Inside the AG Settlement

The big servicing settlement with the state attorneys general is being actively debated. Mortgage investors, it seems, are not among its biggest fans

Mortgage Banking

May 2012


By Robert Stowe England


Some observers heaved a big sigh of relief on hearing news of the $26 billion national mortgage servicing settlement with the five largest mortgage servicers forged by the Obama administration and state attorneys general (AGs).


It was supposed to be a watershed event, covering 3.8 million foreclosures between 2008 and 2011, where the issues swirling around the improper filing of foreclosure documents could be resolved for more than half the mortgages in the nation.

President Barack Obama boasted that the deal—the largest such settlement in U.S. history—would “turn the page on an era of recklessness.”


The settlement, whose overall value could reach up to $40 billion just for the five servicers covered by the deal, was being seen as a template that could be used to sign on more servicers. Such an outcome could close the chapter on the whole foreclosure controversy, while still leaving a slew of civil securities suits in place, as well as federal and state criminal investigations into mortgage fraud.


Attorney General Eric Holder touted the benefits of the settlement at a press briefing Feb. 9 outlining the broad parameters of the deal. “[W]ith this settlement, we aren’t just holding mortgage servicers accountable for wrongs they committed. We are using this opportunity to fix a broken system and to lay the groundwork for a better future,” he said.




The details of the agreement did not emerge until March 12, when 49 states, the District of Columbia and the federal government signed consent agreements with each of the five mortgage servicers in response to specified claims in a complaint filed simultaneously with the U.S. District Court for the District of Columbia.


On April 5, the consent agreements went into effect when they were approved by Judge Rosemary Collyer in the Federal District Court for Washington, D.C.


The attorney general for Oklahoma, Scott Pruitt, signed a separate $18.6 million agreement with the servicers. He denounced the broader agreement for overreaching the authority of state attorneys general and warned that the terms created questions of fundamental fairness and justice by rewarding homeowners who stopped paying their mortgages over families who continued to make payments even if they were underwater on their loans.


The role played by the Obama administration proved decisive in crafting the final settlement, bringing on board two holdout states that wanted better terms than had been reached in negotiations by an executive committee of the state attorneys general headed by Iowa Attorney General Tom Miller. The holdouts were New York, represented by Attorney General Eric T. Schneiderman, and California, represented by Attorney General Kamala Harris.


As interested parties and analysts began to comb through the legal documents, it became clear the settlement did not satisfy one key private-sector constituency not represented in the negotiations—namely, mortgage investors.


The agreement’s terms governing $10 billion in principal reductions for delinquent loans was a key sticking point for mortgage investors.


Under the deal, principal reduction on the primary mortgage occurs in tandem with principal reductions on second-lien or home-equity mortgages. This essentially pits two groups against one another because many primary mortgages were securitized and owned by investors, while home-equity loans were generally held on the books of banks.


Under bankruptcy laws governing first and second mortgages, as well as under the terms of securitization deals, second mortgages should generally be wiped out entirely before first mortgages incur any losses because they are subordinate claims.


The Association of Mortgage Investors (AMI), Washington, D.C., is reserving the right to file a lawsuit challenging the settlement, according to Chris Katopis, the association’s executive director.


AMI represents such investors as DoubleLine Capital LP, Los Angeles; AllianceBernstein LP, New York; and Angelo, Gordon & Co., New York. It also represents public and private pension funds and endowments with investments in mortgage-backed securities (MBS). Other critics are faulting the deal because it funnels cash to the states facing fiscal difficulties. Others complain the relief for homeowners is paltry, limited in scope and, thus, mostly symbolic.


Further, as the servicer-banks begin to provide the principal reduction required in the settlement, they may face individual lawsuits from mortgage securities investors if it violates existing pooling and servicing agreements (PSAs).


The deal


The Department of Justice and the Department of Housing and Urban Development (HUD) were lead federal negotiators. They were joined by the Department of Agriculture; Department of Veterans Affairs (VA); Federal Trade Commission (FTC); Consumer Financial Protection Bureau (CFPB); and the Executive Office for United States Trustees, an organization whose 21 regional U.S. trustees oversee the efficiency and integrity of the bankruptcy process.


The Treasury Department and the Securities and Exchange Commission (SEC) were not part of the negotiations or the settlement.


