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

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.

Treasury Official Speaks Out About Excessive Risk Taking

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.

Countrywide Files Motion to Dismiss in Greenwich Financial Case

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.

U.S. Regulators Chastise Banks on Loan Modifications; Political Tide May Be Turning on Home Loan Servicers

Servicers of home loans have thus far enjoyed preferential treatment by regulators in the shakeout from the recent financial crisis, but that may all be changing.

On August 13, U.S regulators issued a joint statement to residential mortgage servicers warning them that "[a] servicer's decision to modify the first lien mortgage should not be influenced by the potential impact of the modification on the subordinate loan and vice versa." The statement was issued by the Federal Financial Institutions Council, an interagency group that includes the Fed, the FDIC and the Office of the Comptroller of the Currency, among others. The regulators further noted that entities servicing both first and second loans on the same property "may be faced with potential conflicts of interest when making loan modification decisions," and that the failure to modify loans in cases that would produce a greater anticipated recovery for owners and investors, "may be a breach of the servicers' obligation to those owners/investors."

Until recently, it appeared that residential mortgage servicers--often the very same banks that had issued the loans that borrowers are now unable to afford--were the favored sons of this nation's regulators. First, Bank of America/Countrywide was allowed by state Attorneys General to saddle investors with the lion's share of an $8.4 billion settlement stemming from its irresponsible lending practices. Then, servicers were given a Safe Harbor and cash incentives to clean up their problematic loans when Congress passed the Helping Families Save Their Homes Act back in May of this year.

However, a letter issued by congressmen Christopher Dodd and Barney Frank on July 10 signaled a shift in the way regulators viewed home loan servicers. This letter, which was sent to the Fed, the FDIC and the Office of the Comptroller of the Currency, among others, was the first acknowledgment from Congress that servicers may have been resisting performing the loan workouts needed to stem the foreclosure crisis because they were the foxes guarding the henhouse. Though industry experts and commentators have recognized servicers' conflict of interest stemming from their own holdings for months, this letter may have been the first to alert the Federal Financial Institutions Council that servicers were acting in their own interests, not those of the borrowers or bondholders servicers were contractually obligated to further.

Also contributing to this shift in momentum was the release by the Treasury Department of its first monthly progress report on its plan to aid homeowners through loan modifications. This report found that just 9% of eligible homeowners have received trial modifications. The Treasury also released a breakdown on modifications by home loan servicers, which showed that none of the Big Four servicers (Wells Fargo, Citibank, BofA and Chase) had modified more than 20% of the loans eligible.

Officials from the Obama administration already met with mortgage servicers last month to encourage these companies to double the number of borrowers receiving aid. However, as this was before the Treasury released its numbers, I expect the frequency and intensity of such meetings to increase over the coming weeks. As those who have followed this blog are aware, I believe it is high time to acknowledge the role that banks (and now servicers) have played in fomenting the current financial crisis, and force those entities to pay their fair share to help clean up this mess.

Article on William Frey, Countrywide and the Servicer Safe Harbor Published in Lombard Street E-Journal

I am excited to report that FinReg21, a leading website on financial services regulation, has published a feature-length article by me, entitled Why Should Servicers Get a Safe Harbor? How One Investor's Lawsuit Forced Bank of America to Seek Shelter in Washington, in its Lombard Street e-journal. Lombard Street is billed as "the first e-journal focused exclusively on financial services regulation in the 21st century."

The article tells the story of William Frey and Greenwich Financial Services' ("GFS") legal challenge to Countrywide's settlement with the Attorneys General, and how this lawsuit spurred the passage of the Helping Families Save Their Homes Act by Congress. The article pulls together many of the facets of this story that we have followed on The Subprime Shakeout, from the cycle of securitization that led to the subprime mortgage meltdown, to Washington's push for loan modifications that led to Countrywide's $8.4 billion settlement with Attorneys General from over 30 states, to the litigation and legislation that followed.

