My Take On Newly Filed AG Foreclosure Settlement: As Bad As We Thought It Was

Posted on March 12, 2012 by igradman

“They are who we THOUGHT they were — and we let ’em off the hook!”

This famous postgame rant from former Arizona Cardinals coach Denny Green after his team’s epic meltdown on Monday Night Football against the Bears could just as easily apply to my reaction to reading the official terms of the Attorney General Foreclosure Settlement (the “AGFS”), filed today.  The nation’s largest banks get off with a relatively small penalty (much of it paid by investors or in “credits” for things the banks should already be doing) in return for releases across a broad spectrum of misconduct that pervades just about every dark corner of mortgage servicing.  The categories of servicer misconduct are laid out in detail in the complaint filed today in D.C. Federal Court, and include the following:

  • Providing false or misleading information to borrowers,
  • Overcharging borrowers and investors for services of dubious value,
  • Denying relief to eligible borrowers,
  • Foreclosing on borrowers who were pursuing loan mods in good faith,
  • Submitting forged or fraudulent documents and making false statements in foreclosure and bankruptcy proceedings
  • Losing or destroying promissory notes and deeds of trust,
  • Lying to borrowers about the reasons for denying their loan mods,
  • Signing affidavits without personal knowledge and under false identities,
  • Improperly charging excessive fees related to foreclosures,
  • Foreclosing on servicemembers on active duty,
  • Making false claims to the government for insurance coverage, and
  • Being unorganized, understaffed, and generally slower than molasses to respond to borrowers desperately in need of relief, while servicing fees continue to accrue.

The list goes on and on, but I can sum it up in one phrase, from the Honor Code of University of Virginia: lying, cheating and stealing.  Such conduct would have broken every tenet of my alma mater’s Honor Code. There, we had a strict no-tolerance policy and a single sanction – violating any tenet of the Code resulted in automatic expulsion.

But what’s the result when lying, cheating and stealing is perpetuated on the largest scale imaginable, by five of the largest banks in the country, thereby exacerbating the worst financial crisis since the Great Depression?  A broad release of liability, no admission of guilt, and a monetary settlement that pales in comparison to the size of the problem, even if it were paid in full by the banks themselves (which it will not be, as we’ll get into in a moment).

Ally, BofA, Wells Fargo, Citigroup and Chase get to continue on with their business (Ally’s purportedly received a discount so that it would have the means to pay), having agreed to process reforms that they generally should have already had in place, and only 5% of the nation’s 10 million underwater borrowers have even the faintest prospect of relief.  What’s that you say, Denny? “WE LET ‘EM OFF THE HOOK!”

The Nitty Gritty

So, we now have confirmation about the actual terms of the monetary penalties and how they’ll be credited (conveniently summarized in Exhibits D & D1 of the Consent Judgments, or starting on p. 170 of the J.P. Morgan Chase Judgment, which I’ll use as a reference throughout).  Frankly, there are few surprises here, as most of the key details have already been made public.

Of the $25 billion announced value of the settlement, only $5 billion will be paid in cash to state and federal regulators as penalties for the alleged misconduct.  Another $3 billion will be paid in refinancing packages to lower borrowers’ interest rates.  The bulk of the settlement – $17 billion – will be “paid” with credits that banks receive for engaging in various types of homeowner assistance.

The first problem is that, as the Wall Street Journal recently noted, the actual amount of loan forgiveness isn’t large relative to the problem of underwater debt.  The WSJ attributes to Ted Gayer, co-director of economic studies at the Brookings Institution, the estimate that the settlement’s complex set of requirements mean that about 500,000 borrowers, or 5% of those who are underwater, may be eligible for help.  Let me repeat that so it sinks in – if you are one of this nation’s 10 million underwater borrowers, you have only a 1 in 20 chance of getting any semblance of relief.

The second problem is that the banks have a right to “earn” credits towards that $17 billion bill by modifying loans held by investors.  For every $1 of loans modified from securitized portfolios (i.e. loans in mortgage backed securities trusts), banks will get $0.45 of credit.  Keep in mind, the defendant banks no longer have any ownership interests in these loans, they merely get paid a fee by the owners to protect their investments.  And these owners typically have contracts that prevent the unauthorized modification of loans they own.