The following servicers are signatories to the deal:


• Bank of America Corporation, Charlotte, North Carolina, along with BAC Home Loans Servicing (formerly Countrywide Homes Loans Servicing LP), Calabasas, California;

• Citigroup Inc., New York, along with CitiMortgage, O’Fallon, Missouri;

• JPMorgan Chase & Co., New York, along with JPMorgan Chase Bank NA, Columbus, Ohio;

• Ally Financial Inc., Detroit (formerly GMAC), along with GMAC Mortgage LLC, Fort Washington, Pennsylvania, and GMAC Residential Funding Co. LLC, Minneapolis; and

• Wells Fargo & Co., San Francisco, along with Wells Fargo Bank NA, Des Moines, Iowa.


The five servicers are among 14 servicers whose foreclosure practices came under regulatory review after press reports of foreclosure abuses first surfaced in the fall of 2010. (The following nine servicers were also reviewed by the banking regulators: Aurora Bank FSB, Wilmington, Delaware; EverBank Financial Corporation, Jacksonville, Florida; HSBC Bank USA, New York; MetLife Inc., New York; OneWest Bank FSB, Pasadena, California; PNC Bank NA, Pittsburgh; Sovereign Bank NA, Wyomissing, Pennsylvania; SunTrust Banks Inc., Atlanta; and U.S. Bancorp, Minneapolis.) The review was conducted by the Federal Reserve System, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC).


Noticeably absent from the settlement is the company at the center of much of the robo-signing controversy—Mortgage Electronic Registration Systems (MERS), Reston, Virginia.


Lawsuits against some of the servicers filed by New York and Massachusetts ahead of the settlement are preserved and are going forward. Also, Delaware has the right to pursue its own lawsuit against MERS.


The settlement with the five servicers is aimed broadly at three different groups: homeowners, the states and the servicers. The agreement consists of $5 billion in hard money (cash) and $20 billion in soft money, representing commitments by servicers for write-downs for principal reductions, interest-rate reductions and other loan modification and forbearance required under the agreement.


From the $5 billion in hard money, $1.49 billion goes to a borrower-relief fund for homeowners whose homes were taken or sold in foreclosures between Jan. 1, 2008, and Dec. 31, 2011. These funds will help an estimated 750,000 borrowers, according to the National Mortgage Settlement website (, set up by the attorneys general who negotiated the settlement.


Cash relief is distributed to the states, with some states getting fairly large amounts—for example, California, $410.5 million; Florida, $334 million; Illinois, $105.8 million; New York, $107.6 million; and Texas, $134.6 million.


In a separate side agreement, the servicers committed $12 billion of dedicated relief to California and $4 billion in dedicated relief to Florida as part of the $25 billion settlement.


Bank of America’s outlay in is expected to be the most of any of the five servicers at $10.9 billion, according to estimates by New York–based ProPublica. This includes a separate $1 billion agreement to settle claims from the Federal Housing Administration (FHA) that Bank of America and (its predecessor, Countrywide) originated bad loans that FHA insured. This $1 billion agreement increased the value of the overall settlement with the five servicers from $25 billion to $26 billion.


The $20 billion in soft money is roughly divided into two parts:


• $17 billion for principal reduction and other forms of forbearance for delinquent borrowers; and

• $3 billion for refinancing for homeowners current on their mortgage, but who owe more than their home is now worth.


“None of the $20 billion [in soft money] goes to any particular borrower who was allegedly injured as a result of the foreclosure package,” explains Laurence Platt, practice area leader in consumer financial services at the law firm of K&L Gates LLP in Washington, D.C. He participated in the negotiations as a representative for one of the servicers.


“There’s no connection between who gets the consumer relief other than the $1.5 billion [in the hard-money part] and whether or not they had any issues with their servicer,” says Platt.


Principal reduction


At least 60 percent of the $17 billion in relief for delinquent borrowers—or about $10 billion—goes toward the combined principal reduction on first-lien and second-lien loans. Of this amount, 30 percent or about $5 billion goes to first liens. “In theory, it could be 60 percent all first liens because there is not a minimum percent for second liens,” explains Platt.


The remaining $7 billion of the $17 billion in relief for delinquent borrowers is for other forms of relief, including forbearance of principal for unemployed borrowers, anti-blight programs, short sales, transitional assistance and benefits for service members who were forced to sell their homes as a result of a permanent change in station, and other programs.


The hope is that principal reduction and other forms of relief will prevent new foreclosures.


