Bondholders Battle Back Over Servicer Safe Harbor

Posted on April 29, 2009 by Isaac Gradman

Back in early March, without much fanfare, the U.S. House of Representatives passed H.R. 1106, entitled the “Helping Families Save Their Homes Act of 2009”, which contained a “Servicer Safe Harbor” provision that would allow servicers to disregard bondholders’ contract rights when modifying mortgages. It now appears that the bill will not fly so easily through the Senate (keep tabs on the progress of this bill here at govtrack.us or here at thomas.loc.gov).

On March 25, 2009, Bill Frey, the head of hedge fund Greenwich Financial Services LLC, gave a talk in Washington to more than 30 money managers with stakes in the $6.7 trillion mortgage bond market, warning them that government efforts to assuage the housing crisis will undermine debt contracts and do more harm than good. Also presenting at the bond investor conference, which was attended by, among others, representatives from Royal Bank of Canada’s Voyageur Asset Management Inc. and Thrivent Financial for Lutherans, were David Grais, the lawyer who represents Frey in his suit against Countrywide (which may have prompted this bill), and Laurie Goodman, an analyst at Amherst Securities and UBS AG’s former fixed income research chief. According to this interesting report from Bloomberg, as a result of this meeting, a group of investors with residential mortgage-backed securities (RMBS) holdings totaling more than $100 billion hired Patton Boggs LLP, Washington’s biggest lobbying firm, to gear up for the fight in Washington over the pending legislation.
As part of this new lobbying effort, Grais and his firm, Grais & Ellsworth LLP, have issued a press release entitled “Five Reasons Why ‘Servicer Safe Harbor’ Would be Bad for America.” This release does an excellent job of explaining the perverse consequences of the bill, while capturing in straightforward terms the various reasons why mortgage bondholders oppose this legislation, despite its purported purpose of “helping families save their homes.” For one, bondholders negotiated for the valuable contract rights at issue, which impose the cost of modifications on servicers (Grais identifies these servicers as “mainly the Big Four Banks, Bank of America, Citibank, JP Morgan and Well[s] Fargo”), as a precondition to investing their money into RMBS. Bondholders secured these rights because they knew that modifications would otherwise come out of their bottom line, not from that of the servicers who had the discretion and authority to conduct loan modifications. Allowing servicers to abrogate these rights would unfairly place the financial burden of modifications on bondholders and thereby discourage future investment in the RMBS market.
A second reason is that, while servicers don’t hold many of the senior or first-lien mortgages on their books, they do hold many junior or second-lien loans. By law and/or contract, second liens are often required to be modified before first liens. Allowing servicers to modify first liens before or in lieu of second liens improves these banks’ bottom lines at the expense of their investors.
Third, the legislation offers cash incentives of $1,000 per loan modified and other incentives to the servicers, allowing the entities that made a fortune from lending and then passing off loans that borrowers couldn’t afford to further profit from going back and attempting to correct their mistakes.
When Grais runs into a bit of trouble is when he claims that the Servicer Safe Harbor “would not help homeowners.” Grais’ argument is that servicers will often increase the principal balance of loans they modify by adding the extra fees they charge borrowers who fall behind. He contrasts this with investors’ plan for modifications, which he claims will “reduce principal to give homeowners equity.” What Grais doesn’t tell us is how many mortgages will be modified if the Servicer Safe Harbor is passed versus under the investors’ plan. Ultimately, most homeowners would choose to stay in their homes, even at the expense of an increase in principal, over having to leave because they couldn’t afford their current mortgage payments. And while the investors’ plan may favor lowering principal balances, the likely consequence will be a higher monthly payment than under the banks’ modification plans.
In the end, there is little argument that the Servicer Safe Harbor will likely result in more mortgages being modified than before, something that investors, banks, politicians and homeowners would all agree is a good thing. The real fight is over who should pay for these modifications, and Grais and Frey would be wise to keep the focus on this debate. Investors believe that either the government or the banks should bear the costs, while the banks would like nothing more than to place the burden on the investors. Washington now appears likely to be the one to decide this issue, and as is often the case (unfortunately) when it comes down to politics, the answer will be in large part a result of how much money has been spent on lobbying and campaign contributions. Just look at the two politicians who introduced the “Helping Families Save Their Homes Act” in the House, Paul E. Kanjorski (D-PA) and Michael N. Castle (R-DE). Bank of America (which now owns Countrywide) was the second biggest contributor to Castle’s campaign during the 2007-2008 election cycle, making Castle one of the top 10 beneficiaries of BofA last year (behind only presidential candidates). Kanjorski was the second biggest recipient of Countrywide campaign contributions since 1989. Clearly, BofA expects (and has received) a tangible return on its investment.
Yet, there is already evidence that bondholders’ lobbying efforts are countering those of the big banks and paying significant dividends. Though the mainstream media had up to this point largely ignored the Servicer Safe Harbor issue, Gretchen Morgenson, a columnist for the New York Times, published a column last week discussing the “unintended consequences” of the Helping Families Save Their Homes Act and loan modifications in general. Morgenson notes, correctly, that while “big-time speculators and market sophisticates” make up part of the group of investors who would be harmed by this bill, the group also includes ordinary individuals who invested in mutual funds and other professionally managed accounts that acquired RMBS as part of their portfolios. Ultimately, if votes mattered more than dollars (a debatable proposition), it would be this argument, with its populist appeal, that
would carry the day in Washington.