Now, regulators clearly intended this reduced credit to incentivize banks to modify more loans on their own books, for which they get a full $1 of credit for principal reductions for the portion of principal below a 175% loan-to-value (“LTV”) ratio.  But when you actually think about how these incentives will play out, it quickly becomes apparent that they will lead to unintended conequences.

Let’s say Brutus, the school bully, has been stealing kids’ lunch money for a few years.  When he’s finally caught, the principal, who knows Brutus has stolen at least $20, says, “Ok, Brutus, your penalty for these crimes is to give $1 back to the poor kids of this school.  You can either pay that $1 out of your own pocket, or go and steal the money from others and give it to the kids.  But, you’ll actually have to steal $2.22 from others and give it to the kids you bullied to satisfy your $1 punishment.”

Now, Brutus has been stealing money for years, and has developed a plethora of clever ways to do so.  And even if he might have had some fear of running afoul of authority, the principal has essentially condoned the act of paying the fine with someone else’s money.

What do you think Brutus will do?  What would you do?  It would be one thing if banks shared in the cost of modifying a loan in securitization, and the credit was proportionate to the cost they paid.  But aside from transaction costs, banks absorb not one cent of a reduction of principal or interest on a loan held by investors.  Thus, by giving banks the opportunity to pay their settlement amount with investors’ money, regulators may be encouraging banks to modify twice as many loans, but they are also encouraging banks to impose the costs of those loan mods on the investors who had absolutely nothing to do with these servicing atrocities.

Investors have said as much in initial responses to the AGFS, including this response from the Association of Mortgage Investors, as quoted by Bloomberg:

It is unfair to settle claims against the robosigners with other people’s funds… While we request that it not be done, at a minimum we request that a meaningful cap be placed on the dollar amount of the settlement satisfied by innocent parties. Restitution should come from those who are settling these claims, and lien priority must be respected.

Ah yes, and then there’s the topic of lien priority.  Recall that second liens, which are overwhelmingly owned by the banks and held on their balance sheets at close to par, are subordinate to first liens and should be wiped out if the first lien is modified.  Under the terms of the AGFS, seconds are only to be written off completely if they’re over 180 days delinquent – meaning the borrower hasn’t made a payment in 6 months and should probably be written off, anyway (servicers get $0.10 of credit for writing these nearly worthless loans off, by the way).

If the loans are less than 180 days delinquent, they will be written down a minimum of 30% of the unpaid principal balance or to 115% LTV, whichever results in less forgiveness, consistent with the oh-so-successful HAMP Second Lien Modification Program.  In other words, rather than respecting lien priority, the AGFS resorts to the tired mantra of proportionate write-downs for subordinated second lien loans.  This may be the biggest backdoor bailout in the entire settlement, as banks own $400 billion worth of these junior liens.

The Process Reforms

You’ll hear a lot of supporters of the AGFS tout in the media the process reforms to which servicers have agreed as a major success of the settlement.  While it is true that many reforms will be put in place by way of this settlement that are necessary and will improve servicing, most of them are simple mandates that banks should have already been following.  I won’t linger on this point for long, but I think it makes sense to point out some of the agreed “process reforms,” just to understand the consideration that taxpayers, homeowners and state and federal governments are receiving in exchange for granting the banks broad releases of liability (discussed next).  These reforms may be found starting at Exhibit A (page 93 of the Chase Consent Judgment), and include:

  • Servicers will ensure that factual assertions made to courts and borrowers are true,
  • Servicers will ensure that people signing affidavits actually have personal knowledge of the facts to which they’re attesting,
  • Servicers will ensure that affidavits properly identify the name and title of the affiant,
  • Servicers will comply with state and federal law,
  • Servicers will ensure they have a documented interest in the mortgage loan and note before foreclosing,
  • Before servicers submit lost note affidavits, they must make a good faith effort to look for the note,
  • Servicers will not intentionally lose or destroy notes (!), and
  • Servicers will only charge default service fees for reasonable and appropriate services that are actually rendered.

Again, while some reforms called for in this section are steps in the right direction – elimination of dual tracking, single points of contact, and additional borrower disclosures, for example – the fact that the AGs had to include the above in the list of reforms speaks volumes to how far mortgage servicing has careened off the track.