“State attorneys general anticipate the settlement’s requirement for principal reduction will show other lenders that principal reduction is one effective tool in combating foreclosure and that it will not lead to widespread defaults by borrowers who really can afford to pay,” claim the state attorneys general in a statement on the National Mortgage Settlement website.


HUD has estimated that the $17 billion commitment to principal reductions and other relief, however, could require servicers to make $40 billion in actual principal reductions and other relief. The reason is that servicers do not get dollar-for-dollar or 100 percent credit for all principal reductions and other forms of relief they provide.


The amount of credit on the second liens depends on the payment status of the loans. A servicer can get credit toward its required commitment for any write-down on a first-lien modification if the property is occupied and the borrower is 30 days delinquent or faces imminent default because of the borrower’s financial situation. In the case of second-lien mortgages, the loan must be at least 30 days delinquent.

The credits to the servicer for relief are higher for first-lien loans held by the originating banks for investment (100 percent) than for loans serviced by the bank for third parties (45 percent).


“The incentives are geared toward encouraging the banks to apply the principal reduction on their own loans,” Platt explains.


As for second liens, the credit is higher (100 percent) if the servicer makes a payment to an unrelated second-lien holder to release the second lien. The bank gets credit for only 20 percent on second liens, however, if the forgiveness of principal is done by the investor.


Importantly, an estimated 3 million underwater mortgages either owned or guaranteed by Fannie Mae or Freddie Mac are not part of the settlement, as the conservator, the Federal Housing Finance Agency (FHFA), continues to oppose principal reduction for such loans.


Refinancing relief


There is a separate agreement with the servicers that requires a mandatory commitment of at least $3 billion to refinance mortgages for all underwater borrowers eligible for the program. “Refinancings are only for loans owned by the bank,” Platt says.


The $3 billion in refinancing provision came about during some of the horse trading that went on to forge the deal. Servicers had sought a broad release for all civil liability for origination fraud. However, New York Attorney General Schneiderman, among others, vigorously opposed this concession, according to a source who participated in the negotiations. “I was on a call where [Iowa] Attorney General Miller said the origination release was given at the state level in exchange for the $3 billion refinancing,” says the participant in the negotiations.


To be eligible, loans must have an interest rate higher than current mortgage refinancing rates and the loans must be held for investment by the originator. Eligible loans must have been originated before 2009, and payments must be current with no delinquencies within the last 12 months and no modifications done in the last 24 months. The loans must also be in excess of 100 percent of the value of the home and have a remaining balance at or below the highest government-sponsored enterprise (GSE) conforming loan limit cap as of Jan. 1, 2010. FHA- and VA-insured loans are not eligible.


Servicers can make refinancing commitments above their settlement-mandated commitment amounts, and those refis can be credited toward the required commitments for principal reduction—although the total amount that can be thus credited is capped. Dollars spent on underwater refis are credited at 25 percent for first-lien principal reduction and 75 percent for second-lien principal reduction.


Liability releases


In return for these commitments, the servicers are granted releases for civil liability for prosecution and administrative and enforcement actions in two broad areas of mortgage activity: origination and servicing. The releases apply to activity prior to the date of the announcement of the settlement (Feb. 9, 2012).


The servicing releases are fairly broad, while the origination releases are mixed and sometimes narrow.


“As it relates to servicing, you have releases against most federal and state consumer credit laws, with certain exceptions,” says Platt. The release for servicing does not cover federal fair lending laws, for example, while it does for the states.


“For FHA, there is a release from servicing violations pretty much across the board,” says Platt.


On originations, there is a release for consumer credit laws on both the federal and state level, except for fair lending laws.


The release for the FHA in the area of origination “gets really complicated,” Platt says. “They don’t release anything related to individual loans, like if you fail to originate a loan in accordance with FHA rules and regulations. They do release [you] if you provided a false annual certification.”


For civil fraud laws, such as the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the False Claims Act of 1863, there is a general release on the servicing side while it’s “sharply limited” on the origination side, according to Platt.


HUD retains the right to suspend, debar or exclude any current director, officer or employee of the five servicers. The Consumer Financial Protection Bureau carved out an exclusion from the release for violations of the Real Estate Settlement Procedures Act (RESPA), “but only related to mortgage insurance,” Platt says.


