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Orders in the Courts

_Will Loan Modification Disputes Change Servicing and Further Damage U.S. Capitalismx_
What a year it was. In 2008, home values took a beating while Wall Street investors were out nearly $7 billion. In the American tradition, the next step is to figure out who’s responsible for what, and that means a lot of people will be heading to court and to Congress in 2009. Every era and every industry has its defining court cases, and the litigation for servicers to watch this year involves mortgage modifications. Who has the right to modify loans, who doesn’t—and who paysx
At first it may seem as though such questions are long-settled, but with the foreclosure glut of 2008, the doors to change have swung wide open. In fact, millions of loan contracts were effectively modified during the past year, often without the approval of lenders, investors, or borrowers. Here’s how:
> A number of states enacted foreclosure moratoriums. Under the terms of a moratorium, an investor has no leverage to compel payment because local courts will not order foreclosure actions.
> At year-end, both Fannie Mae and Freddie Mac announced holiday-season foreclosure moratoriums—moratoriums that were then extended until the end of January.
> Many lenders—including Bank of America, JPMorgan Chase, and Citigroup—announced massive loan modification programs.
> At the start of 2009, Citigroup reportedly agreed with Capitol Hill lawmakers to support the right of bankruptcy judges to modify residential mortgages—a substantial change from the longtime industry position.
*Two Fronts *
For servicers, the emerging litigation debate has two fronts: what happens in courtrooms nationwide as well as what happens in the political arena. On the legal side, the most important case will likely involve Bank of America’s newly acquired Countrywide subsidiary and its announced plans to revamp 400,000 loans with up to $8.4 billion in mortgage modifications.
Given the widespread public and political support for loan modifications, it might seem as though the Countrywide plan would be hailed unanimously as good news from the lending community. But in December, Greenwich Financial Services and QED LLC sued to stop the Countrywide modifications.
""Countrywide plans not to absorb the $8.4 billion reduction in mortgage payments itself,"" according to the lawsuit. Instead, the suit claims that Countrywide’s plan involving 374 securitizations would ""pass most or all of that reduction on to the trusts that purchased mortgage loans from Countrywide. If the trusts are forced to absorb the reduction in payments occasioned by Countrywide’s settlement of the allegations against it, then the value of the securities that those trusts sold to investors will decline.""
Translation: The suit alleges that Countrywide wants to modify loans it doesn’t own.
John H. Beisner, an attorney with O’Melveny & Myers, the law firm representing Countrywide, said in a letter released to DS News that ""Countrywide has authority to make the planned modifications, and it intends to do so."" Moreover, says Beisner, Greenwich lacks the standing to sue under the pooling and servicing agreement and adds that Greenwich ""should support Countrywide’s efforts to make modifications; not only will they keep families in their homes, but they will also benefit investors in Countrywide mortgage-backed securities by maximizing the value of mortgage loan assets, something that won’t happen if foreclosures occur.""
Some banks argue that servicers do have the right to conduct loan modifications—so long as the modifications maximize returns to all investors.
""There are already a record number of workouts going on with the various homesaver programs offered through Fannie, Freddie, and HUD,"" says attorney Matthew C. Abad with the Indiana-based firm of Burke Costanza & Cuppy.
In response to claims by state attorneys general regarding lending practices prior to its acquisition by Bank of America, Countrywide agreed to make billions of dollars in loan modifications as part of a settlement package.
""The precedential value of any lawsuit is always clouded by the facts that drive the outcome,"" Abad explained. ""In this case, we have a large servicer that was under attack as a result of its origination practices. The attack came in the form of several state attorney general lawsuits seeking some kind of redress for their constituents. If the plaintiffs are successful, it will likely force servicers that are under attack from various government agencies or class-action groups to carefully review the terms of a proposed settlement to ensure that 1) the servicer has the authority to accept the terms of the agreement and 2) that complying with the terms of the agreement will not violate the rights of those for whom the servicer services loans.""
*An Invitation to Washington *
In October, The New York Times reported that some mortgage investors were ""fighting proposals to ease the terms of home mortgages, arguing that such a move would hurt their investments.""
William Frey, president of Greenwich Financial Services, told the paper that ""any investor in mortgage-backed securities has the right to insist that their contract be enforced.""
Frey’s argument did not go unnoticed. Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee, and five other committee members sent a letter to Frey saying, ""We were outraged to read in today’s New York Times that you are actively opposing our efforts to achieve a diminution in foreclosures by voluntary efforts. Your decision is a serious threat to our efforts to respond to the current economic crisis, and we strongly urge you to reverse it."" They also wanted Frey to testify at a congressional hearing to be held November 12, an invitation not to be ignored.
Frey showed up as requested but was not given a chance to speak. Frey is a broker-dealer not a hedge-fund manager, invests his own money, and has no involvement with the ""affordability"" loan products widely marketed during the past few years.
""I invest my own money in the U.S. and international capital markets, and I do so judiciously and carefully after much research and analysis,"" said Frey in a written statement prepared for the committee.
""All of the credit support securities I own were originated before 2004 and are not based on subprime or Alt-A collateral,"" he continued. ""The loans backing the securities I own have low loan-to-value ratios [meaning high levels of equity] and are performing well. The borrowers were not tricked by teaser rates or encouraged to misrepresent their incomes. These are securities backed by mortgages secured by the homes of thousands of ordinary hard-working Americans who are making their payments as agreed, honoring their contractual commitments.""