Thank you to David Proman and Chris Corio who contributed helpful insight and research to this story – IMG.
Posted in BofA, Countrywide, Greenwich Financial Services, Helping Families Save Homes, irresponsible lending, legislation, loan modifications, lobbying, Servicer Safe Harbor, William Frey | 2 Comments

Center For Responsible Lending Publishes Report Linking Failures of WaMu and IndyMac to Poor OTS Oversight

Posted on April 17, 2009 by Isaac Gradman

The Center for Responsible Lending (CRL), a non-profit, non-partisan research and policy organization, has released a report that begins to shed some light on the role that lax regulation played in the mortgage meltdown of the last year and a half. The report, entitled “The Second S&L Scandal,” is subtitled, “How OTS allowed reckless and unfair lending to fleece homeowners and cripple the nation’s savings and loan industry.”

CRL has released several insightful and informative reports in the aftermath of this crisis that have helped to uncover what was really going on towards the tail end of the housing bubble and how such irresponsible lending and oversight were allowed to take place. In a prior posting, I discussed CRL’s jaw-dropping look into the pervasive culture of quantity at the expense of quality prevailing at IndyMac Bank prior to its collapse in July 2008, entitled “IndyMac: What Went Wrong.”

“The Second S&L Crisis” also includes insight into the culture of excess and irresponsibility that ran rampant at IndyMac and Washington Mutual (WaMu) during the housing bubble. But even more eye-opening is its account of the role that the Office of Thrift Supervision (OTS) played in the collapse of these two institutions. CRL’s conclusion? That, unequivocally, “OTS failed in its responsibility to ensure the safety and soundness of thrifts and to protect consumers from abusive practices” (p. 1).

Among CRL’s findings, some of the most shocking are that OTS actually obscured the seriousness of thrifts’ financial problems, going so far as to allow banks to falsify financial results to mask poor performance (p. 1, 6, 10). In IndyMac’s case, despite the fact that several prominent measures of the bank’s financial health showed significant signs of trouble as of June 30, 2007, OTS failed to place IndyMac onto the FDIC’s list of troubled institutions until June 2008, just one month before the bank’s July failure! The report also cites a probe by the Treasury Department’s Inspector General that found that, “just two months before IndyMac’s collapse, [an] OTS official gave the thrift permission to falsify its financial statements, a move that allowed it to avoid increased regulatory oversight” (p. 6).