The Release

We now have the language of the actual release, which the banks have been given in return for the penalties and reforms discussed above.  As expected, the release is fairly broad in the arena of servicing activities, releasing essentially any claim that any regulator may have based on mortgage servicing, loss mitigation, collection or accounting of borrower payments, or foreclosure or bankruptcy practices.  In other words, this is the last we’ll see of any government agency digging into the who, what, where, when and how of robosigning and forged affidavits.

However, to give credit where credit is due, the release does not appear to encompass the vast majority of claims based on the origination, purchase, securitization, transfer or sale to investors of mortgage loans, nor does it release the actions of securitization trustees.  The state releases very clearly spell out that they will not apply to origination or securitization activity, while the federal releases state that they’ll apply to all origination or securitization activity except for certain exemptions (which include most of the origination or securitization issues that may engender liability for the banks).  Either way, regulators appear to have done a good job of only releasing activity covered by their allegations and investigations (what little there were), and nothing more.

But here’s the rub.  In the face of the litany of charges brought against them, the banks are not forced to admit to any wrongdoing.  The language in the Federal Release (p. 231 – Chase Consent Judgment) makes this explicit:

This Release is neither an admission of liability of the allegations of the Complaint or in cases settled pursuant to this Consent Judgment, nor a concession by the United States that its claims are not well-founded.

The state release is not so explicit, but conspicuously absent is any language by the bank admitting to fault, mistake or wrongdoing.

In fact, this glaring omission may be the best source of leverage for investors and others seeking to challenge the propriety of the settlement.  Ever since Judge Rakoff issued his scathing order rejecting the SEC’s proposed settlement with Citigroup, judges have been more conscious about rubber stamping government settlements where there is no admission of wrongdoing by the defendant and few details provided supporting the allegations.  I would imagine that the federal judge assigned to oversee this case will have to contend with the same sort of misgivings – that he or she is being asked to enforce a $25 billion settlement in which the defendants have made no admissions of wrongdoing and the government has provided few specific details that would support their allegations.

Perhaps objectors can seize on Rakoff Fever to hold up the settlement in return for stiffer fines, admissions of guilt or caps on the amount of the penalty that should be born by innocent third parties.  Now that we know these servicers are who we thought they were, maybe there’s still time to keep our elected and appointed officials from letting ’em off the hook.

Posted in allocation of loss, Ally Bank, Attorneys General, bailout, bankruptcy, banks, Bloomberg, BofA, broader credit crisis, chain of title, Citigroup, Complaints, contract rights, costs of the crisis, damages, foreclosure crisis, global settlement, Government bailout, homeowner relief, Hope For Homeowners, impact of the crisis, improper documentation, incentives, interest rates, investigations, investors, JPMorgan, Judge Jed Rakoff, judicial momentum, junior liens, lawsuits, liabilities, litigation, loan modifications, loss causation, LTV, MBS, misrespresentation, mortgage fraud, negative equity, oversight, Regulators, Residential Capital, RMBS, robo-signers, SEC, securities, securitization, servicer defaults, servicers, settlements, stipulated judgments, waiver of rights to sue | 7 Comments

Why Mortgage Loan Servicers Behave as They Do

Posted on March 5, 2012 by igradman

Editor’s Note: It seems that we can’t go three months without hearing about yet another species of misconduct by mortgage servicers that shifts losses onto the lienholders they are supposed to protect.  We’ve read reports about force-placed insurance, inflated appraisal and maintenance fees, robosigning and other foreclosure irregularities, interference with loan mods and short sales due to second lien holdings, and, most recently, reports of the ongoing collection of fees by servicers for loans that have already been liquidated.  Why do we seem to be facing a near-constant stream of news stories about mortgage servicers behaving badly?  It turns out that this problem is nothing new, and traces back to a fundamental issue that we discuss at length in Way Too Big to Fail – misalignment of incentives.  In this revealing guest post, former insider Steve Ruterman draws on his experiences to illustrate the roots of this fundamental problem. – IMG

By Steve Ruterman, guest blogger

The Principal – Agent Problem: Part I – RMBS Data Integrity

Back near the dawn of time when I was in business school, and the faculty was hard-pressed to find topics to fill up the curriculum, they introduced the Principal – Agent Problem.  As future corporate managers and agents of the stockholders, I suppose they wanted to explain to us that our economic interests were not identical to those of the owners.  This wasn’t exactly the most shocking news we had ever received, but that was all that was said about the issue, back then.

