In case you had any doubts about what the mortgage settlement was really about and why banks that were so keenly opposed to it are now willing to go ahead, the news of the last two days should settle any doubts.
As we had indicated earlier, one of the many leaks about the settlement showed that there had been a major shift its parameters. Of the $25 billion that has been bandied about as a settlement total for the biggest banks, comparatively little (less than $5 billion) is in cash. The rest comes in the form of credits for principal modifications of mortgages.
Originally, that was to come only from mortgages held by banks, meaning they would bear the costs. The fact that this meant that whether a homeowner might benefit would be random (were you one of the lucky ones whose mortgage had not been securitized?) was apparently used as an excuse to morph the deal into a huge win for them: allowing the banks to get credit for modifying mortgages that they don’t own.
The first rule of finance (well, maybe second, “fees are not negotiable” might be number one) is always use other people’s money before your own. So giving the banks permission to modify loans they don’t own guarantees that that is where the overwhelming majority of mortgage modifications will take place, ex those the banks would have done anyhow on their own loans. And the design of the program, that securitized loans will be given only half the credit towards the total, versus 100% for loans the banks own, merely assures that even more damage will be done to investors to pay for the servicers’ misdeeds.
Let me stress: this is a huge bailout for the banks. The settlement amounts to a transfer from retirement accounts (pension funds, 401 (k)s) and insurers to the banks. And without this subsidy, the biggest banks would be in serious trouble
Why? As leading mortgage analyst Laurie Goodman pointed out in a late 2010 presentation, just over half of the private label (non Fannie/Freddie) securitizations have second liens behind them (overwhelmingly home equity lines of credit). Moreover, homes with first liens only have far lower delinquency rates than homes with both first and second liens. Separately, various studies have found that defaults are also correlated with how far underwater a borrower is. If a borrower is too far in negative equity territory, it makes less sense for them to struggle to stay current, no matter how much they love their home.
The second liens pose a huge problem to the banks. Courtesy Josh Rosner, this is data as of September 30 for Citi, Bank of America, JP Morgan, and Wells, respectively:
Compare these totals with the book value of their equity as of the same date: $42 billion in seconds for Citi versus $177 billion in equity; BofA, $121 billion in seconds versus $230 billion in equity: JP Morgan, $97 billion in seconds versus $182 billion in equity; Well, $109 billion in seconds versus $139 billion in equity. One of my mortgage investor mavens says that BofA’s seconds should bve written down by about $100 billion and JP Morgan’s by $60 billion. That writeoff would exceed BofA’s market cap and would make a major dent in Jamie Dimon’s touted “fortress balance sheet.” And a similar magnitude of haircut to Wells would expose it as being grossly undercapitalized.
Now the banks contend that the seconds are current or not all that delinquent, and hence no writeoffs are warranted. Please. Banks are doing everything in their power to preserve that fiction. First, they are engaging in far more aggressive debt collection against seconds than firsts, even though they service both. In addition, they can and do make insolvent borrowers look whole. They will reduce the minimum payment due when a borrower is close to being officially delinquent, and tell them to send a small amount and declare the loan current. Or they simply increase the credit line on the home equity line and let the borrower pay them with new funds lent to them. Neat, eh?
Finally, they also have been modifying first liens to preserve their second liens. If you reduce the payments on the first mortgage, the borrower has more money left to pay the second lien. From the transcript of Goodman’s 2010 presentation:
Clearly there’s a differential standard of managing second liens and securitizations versus second liens in bank portfolios. It’s very clear banks are doing all they can to get the, to keep, to get the first lien modified in order to keep the second intact, and that is just a huge conflict of interest.
Legally, the hierarchy of payment OUGHT to be clear: a second should be wiped out before a first lien is touched. That’s how it works in a foreclosure or a bankruptcy: only after the first lien was paid in full would a second lien get anything. But that isn’t what is happening now.
An important post by Dave Dayen, “HUD Secretary Expects “Substantial” Payment of Foreclosure Fraud Settlement with MBS Investor Money,” on a small group interview of Shaun Donovan, makes it clear that the Administration is well aware of, indeed almost giddy, about the way investor oxen are about to be gored. Guess they haven’t given enough to Obama to save their hides.