In WaMu’s case, the “reckless disregard” of OTS was even more egregious. WaMu was not placed on the federal government’s list of troubled banks until one week before the bank’s failure (p. 10)! This was despite the FDIC’s efforts in August 2008 to downgrade WaMu’s supervisory rating–a preliminary step clearing the way for WaMu to be placed on the list of problem banks–to which OTS responded that WaMu was stable and that OTS was working to correct the problem (p. 10).

CRL’s findings have since been largely corroborated by an Audit Report regarding IndyMac from the Office of the Inspector General at the Department of Treasury, released February 26, 2009, that was generally critical of OTS oversight of the thrift. The Report found that OTS did not take aggressive action to curb irresponsible lending practices despite many warning signs, and it alludes to the curious fact that IndyMac was not placed on the FDIC problem list until June 2008. In fact, the Report states, OTS should have taken enforcement action against IndyMac as early as 2005!

The Inspector General’s Audit Report generally recommends only that OTS senior leadership “reflect carefully on the supervision that was exercised over IndyMac and ensure that the correct lessons are taken away from this failure” (p. 34). CRL’s Report goes much further, recommending that OTS be eliminated entirely and its role subsumed under the Office of the Comptroller of the Currency (OCC).

CRL also recommends that “[m]arket incentives be aligned to ensure that no party can shirk responsibility for making responsible lending and investment decisions” (p. 23). The Report suggests that this be done by creating assignee liability–that is, by allowing borrowers to go after the trust holding their mortgages in a pool for the benefit of bondholders–when loan transactions are alleged to be illegal, abusive or harmful. While I completely agree that the re-alignment of incentives would go a long way toward preventing irresponsible lending by those with no skin in the game (see my prior post on market incentives), I don’t necessarily agree that assignee liability makes the most sense.

In fact, it is the loan originators and the sellers and sponsors of residential mortgage backed securities (RMBS) who are in the best position to know the facts and circumstances underlying any particular mortgage and the best position to prevent irresponsible lending (see my prior post on misguided protesters directing their anger at Bill Frey and Greenwich Financial’s lawsuit against Countrywide). However, it was these very parties who had nothing to lose by churning out as many loans as possible, because they could turn around and sell them to voracious investors, generating huge fees and passing off most of the risk of default. RMBS investors, and the trusts that represent them, already have every incentive to police these loans for unsound lending practices, because the quality of the loans directly impacts the loans’ default rate and thus the investors’ return on investment. Why they didn’t do so during the housing bubble is an open question, but lack of transparency, investors’ own greed and outright misrepresentations made by originators, sellers and sponsors certainly contributed.

When I raised this issue with Michael Hudson, author of The Second S&L Scandal, he made a number of fair points. First, he noted that, “[a] big part of this [is] that many thinly capitalized brokers and lenders can go out of business or file [for] bankruptcy (and reemerge under some other guise) when there’s an allegation of bad origination practices.” Therefore, it made more sense to go after the big players who purchased the loans and would stick around to face the music. Second, he pointed out that determining whether loans were being done right was not difficult, but that, “big players who were aggregating and bundling loans purposefully turned a blind eye to evidence that fraud and predatory lending was commonplace” (something I’ve seen repeatedly in my work in the subprime industry).

While these are great points, the solution as I see it is not to hold the ultimate trust and bondholders responsible, both because they play no direct role in making these fraudulent or abusive loans, and because they are not in the best position to detect or curb this practice. Instead, the “seller and sponsor” of a securitization–the investment bank that created the securitization, bought the loans, pooled them into a trust, and then marketed and sold them to investors–is the entity at the heart of the RMBS system and in the best position to fix it. These are not fly-by-night brokerages, but large Wall Street players with the most to gain (and lose
) from securitizations and the clout to change the way that loans are made. If securitizations going forward are structured such that the seller and sponsor bears the first loss or can be readily held liable if the loans in the pool are determined to be defective, I think we’ll see abusive lending and delinquency rates decrease across the board.