Of course, there is considerably more to this multi-faceted problem. According to Wikipedia, “The principal–agent problem arises when a principal compensates an agent for performing certain acts that are useful to the principal and costly to the agent, and where there are elements of the performance that are costly to observe,” primarily due to asymmetric information, uncertainty and risk.

Let’s look at the relationship between the RMBS bondholder (principal) and the mortgage loan servicer (agent) in this context.  The bondholder relies completely on the servicer to collect principal and interest each month, remit cash collections to the trust, report monthly collateral performance data accurately, send out monthly bills to borrowers, encourage borrowers to pay on time, persuade them to catch up if they fall behind, and foreclose and sell the underlying property if all else fails.  For these services the bondholder pays the servicer a fee which is a flat percentage of the aggregate unpaid balances of the loans owned by the trust.

Like all businesses, the goal of a servicer is to maximize its profits from the flat fee which is its revenue.  The main route to this goal is to minimize its expenses, of which labor comprises approximately 80%.

The owner of the servicer has its own subset of Principal – Agent issues with respect to its employees.  The incentives it provides its employees add several layers of complexity to the bondholder – servicer relationship.  In this first part, I am going to discuss the effects of Principal – Agent and Owner – Employee relationships on the integrity of the data reported to the bondholder each month, using examples from my past experiences.

By 2001, MBIA, my former employer had about $3 billion of exposure to ten manufactured housing (“MH”) loan pools serviced by an affiliate of the bond issuer.  We’ll call it MH Servicer I. In January 2002, MH Servicer I’s parent, had concluded from the rapidly increasing delinquency levels in the MH loan pools that it wanted to be out of the MH financing business. They present-valued MH Servicer I’s assets and liabilities over their remaining 25- to 30-year lives, and carried the net asset value as the residual value of the now discontinued business.

The parent had a problem to solve.  How could it retain the management of MH Servicer I over an extended period of time, and how could it motivate the servicer to increase the value of a large run-off pool of badly performing MH loans?  The solution was reasonably simple: the management team was awarded above-market base salaries, together with incentive compensation which paid them attractive bonuses if they could increase MH Servicer I’s residual value.  If the residual value went up each year, they stood to make a lot of money.

Calculation of the residual value each quarter was performed by an outside vendor, and the methodology was based on delinquency trends.  If delinquency went down, the value went up.  Because MBIA was at risk if principal and interest collections of the ten trusts were inadequate to pay bondholders, we were delighted to see the elevated delinquency levels go down in 2002.  We were happy, that is, until we found out why they were going down.

During a visit to MH Servicer I’s main collection site, I noticed a white message board which was posted with following two suggestions to the collections staff:

  • Ask for the payment in full.
  • If you can’t get it, offer an extension.

“What’s an extension?” I asked.

“Oh, if a borrower is 90 days past due, offer to extend the next due date by, say, 60 days,” responded a member of MH Servicer I’s staff.

“How is the resulting delinquency reported?”

“Extended borrowers are reported as current until they miss their next payment on the next due date.”

Extensions certainly brought reported delinquency down, while MH Servicer I’s residual value and management’s incentive compensation went up.  Extensions also increased the amount of the trust’s non-earning assets without reducing the par value of the trust’s liabilities.  This dynamic crushed the credit enhancement of each deal in accelerated fashion, and rendered delinquency reporting useless from an analytic perspective.

We had another $600 million of MH exposure coming from 11 trusts involved in the 2003 bankruptcy of another MH servicer we’ll call MH Servicer II.  In this case, the delinquency situation was the reverse of the MH Servicer I story.  These trusts issued bonds which were 3- to 5-years old at the time of the filing.  Despite a vintage profile similar to the MH Servicer I trusts, the Conseco trusts consistently reported 30+ day delinquency in the 3% range.  At least they did so until the month after the bankruptcy filing.

From that point on, delinquency increased each month for over a year, ultimately reaching peaks in the 18% range.  I was not privy to the incentive compensation plans provided to MH Servicer II’s management and employees, but it is easy to infer that reported delinquency trends were somehow suppressed (i.e., held down) for several years.  Once the bankruptcy filing occurred, delinquency increased to MH Servicer I levels and beyond, until a new management team came on board and began to exert control over the loan pools beginning in late 2003.

The point of these two examples is to illustrate how the Principal – Agent Problem, or its subset, the Owner – Employee Problem, can destroy the integrity of reported collateral performance data over extended periods of time.