The SEC, banking regulators, Federal Housing Finance Agency, Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Home Loan Banks, and the Commodity Futures Trading Commission can still bring claims against the five servicers.


Importantly, the agreement does not provide immunity for criminal law violations. Nor does it release claims for unpaid taxes.


The settlement agreement does not provide any liability release for conduct related to the sale and securitization of residential mortgages.


The agreement also does not provide any release from liability for private civil lawsuits.


There is an agreement by the servicers to adopt national servicing standards that address many of the issues raised with regard to foreclosure abuses and complaints.


The settlement agreement remains in effect for three and a half years from March 12, 2012.


Only a party to the agreement, however, can bring enforcement actions before the U.S. District Court for the District of Columbia. If mortgage investors file a challenge to the lawsuit, it would be with Judge Rosemary Collyer in the Federal District Court for Washington, D.C., who is reviewing the settlement.


Pursuing wrongdoing outside of the settlement


The creation of the Residential Mortgage-Backed Securities Working Group on Jan. 27, headed by New York AG Schneiderman, and the issuance of subpoenas to financial institutions suggests to Platt “the securitization carve-out from the federal and state releases will be widely utilized.”


The multi-agency working group brings together federal, state and local partners, including HUD, the Federal Bureau of Investigation (FBI), Internal Revenue Service (IRS), Consumer Financial Protection Bureau, Financial Crimes Enforcement Network (FinCEN) and the Federal Housing Finance Agency Office of Inspector General.


The working group began with 15 and will expand to 45 attorneys, investigators and analysts at the Department of Justice and U.S. Attorneys Offices around the nation. It also includes 10 agents and analysts from the FBI.


Other observers, however, are skeptical that there will be significant new investigatory activity and even more skeptical of future convictions for civil and criminal fraud.


One such skeptic is William Black, associate professor of economics and law at the University of Missouri–Kansas City School of Law.


He contends that, given the scope of the working group’s assignment, the number of people assigned to the working group and the resources it brings to bear are woefully inadequate.


“The Dallas task force to deal with the savings-and-loan crisis [more than two decades ago], just in northern Texas, had more than 100 professionals,” says Black, who was litigation director of the Federal Home Loan Bank Board and deputy director of the Federal Savings and Loan Insurance Corporation, and held other regulatory posts at the time of the thrift crisis.


“This new working group, at maximum,” Black notes, “after it staffs up, will have 55 for the whole country in a crisis where the wealth losses are 70 times larger than the savings-and-loan crisis and the incidence of fraud is concomitantly larger as well.”


“They are creating a group that is supposed to investigate, but the leadership at the top—[Eric] Holder, [Treasury Secretary Timothy] Geithner and [Shaun] Donovan over at HUD—don’t want it to happen. So, we’ll see,” he contends, although many would likely disagree with his assessment.


Black expects the working group to go after small fry and let the big fish get away. By limiting investigations now, it means less political fallout later on, he maintains.

If serious large-scale investigations were to begin, “someone will eventually leak that, ‘Hey, we found these terrible frauds and we reported them on up and Washington refused to let us prosecute, and they got $20 million to prosecute,’” Black says. “I’m just saying that’s how things would have gone if you had allowed the investigations.”


Black believes that the feds and the states gave away too much in the settlement deal. In return for $26 billion from the servicers, the government negotiators gave up hundreds of billions in potential claims.


“No one ever talked about the opportunity cost of giving up your claim,” Black says. “Why is this [settlement] the only way to get money for homeowners?,” he asks.


Black also faults the pressure tactics he claims were brought against holdouts among the attorneys general. He contends that the federal leaders of the negotiations—HUD and Justice—“in the run-up to the elections, . . . were desperate to get [a deal] before the State of the Union Address.”


He adds, “You had incredible things going on I’ve never seen before”—particularly the decision of the federal negotiators to have separate meetings with Democratic and Republican state attorneys general. This was done, he contends, “so you could make a more political pitch to the Democrats.” Black says the feds’ message to the state AGs was, ‘Get on board, turkeys—you’re screwing up everybody.’”

The only real victory for the attorneys general, Black claims, was to put some limits on the release granted for origination fraud.


Second liens


The ability of servicers to preserve second liens largely intact is seen as a “surprising positive” for banks by Dick Bove, senior vice president of equity research at Rochdale Securities LLC, Lutz, Florida.


