. Many large banks earn significant fees from serving as the Trustee or Master Servicer of securitizations, and would not want to lose those revenues. Yet, surprisingly, the biggest challenge to this plan may be prodding institutional investors–those who stand to benefit the most from replacing the Trustee and Servicer–to take action. Up until now, institutional investors have been reluctant to take on the Big Four Banks, with which they have longstanding relationships, or to risk being portrayed as self-interestedly opposed to politically popular loan modifications.

Nevertheless, as losses mount in the MBS portfolios of these pension funds, insurance funds and the like, and especially now that senior tranches of securities in certain MBS trusts are beginning to take a hit, somebody is going to be willing to go out on a limb. Large funds such as CalPERS, whose investment portfolio took a hit of over $56 billion in the last fiscal year, should be eager to find a way to cut their losses and begin liquidating their large holdings in mortgage-backed securities.

With Treasury officials admitting last month to the failure of their efforts to cajole servicers into modifying loans or working with borrowers to allow short-sales (the sale of the property for an amount less than the amount owed on the mortgage), maybe institutional investors will finally take matters into their own hands. And, just one reported instance of this plan being successful will likely create a chain reaction. Soon, many bondholders will be open to joining forces and taking on Servicers and Trustees who aren’t honoring their contractual obligations.

In the meantime, loan modifications or workouts, which require the cooperation of servicers, will grind forward at a snail’s pace. This is because servicers have the sole power within a trust to modify a loan, foreclose, or allow a short sale, and they have generally been responsible for dragging their feet and keeping these loans in stasis. When servicers refuse to service loans in the best interests of the ultimate owners, which they’re contractually-obligated to do, they should be shown the door just like anyone else that fails to perform their basic job functions. The question is whether any institutional investors will have the courage to break ranks and stand up to banks that have demonstrated unparalleled influence in Washington and on Wall Street.

Posted in banks, CalPERS, fiduciary duties, Investor Syndicate, investors, loan modifications, pooling agreements, securities, securitization, servicers, short-selling, toxic assets, Treasury, Trustees | 2 Comments

Wikipedia Loan Modification Page Offers Concise Look at History and Current Programs, Ignores Government Failures

Posted on December 3, 2009 by Isaac Gradman

I get frequent questions about loan modifications and resources for learning more about available programs. Those interested in learning more about this subject at the heart of the current financial crisis should start with the Wikipedia page entitled “Loan Modification in the United States.”

The page traces a brief history of the use of loan modifications during the Great Depression, then launches into a more substantive explanation of the factors that brought about the housing crisis in the late 2000s and the legislative efforts that have been made to use loan modifications to mitigate the effects of this crisis. Unfortunately, the page leaves out any mention of the many failed programs by which the government has sought to encourage modifications, such as the Helping Families Save Their Homes Act, which attempted to shore up the equally ineffective Hope For Homeowners Act. Moreover, the brief section entitled “Analysis of the results of the government-sponsored programs” gives little indication of the abject failure of these programs to reduce foreclosures.

Indeed, even the cash incentives in the Helping Families Save Their Homes Act have not compelled banks to perform as many modifications as Washington would like. As discussed in a recent article in The Huffington Post, Treasury Secretary Michael Barr said last week that, “The banks are not doing a good enough job. Some of the firms ought to be embarrassed, and they will be.” So, the Treasury’s solution is to compel action by public shaming? What Barr fails to discuss or maybe even recognize is that regulators have been pursuing this tactic for some time now, apparently without much success.

The alternative that was originally suggested as part of the initial government bailout, and which I have been advocating for months now, is to use TARP funds to create a new version of the Home Owners’ Loan Corporation (HOLC). Many readers will recall that the government established the HOLC in 1933 to refinance the loans of distressed borrowers to help avert foreclosures. The HOLC came to own nearly one fifth of the home loans in America but was ultimately able to sell off the loans and any underlying properties acquired via foreclosure—and even turned a small profit—when the market stabilized. In the present case, though this solution does not appear politically palatable, there is good reason to believe that an entity that could afford to hold these loans for long enough could recoup a significant portion of its investment (or even a profit) when the housing market recovers. Moreover, the government is probably the entity best equipped to cut through the red tape surrounding workouts and mediate between the various players involved in the securitizations containing most of the loans at issue. By utilizing its powers under the Takings Clause and paying just compensation to injured investors or lenders, the government could compel loan modifications that it determines will serve the public interest.