The Principal – Agent Problem: Part II – Asymmetric Information

In this second part, I’m going to discuss a different facet of the Principal – Agent problem: asymmetry of information.  It is difficult to imagine a business relationship which features greater information asymmetry than that of an RMBS bond investor (owner) and the mortgage loan servicer (agent).  In this case, the servicer is in a position to know everything there is to know about each individual loan in the loan pool and its past and expected future performance. The bondholder gets a monthly remittance report from the servicer via the trustee (another problem for another day), and, in some cases, historical loan level data about loan attributes and payment status from the servicer’s website.  If he wants anything over and beyond these basics, he has to buy it from third party vendors (e.g., Intex, Bloomberg, CoreLogic, Lewtan).

At the end of the last subprime crisis (circa 1999 – 2001) MBIA found itself doing business with several new replacement servicers.  We had to find new replacement servicers in a hurry because the original servicers were affiliates of the subprime issuers. Each of these issuers was in bankruptcy and ultimately in liquidation.  The issuers included ContiMortgage, Delta Funding, First Alliance, Southern Pacific Mortgage and American Business Financial Services.  Our new servicers included Litton Loan Servicing, Ocwen Financial Services and Fairbanks.

Before getting into the details of various asymmetric situations, a brief discussion of servicer advances is required.  Servicers are generally required by the Pooling and Servicing Agreements (“PSAs”) to advance to the trust delinquent principal and interest payments due from but not paid this month by obligors.  The servicer is obliged to continue advancing until he deems that the unpaid note balance plus the cumulative advances will exceed the net liquidation value of the underlying property.  When the property is liquidated, the servicer is first in line for reimbursement.  If the liquidation proceeds do not cover its advances, the servicer then has access to all funds collected by the entire trust in order to recover its “non-recoverable” advances.  In this way, the servicer is not at risk of non-payment for its advances.

For its part, the trust receives the servicer advances and applies them to the monthly cash distribution waterfall.  However, the trust does not recognize any new liability or note payable to the servicer, and remittance reports often do not report monthly advances and reimbursements.

In 2002, during a routine visit to subprime servicer Fairbanks (now Select Portfolio Servicing), we asked about an amount being billed to a borrower.  We were told that it was for interest on a servicer advance.  The following exchange ensued.

MBIA: “You can’t charge borrowers (or anyone else) interest on servicer advances.”

Fairbanks: “Where does the PSA say that we can’t?”

While Fairbanks had a point, and the relevant PSAs were silent on interest on advances, they were also silent on the general topic of imposing new costs on borrowers who were having difficulty meeting their monthly mortgage obligations in the first place.  It hadn’t occurred to anyone that servicers might pursue various means of parasitizing borrowers and trusts to the direct detriment of RMBS investors.

In 2003 Fairbanks paid the FTC and HUD $40 million to settle charges that it had engaged in “unfair, deceptive, and illegal practices in the servicing of subprime mortgage loans.”  Clearly, Fairbanks employees believed they would be rewarded for thinking up new revenue generating ideas, and they certainly showed great ingenuity in these endeavors.

Years later, as MBIA’s insured subprime loan pools liquidated down to relatively small numbers of remaining loans, another anomaly began to show up in the remittance reports.  In some cases, trusts began to report negative principal collections on a monthly basis.  It is certainly possible that an older trust supported by a small number of (possibly delinquent) loans might have zero principal collections, but how could collections equal some negative number?

In 2008, this was the question MBIA had regarding the subprime servicer reporting the negative collections.  Under what circumstances could a trust experience a negative principal collection amount?  Several tortuous weeks later, the answer was finally extracted.  The subprime servicer was modifying loans in the following fashion:

  1. First, it found a delinquent borrower willing to sign a new note with a larger unpaid principal balance and a significantly lower interest rate so that the monthly payment would decrease at least a little.
  2. The amount of the increase in the note balance was equal to the servicer’s cumulative servicer advances to date.
  3. Because this transaction had the effect of transferring the servicer’s unsecured loan balance to the trust, the servicer advances to the borrower became “non-recoverable”, and the servicer could be reimbursed in the month of the loan modification from the top of the collections waterfall – that is, from all principal collected that month by the trust from all obligors. In this way, the servicer didn’t have to wait until the loan liquidated for reimbursement of its advances.