“I think banks are going to walk away from this thing, having set aside reserves—some guys did; Citigroup didn’t—and therefore their cash out of pocket is going to be  de minimis,” he says.


Bove contends that the settlement is contributing to moral hazard when it gives people facing foreclosures principal write-downs while responsible homeowners have seen their considerable down payments be wiped out. This, in turn, will bring negative fallout for banking, the mortgage industry and housing market, Bove predicts.


“I just think this whole deal is a total outrage,” Bove says. “At its very core, it’s probably the most anti-American thing done in this country,” he adds.


The long delays created by state investigations and lawsuits regarding foreclosures have already pushed down home prices and extended the life of the housing crisis, according to Bove.


The future damage from the settlement deal could be even more costly, according to the banking analyst. Bove expects it will drive up interest rates and drive up monthly payments as servicers adjust their fees upward in response to the new risks they face.


“The lenders have now been put on notice that they cannot recover on a defaulted loan in the housing industry, that the weight of the state is against them,” Bove says. “And, therefore, they better be careful in how they underwrite that next mortgage because if they underwrite that mortgage poorly, they are going to get it back and they are going to eat the whole thing because a state wants them to.”

In the future, mortgage lenders will charge a risk premium on mortgages because “you now have to assume there’s zero recovery,” Bove says.


Servicers also will likely end the practice of pricing mortgage servicing based on cost-saving advances in technology, and will now begin to price it based on risk, according to Bove.


Instead of 25 basis points or one-quarter of a percent, “think more of 2 percent—and maybe 2 percent isn’t even enough, if you think about the amount of the money the servicers are liable or are on the hook for” based on the mortgage settlement, he says.


PIMCO objects


The world’s largest bond fund manager, Pacific Investment Management Co. (PIMCO), Newport Beach, California, an investor in mortgage-backed securities, is unhappy with the mortgage settlement deal.


“The big negative from [the settlement] is that it makes the private mortgage market less likely to redevelop anytime soon,” says Scott Simon, managing director and head of mortgage-backed securities and asset-backed securities (ABS) at PIMCO.


Simon contends that servicers “have repeatedly violated contract law and property rights” to the detriment of investors in the years since the financial crisis of 2008. The federal and state AG mortgage settlement affirms such practices with further violations of the rights of primary lien holders, he adds.


“To the degree you are a buyer of private-label mortgages, you’re the lender—and if you can’t get the collateral when you need it or the rules don’t apply, then in the future you need bigger down payments and you need to charge more in terms of rate,” Simon says. Such a future outcome “would be very bad for housing and it would be very bad for borrowers.”


When the servicers service the first lien and own the second lien, they are more likely to favor principal reductions on the first lien, Simon contends. “Call me old-school, but the second is the second and not a first,” he says. “Why shouldn’t the second get written down before the first?”


Simon says the unwillingness of servicers to write down or even wipe out second liens has been a big barrier to loan modifications. The loan modifications “may be in the best interest of the lender and the best interest of the homeowner, but they are not in the best interest of the servicer. Therefore, they don’t happen,” he says.

Echoing other critics, Simon argues that with the settlements, the servicers managed to trade $500 billion in exposure to lawsuits for a tiny sum of “real money.”


Simon also questions whether proposed new servicing standards will really be as helpful as the architects of the deal suggest. “The real problem, if you go back over time, wasn’t that there weren’t rules in place and there weren’t documents in place,” he says. “It’s just that when it became cost-effective for the servicers to ignore them, they did.”


Simon contends also that it is difficult to sue servicers for fraud because you need the loan documents to prevail in a lawsuit. “And you can’t get the loan documents unless you have proven fraud. It’s a catch-22,” he says. This is “why there haven’t been more lawsuits. It’s very difficult,” he explains.


The problems investors have faced from servicers reminds Simon of a quote from the 1987 film Wall Street. “The Hal Holbrook character [Lou Mannheim] said to Charlie Sheen’s character [Bud Fox], ‘The problem with money, Bud, is that it makes you do things you don’t want to do.’ That really explains most of the bad things you read about,” Simon says.


Simon does not agree with those who predict that the cost of servicing will rise in the future. He thinks the cost will decline from where it is now because of the good credit quality of new loans coming into the system.


“Look at credit scores on mortgages. For FHA loans, FICO® scores are up 75 points. The average scores in the new production of Fannie Mae [loans] and Freddie Macs are 775. I don’t know if I’m a 775,” Simon says. “Those loans will be very cheap to service.”


