Since October, 2008 LoanWorkout.org has been following various legal developments as they pertain to loan modifications. One such issue is whether loan servicers can be sued by share holders for providing loan modifications without the consent of the owners of mortgage back securities. Since President Obama has passed a stimulus package that incentivizes services to modify loans the debate is heating up again. It seems more likely now that we’ll see some lawsuits over modifications before the mortgage crisis comes to an end.
Understanding the basis of these suits is important. The February 22, 2009 edition of the Financial Times provides great insight in to the unique role the servicers play:
“Formerly a back office for the booming US mortgage market, mortgage servicers are now at the front line of the US housing bust. They are responsible for collecting home loan payments, assessing late fees and working with struggling borrowers on behalf of lenders and investors in the securities that package home loans. However, their efforts to modify home loans have been impeded by the threat of lawsuits from securities investors threatened with losses. For the $2,500bn market for securitised loans, where 60 per cent of the most troubled mortgages reside, servicers are obliged to try to maximise the value of the mortgage for the end investor.
However, the legal arrangements for such securities can vary enormously, with servicers often facing limitations on the number and type of modifications they are allowed to conduct. There is also disagreement over whether mortgage modifications are effective in minimising losses for investors, with about half of all modified mortgages falling back into arrears within six months. Disputes over these agreements have sparked a spate of legal challenges for servicers, many of which are owned and run by banks such as Bank of America, Wells Fargo and JPMorgan Chase.”
The specific grounds for potential lawsuits fall in to two categories. First, Government incentives for loan modifications create a conflict of interest between servicers, borrowers and the shareholders of the securities and (2) shareholders have no control over the terms of the modified loan contracts. According to Michael Bopp at Gibson Dunn & Crutcher, “If you have servicers voluntarily restructuring mortgages, that’s where you could see some litigation …investors would be taking the losses.” Explaining the specific conflict of interest more completely, Talcott Franklin, partner at Patton Boggs LLP in Dallas, said that the mortgage modification program could lead to investor lawsuits, particularly when it comes to pre-default modifications.The Obama plan gives a mortgage servicer a $500 cash incentive to modify a mortgage before the borrower falls behind (the homeowner receives $1,500 in this situation). Franklin said he worries that pre-default modifications may give rise to conflicts of interest that could violate some servicer contracts with investors. He expects mortgage investors to wait until modifications really start happening in large numbers before suits are filed. According to Franklin, “Motivation is a state of mind, so questions could arise as to whether the loan was modified because the servicer and borrower both wanted the incentive payments, instead of because the loan actually required modification.”
Does the problem already have a solution?
Mortgage investors are also looking for guidance on Capitol Hill, where legislation is under consideration in the House that could block their ability to file lawsuits. Reps. Paul Kanjorski, D-Penn., and Mike Castle, R-Del., have introduced legislation that they believe will greatly cut down the number of mortgage investor lawsuits at the same time as they encourage mortgage servicers to modify loans.
The bill would give home loan servicers legal protection if they modify mortgages. The Kanjorski-Castle bill was approved by the House Financial Services Committee on February 5, 2009. A Kanjorski spokeswoman said she was hopeful the bill will be approved later this year.
Kanjorski and Castle introduced similar legislation last year that was ultimately removed from a mortgage modification bill approved by Congress in July.
Georgetown University Finance Professor James Angel points out that the measure didn’t make the cut because the Bush administration was against it. However he noted that the July loan modification program, known as Hope for Homeowners, hasn’t been working. Angel argues that the Obama administration will likely support it, in part, because it has the benefit of seeing how unsuccessful the July program has been.
One possible deterrent, Angel added, are Democratic-backing trial lawyers who may seek to protect their members’ ability to litigate by opposing any legal protection for servicers.
“So far these modifications have failed because the servicers have been risk averse,” Angel said. “Now we have a financial incentive with the bonuses but we need legal protection.”
Even with investor suits, many loan modifications are likely to take place. Fannie Mae and Freddie Mac will likely modify mortgages that the government-backed entities control, Angel said. Congress is also working on legislation that would allow bankruptcy judges to modify mortgages for troubled homeowners. Even with GOP opposition, a measure that would allow judges to alter some mortgages is likely to be approved.
The Obama administration supports bankruptcy judge provisions that would apply only to loans that fall within size limits that apply to loans that can be purchased by Fannie Mae and Freddie Mac. Congress is considering legislation that is supported by Citigroup Inc. that would allow judges to modify only mortgages that exist prior to the enactment of the legislation.
As we have reporting since late in 2008, opinions as to the best route to solve this problem vary tremendously between the investor class, government, Wall Street and Main Street. Dan Alpert, managing partner at Westwood Capital, a boutique investment bank, said: “The incentives do not take the risk of lawsuits off the table. Now the plaintiff can say the servicer modified for the fee. The payment simply creates an additional conflict of interest.” Adding fuel to the fire, William Frey, President of Greenwich Financial Services argues “Any investor in mortgage-backed securities has the right to insist that their contract be enforced.”
In response to the hedge fund manager, John Taylor, The Center of Responsible Lending’s President said it best in response to the above hedge funds. “We can’t try to operate in a crisis and think that we will be able to satisfy all the lowest common denominators like hedge funds.”
Tom Miller, the Attorney General of Iowa and a leading proponent of aggressive loan modifications said “We think that by doing more modifications rather than less, investors are going to be better off.”
Moe’s Comments:
The fact is that when there is a world-wide crisis and potential solutions are proposed, not everyone will be happy with the proposals. Such is life. But when it comes to our economy and the mad dash to hold on to cash, many investors on Wall Street are not going to accept these proposals lightly. The hedge fund managers are excellent examples.
Now, that their returns are waning, these fund managers are simply trying to find a scapegoat to blame their losses on. These funds are one of the main causes of our broken economic system. Instead of taking the blame for overselling risky mortgage backed securities, they’re playing the role of the victim. To me, the hedge funds just want to have their cake and eat it too.
In the end, I agree with John Taylor because many of these hedge funds were nothing more than unregulated boiler rooms that made billions of dollars off of toxic assets they hedged and sold around the world. A lot of them had their hands in the world wide ponzi scheme of Mortgage Backed Securities and their risky “bets” have gone bad. The fund managers should take their losses like everyone else and we should focus on improving Main Street through viable loan modifications before preserving the capital of the fund managers.
Sources:
Financial Times
LoanWorkout.org Hedge Funds Balking at Loan Workouts
LoanWorkout.org Bill Frey & Greenwich Investors
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