This particular servicer was the replacement servicer for several subprime deals insured by MBIA.  Some of the related PSAs required the servicer to obtain MBIA’s consent to the modification of any loan in the affected trust.  As a result, I noted that approximately two thirds of the borrowers I reviewed for modification consent purposes had negative equity 10 years or more after loan origination, and before the addition of the servicer advances to the modified note balance.

These experiences with servicers have led me to believe that the current mortgage market meltdown, documentation deficiencies, robosigning and related foreclosure problems all stem from the same cause:  the collapse of any regime of internal controls at some mortgage originators, sellers and servicers resulting from a misalignment of incentives.  Once the loan underwriter sells all of its originations, and expects to do so in the future, it concludes that it can do without the internal control provided by things like underwriting guidelines.  In fact, it finds that it can dispense with all of its former internal controls, which only cost it money.

Once all internal controls are dispensed with, management and employees pursue the incentives given them by the owners, and you get the fiasco in the mortgage markets we are living with today.

Steve Ruterman is an independent consultant to institutions and institutional investors with significant RMBS exposures and a fan of The Subprime Shakeout.  He recently retired after a 14 year career with MBIA Insurance Corporation, during which he transferred over 20 mortgage loan pools to new servicers.  Mr. Ruterman welcomes your comments, and can be reached by email at Steve.Ruterman@yahoo.com.

Posted in accounting fraud, allocation of loss, appraisals, auditing, banks, broader credit crisis, causes of the crisis, conflicts of interest, contract rights, costs of the crisis, firing servicers, foreclosure crisis, improper documentation, incentives, investigations, junior liens, lending guidelines, loan modifications, MBIA, MBS, monolines, mortgage fraud, private label MBS, RMBS, robo-signers, securitization, servicer defaults, servicers, settlements, subprime, underwriting guidelines, underwriting practices, Way Too Big to Fail | 4 Comments

BREAKING: BoNY-BofA Settlement to Return to State Court After Second Circuit Reverses Pauley

Posted on February 27, 2012 by igradman

Some rare good news for Bank of America: the Second Circuit just reversed the ruling of District Court Judge William Pauley in the highly-publicized $8.5 billion settlement between BofA, Bank of New York (BoNY), and Kathy Patrick’s institutional investors over mortgage putbacks; meaning the case will be sent back to state court to be tried as an Article 77 proceeding, rather than a class action.  In doing so, the Court of Appeals held that the “securities exception” to the Class Action Fairness Act (CAFA) applied, because the case related solely to the rights and duties created by or pursuant to a security.  This means BofA will have to weather only limited scrutiny of its proposed settlement and benefit from a much more deferential standard of review (“abuse of discretion” versus “entire fairness”)

In speaking to folks last week who attended the hearing before the Second Circuit on Feb. 15, it was clear that the three-judge panel was uncomfortable with the idea of this case remaining in federal court.  Originally filed in state court under Article 77, the case had been removed by intervenor Walnut Place to federal court, as the aggrieved bondholder had argued that the case was more akin to a federal mass action and should be treated as such, including allowing dissatisfied bondholders to opt out.  Judge Pauley in the Southern District of New York agreed, holding that this was the very type of case that Congress had directed be tried in federal court under CAFA.

However, rather than reversing Pauley on the threshold hurdles to CAFA jurisdiction, such as its requirements that the case be about monetary relief, have more than 100 plaintiffs, and involve common issues of law and fact; the Second Circuit relied solely on the securities exception to CAFA to support its decision.  In this regard, it found that, having first characterized the Trustee’s claim as seeking a “declaration authorizing the exercise of a trustee’s powers,” the Trustee’s claim thus related solely to “the rights, duties (including fiduciary duties), and obligations relating to or created by or pursuant to any security. 28 U.S.C. § 1453(d)(3).” (Opinion at 23-24)

What’s novel about this finding is that prior Second Circuit holdings, such as Greenwich Financial v. Countrywide,  indicated that the securities exception only applied to claims relating to the rights of Certificate holders as holders.  The mere fact that a claim involved a security was not enough – it had to be a claim by the holder of the security to enforce the duties or rights created by or pursuant to the security.  This latest decision extends that holding to trustees of a security acting as trustees – something that likely was not contemplated by Congress when passing CAFA, or even by the Second Circuit when issuing its prior holdings.