In the end, the fallout from the mortgage settlement means the government will play a dominant role indefinitely, according to Simon.

PIMCO’s dissatisfaction with the mortgage settlement also led it to exit the American Securitization Forum (ASF) in February after ASF declined to issue a statement reflecting investors’ views on the AG settlement.


Second-lien compromise


Despite complaints about the favorable treatment of second liens in the settlement, it is not “realistic” to expect that the seconds would have to be written down entirely before principal reductions can occur on first liens, according to Bose George, senior vice president at Keefe Bruyette & Woods Inc., New York.

The treatment of second liens in the agreement is a “compromise where they take some write-down on the second as opposed to taking big hits on the seconds, which the banks wouldn’t have accepted,” George says.


“I guess you could argue it is a win for [the servicers] in the sense, in theory, if the first is being written down, the second wouldn’t have value. Here they are able to keep some value in the second and modify it down as well,” George says.

Under the terms of the settlement, 60 percent of the principal reduction is for first and second liens in combination for loans held on the books at servicer-banks. “Our reading of it is that the remaining 40 percent of the write-downs will be on all securitized loans, which probably means it will be first-lien securitization pools,” George says.


While 40 percent could theoretically include second liens in securitization pools, there were not a lot of securitized seconds, he explains. Further, if the first lien is being written down, the second liens were probably written down “a long time ago for a delinquent loan because it really has no value,” he adds.


“There is a net present value [NPV] test, so the servicers can’t indiscriminately write down loans. They have to write down loans where there is a net present value benefit to the trust by providing a principal write-down modification. It should be a positive value to the trust if they do that,” George explains.


“I guess the bondholders’ concern is that [the servicers may] write down more aggressively on the third-party stuff because they get credit on that as well, as opposed to writing down more aggressively in their own portfolios,” the bank analyst suggests.


George is not as worried as mortgage investors about the impact of the mortgage settlement on the future of the mortgage market. “Going forward, it’s pretty clear that no one who has any risk of defaulting is going to get a mortgage anyway. That’s probably true if the [private] securitization market ever comes back. It’s true for the GSEs as well,” he says. The only place for weak credits will be with the FHA, he adds.


The direction of the mortgage market is pretty clear, according to George.


“Everything that has happened has made it very difficult to deal with delinquent borrowers. You can’t foreclose. You can’t do a lot of things to recover the value of the collateral anymore. So, the solution is don’t lend to people who might be at risk of not paying you back,” he says.


George sees the settlement as “modestly positive for the overall mortgage market.” He adds, “It’s good to get this behind the industry. There are still the other banks that signed the consent orders that might be pulled into this as well. There’s a part 2 that potentially happens.”


George does not expect foreclosures to pick up as a result of the settlement. “If anything, the settlement increases the level of modifications that need to be done, increases timelines to foreclosure. So, it looks like it’s probably going to extend the timelines,” he says. “So, from that angle, it’s not going to do anything to unclog the inventory of foreclosures that are still going to take a long time to go through.”

We are still years away from clearing out delinquent loans, according to George.


“The servicer has to wait until the borrower exhausts all opportunities to get a modification. It gives the borrower many more bites of the apple,” he says.

George is also more upbeat about the potential return of the private market. “I think if you have the jumbo [conforming] loan limits come down, I think you could have some new private-label securitizations in a meaningful way,” he says.


“In the CMBS [commercial mortgage-backed securities] market, one could argue that they have all the same problems, but you’re seeing reasonably active new business,” he says.


Whither mortgage investors?


At the time of the settlement, HUD Secretary Donovan reassured investors that their interests would be protected. “Nothing in [the settlement] requires any trustee or servicer to reduce principal where it’s not allowed legally by the underlying documents,” he said. “The misunderstanding somehow that investors will be paying the banks’ share is just false.”


Hold on a minute, say the mortgage investors. “We know of no PSA that allows for these modifications as we understand them,” says the Association of Mortgage Investors’ Katopis.


“The PSAs are supposed to permit modification in the best interest of the trust. The question is why haven’t the servicers been doing this for the last three or four years anyway? We also think the secretary has been misled by the servicers,” Katopis says.