Otherwise, the only solution that makes sense at this point is to tilt the cost-benefit analysis being performed by banks by hitting them where it hurts–in the pocketbook. Washington has tried the carrot, now maybe it’s time to try the stick. Instead of giving servicers cash incentives to modify, try fining them when they don’t. The Treasury is already fining servicers for not reporting final disposition of their trial modifications, but again this strategy seems to be aimed at encouraging better behavior by publicizing intransigence. While I’m a big fan of this sort of reflexive incentive system where companies depend on repeat patronage by customers, servicers do not face the same fears of public scorn because borrowers cannot choose who is servicing their loan. And in this financial climate, it is wishful thinking to believe that those seeking a loan will shun the Big Four banks because of their abysmal record in performing loan modifications. Instead, the decision of who to go to for a mortgage is likely driven by who will approve the borrower for a loan at the best rate.

Though legislators and Wikipedia may pay lip service to the many programs Congress has rolled out to encourage modifications, there is precious little evidence that these programs are actually working. It has been nearly a year since the bailouts and other responses to this financial crisis began; it is high time that Washington abandon its gentle prodding and take a more direct approach to reducing foreclosures.

Posted in banks, Helping Families Save Homes, HOLC, Hope For Homeowners, incentives, loan modifications, Michael Barr, reflexive tactics, securitization, Takings Clause, TARP, Wikipedia | Leave a comment

Treasury Official Speaks Out About Excessive Risk Taking

Posted on October 24, 2009 by Isaac Gradman

At long last, someone in Washington is speaking out about the dangerous precedent set by the government bailouts of major banks. As discussed in this article on the financial regulations website FinReg21, Treasury secretary Michael Barr testified before the House Judiciary subcommittee that the government must enact meaningful reforms to combat the “classic moral hazard problem” that stems from the perception that some banks are too big to fail.

Moral hazard defines the concept that an actor who is insulated in some way from risk will often behave in a riskier or more aggressive manner as a result of that insulation. The classic example is that drivers wearing seat belts and bikers wearing helmets tend to drive and bike more aggressively than they would have if unprotected, thereby leading to more accidents than before. Applied to the banking industry, Barr’s reference to moral hazard suggests that banks (and their creditors) that are perceived as “too big to fail” (i.e., the government will bail them out rather than letting them fail) will be incentivized to engage in greater risk-taking behavior than they would have if there had been a credible fear of failure.
Examples abound of this type of perverse incentive system within the financial services industry. One need look no further than the examples of Freddie Mac and Fannie Mae, which continued to receive support for their risky mortgage-backed securities purchases from investors because it was thought that the government would guarantee the debts of these GSEs. Similarly, the performance of executives of financial institutions is scrutinized on a quarter-by-quarter basis, meaning that these executives must show constant short-term profits to retain their jobs. They are then rewarded for these short-term profits with huge bonuses. On the flipside, unless criminal or grossly negligent behavior can be shown, these executives are rarely liable for any losses the firm experiences because of their choices. Though they may lose their jobs, these executives generally retain the bonuses they’ve received, thus incentivizing highly risky behavior during their tenures.
The incentives for both executives and the institutions they direct must be restructured so that long-term profit and steady, sustainable growth is most richly rewarded, while wild volatility is discouraged. This must begin with erasing the notion that any institution is “too big to fail.” Beyond the moral hazard problem, the fact than any institution would be so critical to our economy that its failure would wreak havoc must be considered extremely dangerous. If the American economy is viewed as a portfolio of investments, then there must be sufficient diversification between industries and within industries such that the failure of one may be balanced against the others. Having our economy hinge on the success or failure of any one institution, let alone a highly leveraged institution such as a bank, is as bad a strategy as it would be for an individual to have his entire retirement account consist of holdings of Google stock.
So, what does this mean? If a bank or any other institution takes risks that don’t pan out, it must suffer the consequences. If it cannot overcome the losses from its risk-taking behavior, it must be allowed to fail. As Barr points out, this “failure” must consist of an orderly unwinding of assets, rather than a sudden collapse, as was the case with Lehman. But, it also cannot be a bailout. Investors must lose a portion of their investment, so that they will be incentivized to direct their resources towards companies that engage in prudent behavior. Upstart institutions must be allowed to sprout in the void left by the failed institution, replacing some of the lost jobs and services and encouraging a return to a survival-of-the-fittest brand of capitalism.
Consistently applying this approach over time will naturally lead to more conservative investments and decisions, but also to more realistic valuations. We all saw how unchecked risk-taking in mortgage lending led to highly inflated home prices that could not be supported and eventually came crashing down.
Now, I recognize that many will point to the failure of Lehman Brothers as an indication of why we should not let big financial institutions fail. Obviously, the failure of Lehman touched off a wave of financial disasters that pushed our economy into recession. The resolution authority proposed by Barr may be part of the answer to this objection. Yet, who can say that this recession was not an inevitable result of too many dollars chasing too little actual value? Would this recession really have been avoided if Lehman were propped up by the taxpayers instead of forced into bankruptcy? I think that to blame the financial crash on the fall of Lehman is to mistake a symptom for a cause. It is like saying that the Great Depression was caused by the stock market crash of 1927.
Further, reforming the bankruptcy process for major financial institutions is only part of the solution. A complete solution must involve a drastic reformation of executive compensation structures to reflect an emphasis on long-term value. Instead of basing executive bonuses on quarterly or yearly performance, have executive bonuses “vest” over a five-year period, provided that the executive remains employed with the company, and that the company (or the executive’s department or division) has shown a net profit over that period. This would incentivize both long-term planning and company loyalty.
While I applaud Barr for admitting the dangers of government bailouts, his proposed solution does not go far enough. Further, as I’ve discussed in the past, allowing the Fed to retain the authority to decide when this resolution authority is applied and withheld gives too much power to a private corporation with a vested interest in preserving certain large banks. There must be a better way.
Posted in bailout, executive compensation, Fannie Mae, Federal Reserve, Freddie Mac, Government bailout, incentives, Judiciary Committee, Lehman Brothers, Michael Barr, moral hazard, too big to fail, Treasury | Leave a comment