Donovan claimed that the money available in the settlement for principal reduction for underwater borrowers would actually come to $35-$40 billion, over double the $17 billion in nominal principal reduction that has been widely reported…
But how exactly does Donovan get to $35-$40 billion when the reports all claim $17 billion (as well as $8 billion in various penalties and checks for wrongful foreclosures, adding up to a $25 billion settlement)? He said that the topline numbers have always reflected the settlement with the five largest servicers. When you throw in the other 9 servicers who have been in discussions on the settlement, the level rises to more like $30 billion. Furthermore, “not all write-downs are created equal” in the settlement, Donovan said. The $17 billion on principal reduction always reflected “credits,” a number that the servicers would have to hit to comply with the settlement terms. Some of the credits are not dollar-for-dollar. For instance, principal reduction on loans that are over 175% LTV (loan-to-value ratio) would not get full credit because it would be a “reduction” on a house that will probably go into foreclosure anyway. “If a servicer is writing down a current first-lien mortgage, that has more value than a second lien 180 days delinquent,” Donovan gave by way of a separate example.
When you add all this up, Donovan asserted, “For every dollar of credit, we’ll be getting on average $2 or more of principal reduction. That’s how you get from $17 billion to $35-$40 billion.”
Notice that Donovan skips over the biggest item that will lead to bigger reductions than the nominal amount: the 50% credit that we noted above and in earlier posts, per a report by Shahien Nasiripour of the Financial Times, for modifications of loans that the banks don’t own.
Donovan tried to tell the journalists that there would be no problem with banks modifying these loans. That seems like a big stretch. The Pooling and Servicing Agreements all have a provision that says that the servicer is required to service the loan in the best interest of the certificateholders, meaning the investors. Modifying first liens owned by those investors pursuant to a settlement of legal and regulatory violations would not seem to pass muster. In addition, as we have reported earlier, a “safe harbor” provision, which was intended to provide air cover for banks to make mods as part of HAMP, was removed during reconciliation even though it had passed both houses. Why? Some investors had said that that provision amounted to a 5th Amendment violation, since it was taking property from private investors without providing compensation (note this is arguably a taking by government because preventing losses at BofA and Wells, which would be next in line if BofA were revealed to be insolvent, has the effect of benefitting the FDIC).
How does the Schneiderman MERS suit play into this? The consensus reaction to his Friday filing of a suit on MERS abuses seemed to be that he had at a minimum redeemed himself for taking the wind out of the dissenting AG effort by joining a Federal task force that looks likely to produce little and becoming coy on where he stood on the settlement deal. After Friday’s filing, some even thought he had outplayed Obama, by getting him to commit in a very public way to investigations and then filing a suit that put robosigning and other foreclosure abuses front and center. It looked as if he had gotten to have his cake and eat it too.
I’m skeptical of this cheery view. As readers know, I doubt that this investigation will produce much except some suits against small or at best medium fry. As Charles Ferguson of Inside Job put it, “Let Them Eat Task Forces.” There is a well established art form to stymieing people like Schneiderman: do the least important 60% of what they asked you to do, slowly.
Schneiderman got to be on a not-likely-to-do-much task force. What did he get? He allegedly gets more resources, and he might get more information, but the Administration scored a huge win by dragging out the settlement talks over a year and running out the statute of limitations on some of the best legal theories. I have to admit I was snookered. I thought the ongoing joke of the Tom Miller “we’re gonna have a deal any day now” was an embarrassing bug, but it was a feature. The AGs were being strung along as long as possible to keep them from filing suits. A few like Beau Biden, Martha Coakley, and Catherine Cortez Masto still did, but not soon enough or in enough numbers to embarrass some of the other fence-sitters into action (Lisa Madigan is an exception that proves the rule).
So what does his MERS suit mean? I’m mainly focusing on how it relates to the bigger game of the settlement, but let me make a few observations about his filing qua filing. It is gratifying to see a long form description of the MERS horrorshow. And this suit could be used to shift focus back to an issue that everyone in the mortgage industrial complex seems to want to push aside: servicers seem unable to foreclose legally and chain of title is a mess. Settlement deals and compensation to abused homeowners could be useful, but they don’t address the underlying mess (and neither do phony baloney OCC consent decrees).
And the media keeps taking the industry line on foreclosure problems. It keeps touting how long it takes to foreclose in New York as if this is the fault of the borrowers and the courts. In fact, it is the fault of the industry. In October 2010, New York implemented a requirement that all attorneys in residential foreclosures certify that they take “reasonable” measures to verify the accuracy of documents submitted to the court. From a formal standpoint, all this did was reaffirm existing law, but procedurally, it makes it much easier for borrower’s counsel to get attorneys who play fast and loose sanctioned.
Look what has happened to foreclosure activity before the requirement was put in place versus this past October:
So foreclosures had already effectively stopped because there are now real consequences to submitting bogus documentation. The Schneiderman filing ups the ante by telling servicers that they are subject to fines of $5,000 per violation (arguably, per each piece of improper paperwork submitted).
