FDIC Calls for Better Disclosure of Servicer Conflicts of Interest in Second Mortgates

There are lots of reasons why servicers are failing to make deep enough mortgage mods to salvage viable borrowers (ones who still have a decent level of income). One of the most troubling is that the parent bank often also has a large book of second mortgages, and writing down first mortgages would require them to ding their second mortgage book. Various conservative estimates have indicated that more realistic valuations of second mortgages would blow a big hole in the balance sheets of the four biggest banks in the US. (The banks’ defense is that borrowers are often still paying their second mortgages when they’ve defaulted on their first. And that occurs because borrowers who are stressed try to stay current on as many obligations as they can, so if they can’t pay both their first and second mortgage, they will often default on the first but keep paying like clockwork on the smaller second mortgage. BTW, that also is in contrast to the widespread “deadbeat borrower” meme, the fact that borrowers keep trying to stay current on the obligations they can meet).

The FDIC seems to be the lone regulator trying to protect investors. And this is simply common sense. Investors are refusing to buy any new deals save those with some sort of government guarantee precisely because securitization industry participants behaved so badly during the housing bubble. Yet the industry refuses to implement even minor measures to make it safe for investors to get back into the pool (no pun intended).

Even more peculiar are the efforts underway by the Treasury (which will also be taken up with even more vigor by the incoming Republican house) to “reform” Freddie and Fannie, which is code for “reduce the role and have more done in private markets”. That’s a great goal in theory, but there IS no private market now. You can’t sensibly be in favor of Fannie and Freddie reform and not also be promoting reform of the securitization process. Yet bizarrely, that is exactly the posture the Administration is taking.

From MarketWatch:

…the FDIC is considering whether big banks that own both servicers and second-lien loans should need to disclose to mortgage investors, before loans are packaged and sold, what would happen to the second-lien loan if the first mortgage comes into distress…

In many cases big bank holders of second lien loans haven’t disclosed what their arrangement is on those loans with the corresponding owner of the primary mortgagee….

The servicer won’t modify the second-lien loan because of what it means for their parent bank’s balance sheet, and the mortgage investors of the primary loan, in return, won’t want to modify the primary mortgage if the second lien is not being modified,” says Henry Sommer, director at the National Association of Consumer Bankruptcy Attorneys. “However, the servicer is supposed to act in the best interest of all parties, not just the second-lien loan its parent bank owns.”…

Regulators may soon want banks issuing primary mortgages for securitization to disclose in pooling and servicing agreements with mortgage investors what happens to the second lien they own if the first lien is in trouble.

With this kind of disclosure, Sommer insists, investors would only agree to buy mortgage securities from banks that agree in advance in the PSAs to completely write off or proportionately write down the second-lien loans in situations where the primary mortgage comes into distress…

One way bank regulators are considering to address this issue would be to have significant disclosure and PSA requirements of this kind for mortgages that are approved as “qualified residential mortgages.” The FDIC and other bank regulators are working on writing a definition for what kind of mortgages would fall into this category. The definition of what constitutes a QRM is controversial because these types of mortgages would be exempt from soon-to-be- approved “skin in the game” rules requiring banks to retain some of the risk of loans they package and sell.

Greater disclosure is a much less intrusive response than that being sought by a group of 10 Democratic lawmakers on Capitol Hill. Rep. Brad Miller (D., N.C.) and nine fellow Democrats want regulators to go one step further and require bank regulators and a newly formed Financial Stability Oversight Counsel to consider requiring big banks to divest their servicer units.

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  1. dejavuagain

    “Fraud on creditors” – this is a classic legal term. Basically, this is when on creditor is preferred over the other when the debtor is insolvent. There can be a fraud on creditors if the second is being paid before the first, even if the servicer is not owned by the bank holding the second mortgage.

    Well, in my view, if a servicer is owned by a bank holding second mortgages being serviced by the servicer, and payments are made on the second mortgage, rather than the first, not only do you have a fraud on creditors, but an actual fraud. Clearly the defrauded party are the Trust certificate holders. Plus, in bankruptcy, there is a preference.

    But, the screwees are the investors, and the servicer and second mortgage lender are in cahoots and controlling the process.

  2. Geithners Viability

    When Yves flips the switch on her anaylsis, I am puzzled:

    “There are lots of reasons why servicers are failing to make deep enough mortgage mods to salvage viable borrowers (ones who still have a decent level of income)”

    Whom – viable or not – are getting principle reductions? Do we have numbers on that? That should be the very definition of “mod”. A “payment reduction” is what some borrowers are getting, actually making their obligation more expensive.
    Incidentally, Banks don’t give a shit if the borrower lands a 6 figure job after being laid off for 18 months.
    In a way, this analysis is a disservice to people losing their homes, they must do a 13 and strip that shit 2nd off.
    Ah but this bit (and this blog) isn’t for those poor bastards, it’s about relatively lame steps a regulator is taking, one of whom should be blamed for the bubble in the first place.

    1. Yves Smith Post author

      There’s no change in position in this post. I’ve consistently called for deep principal mods, consistently said the industry has failed to do so (including repeatedly point out that the HAMP “permanent” mods are mere payment reductions; the ONLY exception in the industry who is doing deep principal mods is Wilbur Ross, who comments favorably on the results he has gotten) and separately repeatedly pointed to the servicer conflicts over seconds interfering with mods AND allowing the banks to overstate equity.

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