Countrywide Files Motion to Dismiss in Greenwich Financial Case

Posted on October 10, 2009 by Isaac Gradman

With Greenwich Financial v. Countrywide having been remanded to New York state Supreme Court, Countrywide has now filed a Motion to Dismiss, arguing that Greenwich Financial’s Complaint is barred by the operative securitization agreements. As discussed in several prior posts, Greenwich brought this suit to force Countrywide to pay for the loans it has agreed to modify pursuant to its settlement with dozens of state Attorneys General. Countrywide’s full memorandum of points and authorities in support of its Motion to Dismiss may be found here.

Countrywide’s Motion asserts that the terms of the Pooling and Servicing Agreements (PSAs)between investors and Countrywide, including the “No-Action” provisions, expressly prevent Greenwich from suing to force Countrywide to repurchase the loans it modifies. Interestingly, while Countrywide cites the Housing and Economic Recovery Act and Helping Families Save Their Homes Act to show that such modifications are within “standard servicing practice,” Countrywide does not argue that Greenwich’s suit is barred by the Servicer Safe Harbor. Instead, Countrywide asserts that while it will brief such matters in future filings, “[b]ecause the immunity question requires consideration of additional documentation…Countrywide does not raise the immunity defense in this motion.” I’m curious what documentation Countrywide will have to review to brief this issue, as the Servicer Safe Harbor seems to have been designed specifically to relieve servicers such as Countrywide from liability based on contractual provisions like the ones in the PSAs.

As I discuss in an article that was recently published in the Daily Journal (an online version of which is available here), if Countrywide is successful when (not if) it eventually argues for dismissal based on the Servicer Safe Harbor, the decision could expose the Servicer Safe Harbor to a constitutional challenge pursuant to the Fifth Amendment’s Taking’s clause (see prior discussion here). If Greenwich Financial is thereby forced to bear losses that it expressly contracted against, it may constitute unconstitutional loss-shifting from one private party to another for a public purpose, in which case the government would be required to provide investors with just compensation.

Nevertheless, it will be interesting to see how Greenwich responds to the instant motion to dismissed based on the language of the PSAs. From my prior analysis of these contracts, it appeared that their language strongly favored holding Countrywide liable for the costs of such modifications.

Greenwich v. Countrywide had been stayed over the summer while the federal court to which Countrywide had removed the case deliberated over whether Greenwich’s case raised a federal question, or otherwise was subject to federal jurisdiction based on its securities class action claims. On August 14, Judge Richard Holwell issued an opinion remanding the case to state court. Judge Holwell found that there was no federal question jurisdiction because the issues of the Servicer Safe Harbor and other federal statutes relied upon by Countrywide would be asserted merely as defenses, and were not essential to Greenwich’s claims. The court further found that the case fell into one of the exceptions to mandatory federal jurisdiction under the Class Actions Fairness Act, and while the issues raised in the case were timely and novel, this was not enough to mandate federal jurisdiction. The full order is available here.