Just ask Bill Frey, whose firm, Greenwich Financial Services, helped to structure one of the first mortgage backed securitizations in Russia in 2006 (see press release here). He told me that he structured these deals so that the lender/servicer took the first loss, the investment bank took the second loss, and only then did the bondholders take any loss on their investment. It just so happens that with this moral hazard problem removed, these deals are performing far better than comparable deals in the United States. All of which reinforces the notion, echoed by Hudson in the CRL Report, that by re-aligning incentives, securitizations can still work as an effective vehicle for spreading risk without incentivizing irresponsible lending.

Posted in causes of the crisis, Center for Responsible Lending, Greenwich Financial Services, incentives, IndyMac, irresponsible lending, OTS, oversight, Russian MBS, sellers and sponsors, WaMu, William Frey | 1 Comment

Geithner Plan’s Use of Wall Street Firms to Value "Toxic" Securities No Panacea

Posted on April 3, 2009 by Isaac Gradman

Several commentators have recently praised Treasury Secretary Tim Geithner’s plan to use Wall Street firms to help value “toxic” assets, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), because it draws on these firms’ supposed expertise in valuing securities. For example, Richard Posner, on the Becker-Posner Blog, had this to say about the plan:

Although my guess is that the political factor is the major driver of Gaithner’s [sic] complex plan, the plan does have other advantages, so that on balance, despite
its higher transaction costs and likely longer delay in implementation, it may
conceivably be the superior approach quite apart from the political imperative.
It will simplify the banks’ balance sheets by removing assets of uncertain value
and replacing them with cash, and it will draw on private-sector expertise in
valuing assets and in negotiating transactions. The government could of course
hire a Wall Street firm to advise it on the purchase of assets from banks, but
both the carrot of profit and the stick of competition are likely to be stronger
motivators to efficient transacting, and this argues for making private firms
buyers rather than just advisers. [Note that this entry, posted by Posner on or about March 29, 2009, appears to have since been removed]

As an initial matter, the reason that these assets are being referred to as “toxic” is not because they “infect” other assets on banks’ balance sheets per se, but because they are so difficult to value that they cause uncertainty and financial paralysis. Yet, as I commented on the Posner post, the solution is not as simple as simply bringing in Wall Street banks or hedge funds to help value the securities, for several reasons.

First, it is not at all clear that these Wall Street players know how to properly conduct due diligence and re-underwrite the underlying mortgage loans to determine how many are likely to pay out and how many are likely to default. This is an extremely time-consuming and non-scientific process, and one that these same firms were manipulating during the housing boom (often under the cover of third-party due diligence firms) to make the securities appear less risky to investors. Who’s to say they’ve now learned how to properly value MBS and will do so in an entirely unbiased manner, especially when they would benefit as buyers from undervaluing these assets?

Second, whether or not the underlying mortgage loans will perform is highly contingent on the current legal and political battle over loan modifications. The most efficient solution to the valuation problem from a bondholder perspective would be to quickly foreclose on all defaulted loans, liquidate these assets, and move forward with only performing mortgages remaining in the securitization structure. However, there is immense political pressure in the current environment to help delinquent borrowers stay in their homes by performing loan modifications. As I’ve discussed in previous posts, Countrywide has settled lawsuits by dozens of state Attorneys General by agreeing to modify 400,000 loans by, for example, lowering monthly payments or interest rates. But because many of these loans have been securitized, Countrywide no longer owns them and acts only as servicer, and any reduction in monthly payments would be borne by the ultimate bondholders. Some bondholders have challenged the Countrywide settlement, alleging that it constitutes improper loss-shifting and violates the securitization agreements. Now, the U.S. House of Representatives has passed, and the Senate is considering, a Servicer Safe Harbor, which proposes to allow servicers such as Countrywide to ignore such contractual obligations (and even gives them a $1000 cash incentive for each loan they modify!). The outcome of this pending litigation and legislation will have a considerable impact on the value of these “toxic” assets, and presents additional uncertainty preventing their accurate valuation, by Wall Street or anyone else.

