The recent news coverage has returned many mortgage and MBS-related issues, both real and illusory, to prominence. The initial headlines that stemmed from the announcement of problems with GMAC's foreclosure filings have morphed into questions about the foreclosure process, the extent and potential cost of loan buyouts, and the legal standing of the securitized mortgage market itself. This article addresses some of the issues currently roiling the financial markets.
The Legitimacy of Securitization. Stories in major news outlets (including a front page story in BusinessWeek subtitled "Who Owns Your House? A $1 Trillion Crisis of Faith") have suggested that unknown huge numbers of mortgage loans are floating around in cyberspace. Everything I've encountered suggests that these concerns are grossly exaggerated. First, much speculation has resulted from the unfounded assumption that the deterioration in underwriting standards after 2004 also infected the process of creating the securitization trusts and transferring assets. Moreover, the reports ignore the 30-year history of the securitized mortgage market, along with the fact that the Uniform Commercial Code (UCC) has language governing the transfers of notes into securitization trusts adopted by all 50 states. The best analysis I've seen of the issue was written by the law firm SNR Denton, which concluded that "the recent allegations of possible wholesale failures to convey ownership of mortgage loans to private-label RMBS trusts are baseless and unfounded. All parties to these transactions...clearly intended that the transactions convey ownership of the loans to the trusts, and appropriate steps were taken to effect such conveyances in accordance with well-settled legal principals governing transfers of mortgage loans."
The Foreclosure Mess. There are many complex and interrelated issues associated with the foreclosure controversies, which were started by revelations that employees of servicers have improperly signed off on affidavits initiating foreclosures in judicial-foreclosure states (in which judges must approve foreclosures). Clearly, serious irregularities (such as allegations of forged paperwork) must be addressed. Nonetheless, the essential issue with so-called robo-signers is procedural in nature; in fact, the majority of states have non-judicial foreclosure procedures that don't require an affidavit to be presented prior to foreclosure.
It is easy to take servicers to task for their failings. However, it's increasingly clear that the servicing industry has the wrong economic structure to operate effectively in the current crisis. Servicing operations were designed and staffed to handle huge numbers of transactions in an efficient and cost-effective fashion. The system was never intended to handle large numbers of nonperforming loans, nor manage the decision processes necessitated by the various foreclosure-prevention and modification initiatives. The industry has never functioned efficiently under stressed conditions, and its problems can be only partially mitigated by additional staff and resources.
The unprecedented volume of nonperforming loans has exacerbated the industry's problems. Combined with the delays imposed by the various modification efforts, a huge backlog of seriously delinquent loans (that have yet to enter the foreclosure process) has developed. According to the Mortgage Bankers Association's most recent delinquency survey, 9.9% of all loans (out of the 44.5 million in their population) are delinquent, and 6.3% (or roughly 2.3 million loans) are delinquent for 60 days or more.
One of the most vexing issues facing the economy has been the question of when and how the industry will make progress in processing the pipeline of seriously delinquent loans. This has weighed on home prices through the huge hangover of "shadow inventories;" it has hurt servicers by requiring them to fund advances; and it has hurt investors by delaying principal recoveries and increasing loss severities. In this context, the calls for a nationwide moratorium on foreclosures are entirely misplaced. In addition to damaging the legitimate interests of bondholders and financial institutions, it would introduce new uncertainty to a housing market that continues to struggle with high unemployment and huge inventories.
It also seems clear that few unjustified foreclosures have taken place due to paperwork errors. The errors cited by the press, such as incorrect street addresses and misspelled names, are trivial under the circumstances. Borrowers that haven't made any payments in over a year (as Bank of America's chairman stated was the case in 80% of the bank's second-quarter foreclosures) cannot retain their properties through procedural loopholes. Rather than impeding an already stalled process, legitimate foreclosures must proceed, while initiatives designed to mitigate the pain (such as rent-back agreementspioneered by Fannie Mae's Deed for Lease program) should be explored.