Regardless of the propriety of this decision, and barring a Hail Mary appeal to the Supreme Court by Walnut Place, it’s clear that this decision is a big win for Bank of America and other institutions with large exposure to legacy private label mortgage issuance.  State court provides a much more favorable forum to the banks, as previously discussed, as it ensures that Article 77’s shortened procedures and deferential standard of review will be applied.  New York Supreme Court Judge Barbara Kapnick will still have her hands full determining how to deal with the impressive slate of intervenors opposed to the settlement, including the New York Attorney General Schneiderman, when ruling on the scope and timing of discovery.  But BoNY and BofA can rest assured that any decision approving the settlement will ultimately bind all bondholders in the affected trusts.

This ruling will also mean that other issuers will likely try to emulate the structure of this deal in reaching global settlements with friendly bondholder groups and trustees, in an effort to rid themselves of RMBS overhang. The challenge for bondholders wishing to avoid this result is to press as loudly and publicly as possible to be included in negotiations, so they can create a record of having been shut out of settlement talks.  On the flip side, the challenge for other issuers will be to create a process that appears to solicit, or at least allow, other bondholder opinions on the deal, while still reaching a settlement dollar figure that is relatively low compared to what bondholders could recover through aggressive court proceedings.

Regardless, this challenge is small compared to the challenge that BofA would have faced if the case remained in federal court, so there is certainly cause for celebration in Charlotte today.

The full Second Circuit Opinion may be accessed here.

Posted in appeals, Attorneys General, Bank of New York, banks, BofA, bondholder actions, CAFA, class actions, contract rights, discovery, fiduciary duties, global settlement, investors, Judicial Opinions, jurisdiction, lawsuits, liabilities, litigation, MBS, pooling agreements, private label MBS, procedural hurdles, putbacks, remand, removability, rep and warranty, repurchase, RMBS, securities, securitization, settlements, Trustees | 3 Comments

The Inside Story on PIMCO’s Defection from ASF

Posted on February 23, 2012 by igradman

ASF Executive Director, Tom Deutsch

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.

Posted in allocation of loss, ASF, Attorneys General, banks, Bloomberg, conflicts of interest, contract rights, global settlement, incentives, investors, junior liens, loan modifications, lobbying, mark-to-market accounting, MBS, PIMCO, pooling agreements, private label MBS, securitization, servicers, The Subprime Shakeout, Way Too Big to Fail, William Frey | 1 Comment

Is Foreclosure Settlement Déjà Vu All Over Again?

Posted on February 9, 2012 by igradman

Today, the Attorneys General of 49 states (with Oklahoma being the lone holdout) announced a record $26 billion settlement with the nation’s five largest servicers over false and fraudulent foreclosure practices like robosigning.  That big number looks great on paper, but I’ve seen far too much during my time covering MBS developments to trust in optics alone.

As expected, when I dig into the details of this settlement, I realize that only $5 billion of the total consists of cash payments, while another $17-20 billion consists of principal write-downs and other aid to homeowners at risk of default. What this means is that, once again, regulators have allowed banks to shift penalties based on their improper servicing practices onto the bondholders that actually own the loans.  As Yogi Berra famously said, “it’s like déjà vu all over again,” only this time, the regulators should have known better.

To understand why, let’s flash back to 2008, the last time we saw a massive, multi-state settlement sponsored by the AGs.  Back then, the target was Countrywide, and the lender was being sued from all sides by AGs over predatory lending practices.  The proposed solution back then, as it has been in every regulatory effort to solve the housing crisis to date, was widespread loan modifications (this is why you’ll notice that the cover of Way Too Big to Fail features Uncle Sam futilely swinging a hammer labeled “Loan Mods” at the problems that keep popping up in a game of Mortgage Crisis Whack-a-Mole).

With great fanfare, the AGs announced in October 2008 that they had reached an $8.6 billion settlement with Countrywide, in which Countrywide would modify 400,000 loans.  What I soon realized was that this would not be a cash payment of $8.6 billion — instead, most of that figure consisted of, you guessed it, principal writedowns and other loan modification “credits.”  The only problem was that 88% of the mortgages that Countrywide had agreed to modify were no longer owned by Countrywide, meaning that the bulk of the costs of this settlement would be born by others.