But how does this suit move forward in practice? Even though the filing mentioned $2 billion lost recording fees, his filing does not seek any damages for that. Readers are invited to chime in, but I see that he has two big hurdles. The first is pinning liability on the banks, as opposed to MERS. MERS has fewer than 50 employees and I guarantee its only meaningful asset is its screwed-up database. It can’t pay any meaningful damages or do much of anything to fix the mess it created. The banks will seek to argue that any liability sits with MERS, LPS and its ilk, and the foreclosure mills. It will probably take some doing to establish bank culpability.
Second is establishing the number of violations per bank. In aggregate, it looks to be massive, but the AG needs to come up with some basis for arguing at least roughly how many violations took place. That probably means establishing how many foreclosures in the relevant time frame had liens recorded in the MERS system and coming up with a solid minimum number of violations per foreclosure. How do you do that? Maybe sampling 100 foreclosures with MERS assignments per bank? The only good news is the foreclosure procedures were so awful that the banks would be hard pressed to find any foreclosures that didn’t have document problems.
Let’s do some rough math. The chart above shows 153 foreclosures a day for September 2010. Let’s assume an average of 150 a day for 2008-2010 and half that for 2007, with 250 work days a year (the court calendar does drop to nada in late August and December). Further assume that the three big banks listed accounted for 30% of the foreclosure filings, and half of those used MERS. That’s roughly 20,000 foreclosures. Assume 2 violations per foreclosure, which is $10,000, plus the $2,000 in expenses per homeowner (this was a separate claim in the filing). $12,000 X 20,000 is $240 million, or $80 million per bank. If you think I’ve been conservative, double that. The point is you don’t get to bank-crippling numbers from this suit. And remember, this litigation will probably be settled, and settlements are for less that the full value of what the plaintiff might win (there’s no reason to settle if the defendant has to pay out the full amount he’s exposed to if he loses in court).
That means it might be better for Schneiderman to use this suit to keep the negative PR about the banks coming (the reputational damage is likely to sting more than the amount they’d need to pay to make the case go away) and to press for real solutions to servicing and foreclosure practices. That has FAR more value than what he looks likely to recover.
This is a long-winded digression. Back to the settlement jousting. Obama succeeded in getting Schneiderman on the sidelines as a leader of the dissenting AGs as the Administration mounted a final push. That destablized the opposition and fed the now widespread impression that the settlement is inevitable (remember, before the Schneiderman announcement, it looked like the Administration would have significant defections of Democratic AGs. At least one AG who had met with the dissenters, Oregon’s John Kroger, has now joined the settlement).
But does the Schneiderman MERS suit hinder or help the settlement effort? Perversely, it may help the Administration push it over the line. If the leak about the scope of the release via Mike Lux is to be believed, MERS-related liability is excluded from the waiver. Schneiderman has just demonstrated you can file what amounts to a robosigning lawsuit using the MERS exclusion. You won’t get the securitizations outside of MERS where the notes weren’t transferred properly, but you’ll get a large proportion of the defective securitizations.
Now why should the banks sign onto a deal to settle robosigning claims that leaves them exposed in a big way to robosiging claims? If they thought the Schneiderman suit revealed a problem in the release, you’d expect them to demand that the negotiations be reopened. It may be too soon to tell, but I’ve seen no sign of bank pushback, and this deal has been so heavily lawyered I am sure the banks were well aware of this issue. Similarly, as reader Pwelder pointed out, all the banks that were targeted in the suit were up on Friday markedly more than the market overall, indicating that investors do not see this suit as threatening.
So the fact that they seem so keen to go ahead on a deal that does not very much to shield them from attorney general suits on robosigning confirms our suspicions: the banks are willing to pay several billion of hard cash among themselves to create the impression that they are Doing Something for Homeowners as cover for a bailout. Nicely played all around.
And Donovon’s cheerleading confirms the Administration’s sense of priorities. He regards robo-signing, foreclosure fraud, and making a mess of title as unimportant, and applauds the this settlement as a way to get principal reductions and allow the banks to escape any meaningful liability or responsibility.
The Obama Administration may have decided that investors have acted enough like patsies, given how they have failed to react to rampant servicer abuses, that they judge the risk of investor litigation and a related PR embarrassment to be small. But this battle is not yet over. The rumblings I am hearing from investor-land remind of the sections of the Lord of the Rings when the Ents were finally roused. It isn’t yet clear that investors will act, but if they do, the Administration will be unprepared for the vehemence of their response.