Loan Buybacks and Putbacks. The notion that financial institutions will have huge liabilities resulting from violations of the representations and warranties embedded in private-label deals (contained in the deals' pooling and servicing agreements, or PSAs) has recently resurfaced. While a full examination of the issue will have to wait, the topic is highly complex. Major questions include the language in the PSAs that defines potential violations (which differs across originators), the ability of investors to gain access to a particular deal's underwriting files, and the portion of losses that will be borne by the banks.
Most industry people I've questioned believe that the process will be a long and arduous, the financial equivalent of urban warfare. Universal settlements are increasingly unlikely, and claims will be filed, negotiated, and settled on a loan-by-loan basis. For example, it is not enough to simply identify a violation for a loan that has gone into default; it still must be demonstrated that the defect directly contributed to the default. In addition, the bank may be responsible for only part of any loss. An example might be a loan with an understated LTV attributable to a flawed appraisal. In that case, the loan might need to be bought back, but the bank may absorb only losses associated with the amount of the LTV discrepancy.
The markets were recently rocked by reports of legal action filed against BofA (the successor company to Countrywide) by a group of large and powerful investors constituting "investors with standing" (i.e., holders of more than 25% of each deal), which included the New York Fed. The group's lawyers sent a letter to BofA accusing it of failing in its duties as the master servicer of 115 separate Countrywide-issued deals backed by prime, subprime, and Alt-A loans. The "Notice of Non-Performance" sent to the bank (along with the Bank of New York, the trustee for the deals) raised a variety of issues, including the (dubious) claim that the bank kept "defaulted mortgages on its books rather than foreclose or liquidate them, in order to wrongfully maximize its Servicing Fee..." It also claimed that loans modified as part of a settlement with a group of state's attorneys general should be bought out of the trusts, since the settlement was based on evidence that the loans were predatory. (A similar suit was recently decided in BofA's favor, as a judge ruled that the investors did not have legal standing to sue.)
More important than the merits of the notice's claims is the nature of the remedy to an "Event of Default" by the servicer. In such an event, the PSAs require that servicing be transferred away from BofA to a third party (or to the trustee, if no other servicer can be found). Given the current unprofitable nature of the servicing business, it's unlikely that a new entity could be found to take on the role of master servicer for these deals. Moreover, a transfer of servicing would be highly disruptive to all investors in the transactions, including the investor group. Servicing transfers are problematic under the best of circumstances, and are typically plagued by glitches such as lost files and misplaced payments. In the current environment, the normal disruptions would be magnified by REO inventories, large numbers of loans in foreclosure, and loans in various stages of modification. This suggests that if the requested action was actually carried out, it would damage the interests of the investors involved in the action.
This leads to questions regarding the motives of the investor group. One possibility is that they expect the servicing to be transferred to parties more agreeable to allowing access to the underwriting documents, which is necessary to directly pursue rep & warranty claims. The more likely explanation is that the letter was intended simply to pressure the bank to negotiate buyback settlements, in part by pushing its stock price down.
Also noteworthy was the involvement in the action by the New York Fed, as owners of non-agency MBS held in their Maiden Lane facilities. In my view, the involvement of the Fed is extremely troubling. If the transfer of servicing were actually to take place, all incomplete modifications would almost certainly be halted, a result contrary to the policies of the Obama administration. While unlikely, it is also conceivable that the notice could trigger unforeseen events that eventually destabilize the financial system, an outcome directly at odds with the Fed's responsibilities in ensuring financial stability.
Finally, the action highlights the major conflicts associated with the Fed simultaneously acting as investor, regulator, and central banker. It's difficult to imagine how the Fed is supposed to effectively regulate a bank that it is separately targeting with legal action; could, for example, BofA refuse to turn over documents and data based on the NY Fed's adversarial role in any legal action? In my opinion, the multiple roles being played by the Fed risk its independence and credibility; in particular, the role of activist investor could damage the Fed at a moment when it is embarking on controversial and risky measures designed to boost the economy.
Bill Berliner is a mortgage and capital markets consultant based in Southern California. His Web site is www.berlinerconsulting.net.