The last two sections of the piece go further, however. In the second-to-last section, I provide a legal analysis of how the Servicer Safe Harbor could run afoul of the Fifth Amendment's Takings Clause if it operates to deprive GFS and other investors of their claims against Countrywide and other loan servicers. In the final section, I offer an alternative solution to the mortgage foreclosure crisis that would be more efficient and equitable than the blunt strokes that Washington has taken thus far.

I look forward to hearing any feedback that readers may have on this proposal or any other aspect of the article. Thanks to Doug Winthrop, Christine Camp, and Michael Ginsborg at Howard Rice for providing skillful editing and insightful feedback, and to Charley Spektor, and Marilyn Cohodas at FinReg21 for supporting critical, non-partisan analysis on this and other issues affecting the regulation of financial services.

In Letter to Bank Regulators, Senators Reverse Course

Loan servicers' star may be quickly fading in Washington. In a stunning reversal of course, Representative Barney Frank (D-Mass.), Chairman of the House of Representatives Committee on Financial Services, and Senator Christopher Dodd (D-Conn.), Chairman of the Senate Committee on Banking, Housing and Urban Affairs, issued a letter last week urging bank regulators to investigate whether mortgage servicers are resistant to modifying loans due to the issues surrounding their holdings in second lien mortgages. The Senators accused the servicers of "unwillingness...to extinguish their liens as required for participation in [the Hope For Homeowners] program, even in return for offers of reasonable compensation." The letter also suggested that servicers may be overvaluing these assets on their balance sheets, resulting in "inadequate reserving" that skewed the financial picture of banks in general.


This warning shot across the servicers' bow comes less than two months after Frank and Dodd marched the Helping Families Save Their Homes (HFSTH) Act through Congress waving the flag of servicer safe harbor. Though the HFSTH Act had the goal of reducing residential mortgage foreclosures by encouraging loan modifications, the bill also featured a Servicer Safe Harbor provision that provided legal immunity and generous incentives to mortgage servicers (the four largest being J.P. Morgan Chase, Wells Fargo Bank, Citibank and Bank of America) to modify mortgages and extinguish second liens. In the process, the bill dumped the costs of the modifications on the investors holding these mortgages, despite the fact that servicers were also frequently the lenders that pumped out these troubled loans in the first place. Apparently, these incentives have not been enough to induce servicers to participate in Hope For Homeowners, as Frank and Dodd are now turning on the banks they fought so hard to protect.


At the outset of the foreclosure crisis, Frank and other congressmen heaped the blame on bondholders, such as Bill Frey, who had simply insisted on their contracts being enforced. Because investors refused to allow the terms of the mortgages backing their investments to be modified willy-nilly, they provoked the ire of the House Financial Services Committee.


In this letter to Frey, Frank and five other congressmen expressed outrage that Frey would oppose their efforts to modify mortgages, and "strongly urge[d]" Frey to reverse his position. They further invited Frey to testify, but when Frey took them up on their invitation, they changed their minds. Deprived of the chance to be heard, Frey wrote this letter to the congressmen instead, pointing out that servicers "have financial incentives to avoid foreclosure...even if it creates greater losses for the mortgage investor." More recently, Frey wrote this scathing op-ed piece in the Washington Times, criticizing the Safe Harbor and breaking down in concise terms the conflict of interest inherent in giving servicers the keys to the modification henhouse.


Though Frank and his colleagues may not have wanted to listen to Frey at first, it seems that they're beginning to realize that servicers have strong motives to act contrary to the interests of investors, borrowers, and the rest of the country. Why it took politicians with a supposed expertise in this field so long to really delve into this issue is beyond me, but partisanship and campaign finance may certainly have come into play (after all, the Helping Families Save Their Homes Act was introduced by two congressmen high on Bank of America's payroll).


While I'm encouraged that legislators appear to finally be unraveling the complexities involved in cleaning up these toxic assets, I'm disappointed that their first solution was to shout and wave a big stick in the hopes of pushing through their "plan." Fixing a problem of this magnitude involves understanding the players and what makes them tick, not bullying people into compliance. And it starts with a willingness to listen without bias, not a coddling of constituency.