While Countrywide states that it intends to appeal Judge Holwell’s order of remand, it appears that Countrywide will move forward with its defenses on the merits in state court. Check back for further updates on this fascinating case.

Posted in consitutionality, Countrywide, Greenwich Financial Services, Helping Families Save Homes, HERA, loan modifications, motions to dismiss, remand, Servicer Safe Harbor, subprime, Takings Clause | Leave a comment

Judge Dismisses UG’s Tort and Statutory Claims Against Countrywide

Posted on October 9, 2009 by Isaac Gradman
Round one in the Battle of the Titans has gone to Countrywide. On October 6, 2009, the Central District of California handed down its decision on Countrywide’s (now part of Bank of America) Motion to Dismiss in the case of United Guaranty Mortgage Indemnity Co. v. Countrywide Financial, et al., holding that United Guaranty’s (a subsidiary of A.I.G.) tort and statutory claims would be dismissed, and only UG’s claims based on breach of contract and breach of the implied covenant of good faith and fair dealing would survive. The full order is embedded below.
Each of Countrywide, the nation’s former number one lender, and A.I.G., the nation’s largest insurer, have filed lawsuits against one another in the Central District of California (UG filed a third case in federal court in North Carolina, citing forum selection clauses) All eyes are on these cases as a bellweather for future decisions in subprime mortgage litigation, especially litigation related to mortgage insurance. This Order is one of the first to tackle head-on some of the thornier issues surrounding who will bear the losses associated with the mortgage meltdown.
Judge Mariana Pfaelzer’s opinion takes the time to walk through the securitization and mortgage insurance acquisition process, and determines that both UG and Countrywide were sophistocated parties that had substantial experience in securitizations and mortgage insurance policies, despite UG’s arguments that it had “limited experience in the subprime market.” In doing so, the Court showed a willingness to take judicial notice of language in the Policy regarding the parties’ assessment and allocation of risk that it found to contradict UG’s allegations. While ordinarily, for the purposes of a motion to dismiss, a court must accept as true all properly pled allegations of material fact, the Court cited the recent Supreme Court case of Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949-50 (2009) for the proposition that the court need not accept as true “unreasonable inferences” when the complaint is read together with the underlying documents (i.e., the insurance policy and commitment agreements).
In my initial analysis of these cases, I noted the dichotomy between UG’s assertions that it was relatively inexperienced in subprime mortgage insurance and Countrywide’s assertions that UG was a sophisticated market actor in this area. It appears this battle has been decidedly won by Countrywide, with the Court finding that UG negotiated a sophisticated contract that contained remedies for fraud and negligence, and that UG had the means and the knowledge to conduct due diligence on Countrywide’s loans prior to insuring them. These findings seemed to be important factors in the court finding that UG’s claims for fraud and negligence must be dismissed, and that it must pursue contract remedies for any such findings.
The opinion also discusses the concept of delegated underwriting, standard in the mortgage insurance industry, in which the insurer delegates the responsibility for properly underwriting the loans it insures to the lender, which represents and warrants the loans were underwritten properly. In return, the insurance company retains the right to audit the loan files to determine whether they were indeed properly underwritten. This structure is often necessary due to the lender’s superior access to information and the short turnaround time available after the loan is closed but before it is sold into securitization.
Judge Pfaelzer noted that this “delegated model makes sense when engaging in bulk mortgage insurance transactions: the applicant represents material information about the mortgage, then the insurer prices and issues the policy based on that information.” However, her Order goes on to find that, “any reasonable mortgage insurer that (1) was doing multibillion-dollar bulk transactions and (2) had an express right to audit or sample the underlying loan files before the transactions closed, would engage in some degree of auditing or sampling of the underlying loan files to be insured.” Thus, the Court found that UG could not have reasonably relied upon any misrepresentations Countrywide may have made to induce UG to provide insurance.
The Court also discredited UG’s “global rescission” argument – that these misrepresentations as to some loans entitled it to rescind coverage as to all loans in a pool. Thus, to succeed in its case, UG will have to go forward on its contract claims and demonstrate, on a loan-by-loan basis, that Countrywide breached the terms of the policy or commitment agreements for each.

AIG-Countrywide Court Order re Motion to Dismiss

Posted in Uncategorized | Leave a comment