Home-equity write-downs


It appears unlikely that the federal and state negotiators could have reached an agreement with servicers without some forbearance for servicers on second-lien loans. “They can’t wipe out the seconds because they would wipe out the banks,” explains Bill Frey, principal and chief executive officer of Greenwich Financial Services LLC, Greenwich, Connecticut.


According to Inside Mortgage Finance (IMF), the five servicers held $583.0 billion in home-equity and closed-end seconds as of Dec. 31, 2011, broken down as follows:


• Wells Fargo, $193.1 billion;

• Bank of America, $186.4 billion;

• Citigroup, $60.9 billion; and

• Ally, $3.4 billion


The percent of home-equity and closed-end second loans in accrual for the entire banking industry stood at 2.7 percent for closed-end seconds and 1.4 percent for home-equity lines of credit (HELOCs) at the end of 2011, according to IMF.

According to Harry Terris, data editor for American Banker, the four largest U.S. banks (Bank of America, Wells Fargo, JPMorgan Chase and Citigroup) have 40 percent of all the nation’s home-equity loans. FDIC’s quarterly bank profile for the fourth quarter of 2011 reports that banks held $603.3 billion in home-equity lines.


Underwater home-equity loans at Wells Fargo represented 125 percent of Tier 1 common equity at midyear 2011, according to Terris’ calculations. Because of the collapse of home prices, these home-equity loans are “rendered uncollateralized,” Terris has argued.


Bank of America’s underwater home-equity loans represent 45 percent of Tier 1 common stock, according to Terris.


For JPMorgan Chase, underwater home-equity loans represented 33 percent of Tier 1 equity, according to Terris. At Citigroup, they represented 17 percent of Tier 1 equity.


Investors contend that the mortgage settlement seeks to protect the exposure of the servicers to second mortgages by transferring some of the cost of principal write-downs over to third-party first-lien holders.


“They are maximizing the damage to the investors while minimizing the damage to the banks,” Frey contends.


First-lien write-downs


The provision that gives banks 45 percent credit for principal reduction carried out by third-party first-mortgage holders is at the heart of the investors’ complaints about the settlement.


“If the settlement was between the five mortgage bankers and the government and all they were doing was working on bank-owned loans, investors wouldn’t really have any conversations in this settlement—we wouldn’t have a horse in this race, if you will,” says Vince Fiorillo, an MBS portfolio manager at DoubleLine Capital and board president of the Association of Mortgage Investors, who made his comment ahead of judge’s April 5 approval of the settlement.


“But because investors now are going to potentially have principal write-downs in their bonds on loans they paid for that the banks sold, and those principal write-downs are going to credit the banks’ fine [or required loan modifications with principal write-down] at 45 cents on the dollar, it just seemed to us that if you are going to do that, you have to include us in the conversation. And that’s where the rub is,” Fiorillo says.


The settlement spells out that second liens will be written down along with first liens under the Second Lien Modification Program (2MP) protocol of the Home Affordable Modification Program (HAMP).


Under the 2MP program, if there is a principal forgiveness in the first lien, then the second lien must also get proportionally an equal level of forbearance. For example, if there is a 5 percent reduction in principal on the first lien, there must also be a 5 percent reduction in principal on the second lien.


Alternatively, the entire second lien can be extinguished in part or full in exchange for a lump-sum payment from Treasury under the HAMP program.

Mortgage investors would like to modify the 2MP approach. “If there are second liens, they should be extinguished before you do any write-down on the first lien,” Fiorillo says. “I don’t know that 2MP gets the job done, because we end up with a pari passu write-down,” meaning the first and second are written down by the same percentage.


Investors would prefer better protections for the first lien, reflecting the fact the second lien is subordinate.


Investors would also like to revise the net present value test that the AG settlement relies on from the HAMP program. “We offered to have someone put together an approach that would look at both the front and back-end debt-to-income (DTI) ratio” with regard to the net present value model, Fiorillo says. “If the attorneys generals are trying to help the consumer, the only way to help the consumer is to view them holistically,” he explains. “So if a front-end DTI is 31 percent and the back-end is 68 or 70, they’re doomed to failure.”


The net present value test, developed by Treasury, assesses borrower and loan information for eligibility for HAMP loan modifications, determines the net present value outcome (positive or negative, and the amount) for a given modification.


The net present value test determines whether or not modifications become permanent, and is one reason that out of 2,520,000 eligible HAMP loans, only 768,773 are active permanent modifications, according to an official report that evaluates the program through January 2012. (The same report reveals that there have been only 47,644 permanent second-loan modifications with 2,160 second liens partially extinguished.)