The settlement resulted in a lawsuit by Greenwich Financial Services on behalf of unnamed bondholders that essentially said, “hey, we actually have contracts with Countrywide that say they can’t modify loans willy-nilly and take money our of our pockets without compensating us.”  The lawsuit put Greenwich CEO Bill Frey in a position to be a spokesperson for aggrieved bondholders, thrusting him into the spotlight and the crosshairs of controversy.  The banks’ response was to begin a massive lobbying effort that led to the passage of the Servicer Safe Harbor in 2009 – a provision that in its original form said that banks could ignore its contracts with investors in the interests of public policy.  Only the Senate’s fears that such a law would run afoul of the Takings Clause of the 5th Amendment (I wrote a feature-length article on this issue), and a last-minute lobbying effort by bondholders, led to the provision being severely watered-down before it passed in its final form.

The question I asked at the time, along with several other astute commentators in the media, was whether the AGs had purposefully bailed out the banks by allowing them to pass costs onto investors, or whether they had been played by a more sophisticated counterparty.  I guessed that it was the latter – the AGs simply didn’t understand that most of these loans were in securitizations, and that the banks that had originated them and still serviced them, didn’t actually own them any longer.

But, what’s their excuse now?  Enough has been written about this issue in the 4 years since the last settlement, and enough trips have been taken to Washington and state capitols by bondholder advocates, that our elected officials should be reasonably knowledgeable about mortgage securitization and the transfer of ownership that took place.   They should understand that the bank that services a mortgage, and has the power to reduce the principal balance or otherwise modify the mortgage, may not actually own it or bear the cost of this modification.  And yet, we see the same strategy being implemented today to solve the housing crisis that was being attempted back in 2008 – yell at the banks about poor practices while bailing them out with a back-door loss shifting strategy, give a small amount of money to underwater homeowners in the form of loan mods, and ignore the fact that our pension funds, college endowments and life insurance investments are being looted in the process (note that homeowners haven’t even received the benefit of many of these bargains, as servicers have been reluctant to actually go through with loan mods due to uncertainty regarding their contractual rights to do so).

This doesn’t even get into the other 800 lb gorilla lurking in the corner of room — the $400 billion of second lien loans held by the biggest four servicers on their books.  These loans are being kept at close to par on banks balance sheets despite being worth a fraction of that because they sit behind underwater first liens in  priority.  Though the terms of this settlement are still emerging, I would bet dollars to donuts that 2nd liens are being handled as they’ve always been by regulators — they’ll be modified in pari passu or “on equal footing” with first liens, which essentially disregards their contractual standing as subordinate to first liens (that is, seconds should be wiped out if a first lien modification becomes necessary).

To someone who has been writing for four years about the dire consequences of this type of loss shifting and contract trampling — including a loss of confidence in the financial markets and the rule of law that will discourage desperately-needed private capital from returning to the mortgage market — it’s incredibly disappointing that this message has apparently fallen on deaf ears. If this crisis is to be resolved, it must be resolved in a way that honors contracts and restores investor confidence, or the housing market will never recover.

The one silver lining in this otherwise grey cloud of an announcement is the fact that the settlement does not release any claims that regulators or private parties may have surrounding the origination or securitization of mortgage loans.  Thus, there remains some hope that by aggressively pursuing remedial action against the banks for the way in which they created and sold mortgage backed securities in the first place, regulators (the Mortgage Fraud Task Force, for example) could create a resolution framework that would disincentivize future fraud and irresponsible lending while sending a clear message to bondholders, insurers and homeowners that contracts and the rule of law still mean something in this country.

Based on what I’ve seen thus far, I’m not holding my breath.  Returning to the always-appropriate Yogi quotes, we may have “made too many wrong mistakes,” to dig ourselves out now.

Posted in allocation of loss, Attorneys General, bailout, banks, BofA, consitutionality, contract rights, costs of the crisis, Countrywide, education, foreclosure crisis, global settlement, Government bailout, Greenwich Financial Services, Helping Families Save Homes, homeowner relief, improper documentation, incentives, investigations, investors, irresponsible lending, junior liens, lenders, liabilities, loan modifications, lobbying, MBS, media coverage, moral hazard, mortgage market, predatory lending, press, private label MBS, probes, public perceptions, Regulators, RMBS, robo-signers, securitization, Servicer Safe Harbor, servicers, settlements, sophistication, subprime, Takings Clause, The Subprime Shakeout, Way Too Big to Fail, William Frey, workouts | 13 Comments