Posted in Countrywide, due diligence firms, hedge funds, legislation, loan modifications, re-underwriting, Richard Posner, Servicer Safe Harbor, Timothy Geithner, toxic assets, valuation, Wall St. | Leave a comment

New Century Debtors’ Complaints Against KPMG Now Available

Posted on April 3, 2009 by Isaac Gradman

The two complaints filed April 1 against KPMG, one against the U.S. arm of the Big Four accounting firm in federal court in Los Angeles and the other in federal court in New York against its parent, KPMG International, are embedded and linked below. Assuming these allegations are true, ask yourself, if you were a juror on either case, whether you would be convinced that KPMG’s irresponsible accounting could have been a direct and foreseeable cause of the collapse of New Century Financial. It strikes me that plaintiffs will not have an easy time justifying their request for $1 billion in damages.

KPMG Intl New York Complainthttp://d.scribd.com/ScribdViewer.swf?document_id=13927228&access_key=key-763ppwcpfyop1ovaqkd&page=1&version=1&viewMode=

KPMG California Complainthttp://d.scribd.com/ScribdViewer.swf?document_id=13927229&access_key=key-2elvfq1kb1g8tw5z00ec&page=1&version=1&viewMode=

Posted in accounting, bankruptcy, causes of the crisis, Complaints, damages, KPMG, lawsuits, loss causation, negligence and recklessness, New Century, subprime | Leave a comment

KPMG Sued for $1 Billion Over New Century Meltdown

Posted on April 2, 2009 by Isaac Gradman

Two separate lawsuits were filed yesterday against Netherlands-based Big Four accounting giant, KPMG International, and its U.S. subsidiary, KPMG LLP, alleging that KPMG conducted “reckless and grossly negligent audits” that contributed to the collapse of top subprime lender New Century Financial in April 2007. If successful, these actions would mark the first time a Big Four accounting firm is held legally liable for the actions of its U.S. subsidiary.

According to the New York Times’ Deal Book Blog, the lawsuits were filed on behalf of a liquidating trust formed by New Century Debtors, and alleges that “KPMG failed in its public watchdog duty” and helped cover up “catastrophic” problems at New Century. New Century was the first major subprime lender to file for bankruptcy as a result of the housing downturn nearly two years ago, and is largely credited with triggering a wave of additional bankruptcies that turned the subprime mortgage crisis into a full-scale global credit crisis. At its peak, New Century was the second-largest subprime lender in the United States.

The two lawsuits, one filed in federal court in New York and the other in federal court in Los Angeles, target the parent company and the U.S. arm of KPMG separately. However, their allegations largely overlap. Though he hadn’t seen the complaints, KPMG spokesman Dan Ginsburg issued a statement saying:

KPMG acted in accordance with professional standards in New Century, and we will vigorously defend our audit work. Any implication that the collapse of New Century was related to accounting issues largely ignores the reality of the global credit crisis. This was a business failure, not an accounting issue.

However, the lawsuits cite emails that allegedly show that specialists within KPMG tried to point out errors in New Century’s financial statements but, as we have seen so often in the shakeout from this crisis, higher-ups in the company silenced these objections in an attempt to protect business relationships. And while it is almost certainly true that, had KPMG spoken out about these errors, New Century would have found itself a new auditor that would have gone along with its shenanigans, that loss of business would have been orders of magnitude smaller than the liability KPMG faces in these actions. If KPMG is held liable, it will mean that major financial players will no longer be able to hide behind “group-think” and an “everyone else is doing it” justification to blindly pursue financial gain, whatever the cost to others. And ultimately, realigning incentives so that actors do the “right” thing is one of the most important functions of the law.

Posted in accounting, auditing, bankruptcy, causes of the crisis, incentives, KPMG, lawsuits, loss causation, negligence and recklessness, New Century | Leave a comment