Investors would also like to see a cap of 15 percent on their potential write-downs of first-lien mortgages. “We would prefer that they not use private-label securities to pay their fines, but if that’s what’s going to happen, there should be some maximum amount per issuer,” says Fiorillo.


Mortgage investors would like to see the seconds eliminated completely before there is a write-down on the first. “If that doesn’t work, maybe a better solution could be a minimum 2-to-1 write-down. Seconds would get written down twice as much as firsts,” says Fiorillo. “So, if we write down the first 10 percent, we write down the second 20 percent.”


Additional issues have surfaced on second-lien write-downs because borrowers do not necessarily become delinquent on second-lien mortgages when they are delinquent on the first mortgage. A December 2010 study by the Federal Reserve Bank of Philadelphia found that one-third of borrowers engaged in “strategic defaults” by defaulting on their first mortgage while also keeping current on their second-lien mortgages.


Fiorillo suggests that if borrowers are current on the second lien and the bank wants investors to take losses on the investor’s first-lien loans, then banks should “release the second lien.”


Mortgage investors, who expect there to be more negotiations to bring more servicers on board, want to be part of those negotiations. “We want a seat at the table,” Fiorillo says.


Finally, Fiorillo wants “full and open monthly access to what’s going on” with the appointed administrator for the settlement, former North Carolina Commissioner of Banks Joseph A. Smith Jr.


The servicers believe some of the concerns of the mortgage investors may be overblown. “The agreement, both the consumer-relief provisions and the servicing standards, explicitly provides that it is subject to investor agreements. So, if the investor agreements prohibit the activity in question, then the servicers can’t do it,” says K&L Gates’ Platt.


He adds, “This is really no different than HAMP. It’s the same issue with HAMP. If a servicer signed up for HAMP, they can’t use it if the contract prohibits it, and investors have been dealing with that one for quite some time,” he says.

“Second, the economic incentives are heavily weighted in favor of servicers doing things for their own account,” he adds.


“Third, most servicing agreements require servicers to use a standard of care where they service the loans of others in the same way they would service their own, which makes it hard [for servicers] to do unto investors as they would not do to [unto] themselves,” Platt argues.


“It’s the Golden Rule. And last, it just wasn’t the intention. I know actions speak louder than words. It wasn’t the intention of servicers to concentrate their activities on third-party servicing,” says Platt.


As for second mortgages being wiped out before capital reductions can occur on the first, “If it does violate [any agreements], then it can’t be done,” Platt contends.


Even so, the Association of Mortgage Investors is committed to preserving the legal property rights of investors not only for the AG mortgage settlement but also for the future of the mortgage industry, according to Katopis.


Mortgage investors have made it clear they will not go quietly into the night. So far, however, it’s not clear just how far the parties to the settlement—the feds, the states and the servicers—are willing to go to accommodate the investors. Stay tuned.  MB


Robert Stowe England is a freelance writer based in Arlington, Virginia, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..




Enforcing the Settlement


Compliance with the national mortgage servicing settlement is being overseen by Joseph A. Smith Jr., the former North Carolina Commissioner of Banks. The Office of Mortgage Settlement Oversight (OMSO) was formally set up in Raleigh, North Carolina, on April 5, and Smith assumed office as monitor of the agreement.


Smith will receive periodic reports from the servicers who signed onto the settlement and he will oversee compliance with its terms. The monitor will report his findings, determinations and actions to the U.S. District Court for the District of Columbia and to the Monitoring Committee representing the state attorneys general and the federal government.


Under the settlement, the monitor is empowered to work with institutions that are not compliant and establish corrective plans. If necessary, the monitor can also recommend penalties or seek injunctive relief to enforce the settlement.


“Since the settlement was announced [in March], people have understandably paid a great deal of attention to the specifics of the consent judgment—who will pay, who will receive, and how much,” Smith said at a ceremony marking the opening of the office.


“Those are important matters to determine. But this settlement also serves those who do not participate in the transfer of money: the neighbors of distressed borrowers whose property values stand at risk because of foreclosed properties in their midst, the communities in which they live, the people saving now toward the goal of homeownership, and everyone whose living depends on a robust housing and home finance industry,” added Smith.


Copyright © 2012 Mortgage Banking Magazine

Reprinted with Permission



Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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