Housing and Urban Development Secretary Shaun Donovan sought to clarify comments to reporters made over the weekend about expectations of “substantial” principal reduction payments from the foreclosure fraud settlement made out of loans owned by private-label investors in mortgage-backed securities, not the banks themselves. In fact, Donovan told FDL News, the “large majority” of principal reduction would instead come from the banks’ own books.
I and other reporters saw Donovan’s comments suggesting that investors, be they institutional bondholders or hedge funds or pension funds, would foot much of the bill for the settlement, which could draw legal challenges from investors objecting to takings of their private property (write-downs on the loans) without fair compensation. While the overall numbers of these write-downs could still reach into the billions (hence the “substantial” in dollar figure, if not percentage of the settlement), and while Dononvan does see such a strategy as a “chance to really jump-start broader principal reduction” in the MBS part of the mortgage market, Donovan expected much more principal reduction to arise from bank-owned loans, including their second liens (typically home equity lines of credit, or HELOCs).
This is an important point. One concern many had with the settlement payments coming off the MBS loans was that the first loans would get written down before the seconds, which varies from the standard practice in the industry. Yves Smith wrote about the second lien issue over the weekend.
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 [...]
[Banks] 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.
This would suggest that by engaging in write-downs of private-label securities, the banks would be protecting their own books by increasing the value of their second liens. This would be an important fix to bank books, as they have nearly $400 billion in second liens on them, and many observers believe most of them to be worthless. It’s why some have characterized banks writing down other people’s firsts to strengthen their own seconds as a back-door bailout.
Here’s what Secretary Donovan told me in a Sunday interview. “We expect a large majority of principal reduction to come from the bank’s own books. And we’re including a requirement that where a first lien is being written down, and any institution signing on to the settlement holds the second lien, they are required to write that second down at least pari passu (“on equal terms”), and if the second lien is delinquent over 180 days, written down entirely.” Administration sources close to the negotiations added that they believe nothing on the investor-owned loans would override the contract responsibilities of the trustees. Furthermore, officials advised that the principal write-downs on investor-owned loans are expected to come from a small number of institutions, who may or may not have deals in place with their investors to offer some manner of compensation for the write-down.
I asked Josh Rosner, the managing director at Graham-Fisher, for his insights on the second lien plan for the settlement. “If there was a real intent to treat borrowers and investors fairly, they would force the write downs of second liens when the first was defaulted or in significant negative equity, firsts are supposed to be senior,” Rosner said. He added that it’s easier to keep second liens current, because you can do so merely by making a minimum payment, unlike with a first lien, where the whole payment must be made every month to stay current. Given that, there probably aren’t a whole lot of second liens that are 180 days delinquent, which would be wiped out under this scheme. However, that “current” status makes them no less vulnerable, Rosner said. “If the first is defaulted or insignificant negative equity it is reasonable to conclude that the second will ultimately default.”
Ultimately, it’s hard to say with much confidence how high a percentage of what kind of debt write-downs we will see in the settlement, especially because nobody but Donovan and the state Attorneys General really know the terms. And while I have no reason to believe that Donovan is cooking the numbers in any way, ultimately he and anyone else are making a guess, however educated, as to what loans the banks will write down. That’s because the banks mostly have discretion, as I understand it, as far as the principal reductions are concerned. They just have to add up to a certain dollar amount in “credits.” I asked Rosner if we could say for sure what percentages of what loans the banks will write down, even with the rules on seconds in place, and he replied, “Given that the terms have not been made public, which is peculiar, we can’t.”
Indeed, while we probably know more about the details of the settlement than we ever have before, as we should expect given how imminent the announcement is, the full details remain pretty murky. Bruce Judson wrote over the weekend that the secrecy in this process is troubling:
Why are the terms of this settlement secret? Prosecutorial negotiations are normally secret in order to prevent the disclosure of evidence that might or might not be relevant to a later trial if the negotiations collapse. This concern does not apply here.
This settlement has far more of the characteristics of legislation than of prosecutorial activities. The offending banks have destroyed the wealth, livelihood, and dreams of millions of Americans. Shouldn’t the public at least have two weeks to view the proposed terms of the settlement and make their views known to their state’s attorney general? And at a time when trust in government is at historic lows, isn’t secrecy for this type of activity the wrong way to build the much-needed confidence of the American people?
Let’s get back to the basics here. We’re about to see a settlement on a range of servicing and foreclosure fraud issues that go back a decade. I think we can say at this point it will happen; New York and California have returned to the bargaining table, and I’m not usually on a first-name basis with the Secretary of Housing and Urban Development. Other AGs have their talking points in order. Things are moving.
And we’re doing this settlement, mostly, with rough sketches of what it would entail, at least for the public (and if you believe Catherine Cortez Masto’s letter, even for the law enforcement officials signing off on it). We can discuss in vague terms but not specifically enough the important issues – what is the penalty for the banks, what part of the penalty can they pass on to others, how to enforce the penalty, what the investigations at the state and federal level have revealed, how legally secure is the settlement, how adequate is the total settlement from a monetary standpoint, what future claims will be aggressively pursued to build on the financial relief in the settlement, etc. I could see a settlement meeting these tests on some of these issues. But it’s not all that easy to say by looking at rough sketches.
At the same time, the damage that resulted from the housing bubble, the crash, and the fraud that fed the system is actually quite well-known. We know about the four million foreclosures since 2007 and the millions of jobs lost as a result of the subsequent financial crisis. We know about the $700 billion in negative equity in America. We know about the damage caused by a foreclosure to overall property values; it immediately lowers the value of a neighbor’s home by $5,000-$10,000, according to Secretary Donovan. We know that the larger economy suffers from increased foreclosures and blight and local government expense for upkeep and dislocation of families and reduced property values and a decrease in construction jobs and the negative wealth effect from negative equity.
All of these things are known. So we have a good understanding of who is responsible for the crisis and how much their misdeeds have cost. That’s not a legal argument, and it’s entirely possible that this group of state and federal law enforcement officials, with the laws they have to use and the predilections they have to use them, would not have come up with that amount on these specific abuses. I think that’s hard to know. Secretary Donovan talked over the weekend about the settlement being a “down payment” for future write-downs, mainly arising from the RMBS working group going after securitization and origination abuses. “There is the opportunity to get very large-scale relief, including serious principal reduction, for families that have been victims of the crisis,” he remarked. Writers like Robert Kuttner see this as essential, that this isn’t the end of the road but the beginning.
I certainly hope so. But I’ll have to wrestle with that in a subsequent post.