*Core Issues *
What are Frey’s argumentsx Frey made these points to DS News:
First, a contract is a contract. Investors who purchase mortgages do so with the expectation that borrowers will fully repay their debts. Only investors—not servicers, unless otherwise authorized—can agree to loan modifications. The government can change loan terms but only if it pays investors for economic losses. Otherwise, says Frey, ""It will violate the taking clause of the Fifth Amendment."" That’s the provision of the Bill of Rights that says government cannot take private property for public use without just compensation.
Alternatively, if the government enacts rules that change mortgage contracts without compensating investors, then Frey worries ""we will be looking a lot like Venezuela or Zimbabwe,"" places where investor capital is in short supply and investors demand political risk insurance, which is one reason for higher borrowing costs.
Second, there are conflicts between servicers and investors. Under the Housing and Economic Recovery Act of 2008 and the just-introduced TARP reform bill (H.R. 384), loan modifications are encouraged when the cost of a loan change on a net-present-value basis is less than the loss that would result from a foreclosure.
The catch, says Frey, is who determines which result is best—the servicer or the investorx
Frey says the servicer is massively conflicted in this modification decision. Frey sees several forms of conflict. One is that servicers have an incentive to do modifications because they receive additional fees for such work. Another concerns financial engineering. In this situation, the servicer is a bank that owns a second lien. It can increase the value of that second lien by writing down the first lien. This, says Frey, ""is allocating the loss to the wrong party."" It’s not allowed, he says, ""but the banks are doing it anyway.""
*Contract Sanctity *
Frey makes the point that under pooling and servicing agreements, ""servicers almost always have the right to buy a defaulted loan at par if they want to modify it."" The other alternative, says Frey, is foreclosure.
The key phrase used by Frey is the term at par because it gets to a central issue: What should be expected of investors—and what should investors expectx
In the context of borrowers, servicers, and investors, it is the investors who provide capital under certain terms, generally in exchange for the full repayment of principal with related interest over time.
Mortgage loans typically do not permit ""appreciation sharing."" When the value of a home increases, no one calls the mortgage investor and says, ""Gosh, since we’re making so much money, we want to give you even more than our original agreement required,"" said Frey.
Since investors are not receiving additional profits on the upside, why should they take a loss when property values declinex That, essentially, is what happens with a modification or short sale.
There are solutions, says Frey. The government or servicers could buy loans at par. Another option could be a settlement.
""The servicer and investors can get together and cut a deal,"" says Frey. ""Given that it is difficult to get the thousands of investors to agree, there has to be some way to have a mass bargaining session."" One approach is to have a class-action lawsuit, just like the Countrywide case. If a deal could be made with court approval, then investors could stay in or opt out of the deal as they prefer.
Few investors, says Frey, would opt out of a properly structured deal. ""To get an acceptable deal, the trust would have to have some money put into the trust and a system to send it to different classes of investors,"" he explains.
And if there’s no agreementx
""Modifications will not come to a halt even if the suit is successful due to the sheer volume of decrease in real estate values nationwide,"" says Indiana attorney Craig Doyle. ""The market correction of debt to asset value will continue.""
In a statement to The New York Times, Countrywide said the suit ""represents an unlawful effort to assert the rights of the trusts."" Further, they said ""Loan modifications have been occurring for decades without objections or challenges, so we are especially troubled at the timing of this complaint. We are confident any attempt to stop this program will be legally unsupportable.""
*The Political Realm *
While the merits of Frey’s suit will be decided in court, foreclosures are more than a legal issue. They are also a visible political matter, and what happens in Washington, D.C. and state capitals may well make moot any court decisions.
In 2008, for example, almost 2.6 million workers lost their jobs—the largest job loss since the end of World War II. At the start of the year, we had more than 11.1 million people without jobs, a number that is certain to increase and a precursor of rising foreclosure levels.
Alternatively, says Frey, mortgage ""investors"" include pension funds, IRAs and 401(k)s. He argues that the public is increasingly aware that mortgages are ultimately owned by individuals and not just the wealthy. These individual investors also have a stake in the foreclosure debate.
The conflict between investor rights and the demand for politicians to ""do something"" in a troubled economy is already being seen in the form of foreclosure moratoriums and media coverage. Politicians are also moving to protect servicer interests—the TARP reform bill, for example, contains a ""servicer safe harbor"" provision that would largely limit liabilities that could arise from modifications.
While the urge to do something may be politically irresistible in the short run, the need for capital is ongoing. A system that makes the United States something other than the safest capital market in the world would profoundly impact the economy for years. As with poorer countries, the cost of borrowing would rise and the availability of capital would contract. Growth, if there were meaningful growth, would be constricted. With less capital to finance commerce—a massive credit freeze—asset values would deflate, job losses would rise, and with continuing deficits and balance-of-payments problems, inflation could become a significant worry. Everyone would lose.
In effect, the Countrywide suit is about mortgage modifications—and it’s also at the center of a much bigger debate.

About Author: Peter Miller


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