The state attorneys general announced last month that they finally reached a settlement with the five largest servicers over improper foreclosure and servicing practices.

Although the final terms of the settlement have yet to be released - in fact, as of press time the deal has yet to be signed - early drafts of the agreement indicate that banks will not be prohibited from accessing private-label MBS trusts to settle the arrangement. The bulk of the settlement cost, approximately $17 billion, will be paid by principal reductions on first- and second-lien mortgages, forbearance modifications and costs to facilitate short sales.

At least $10 billion of the agreement's total amount will be in the form of principal reductions to be applied to loans in non-agency trusts and loans held in bank portfolios. For this to happen on non-agency loans or in bank portfolios, the servicer must determine that the modification results in a higher net present value (NPV) than foreclosing on the home.

Banks are expected to receive a 125% credit for every dollar of forgiveness that they apply to portfolio loans, but only a 50% credit for every dollar of forgiveness applied to loans that they service but do not own, a Barclays Capital research note stated.

Servicers will get 50¢ of credit for every $1 in forgiven balance, and a $17 billion settlement would translate into a maximum of $34 billion in debt forgiveness for non-agency borrowers.

From a purely economic perspective, the arrangement actually creates an incentive for the banks to do the reductions within private-label MBS trusts. While they get only a 50% credit, they also escape the actual monetary costs of forgiveness, Barclays analysts stated.


Double the Impact

By opting to modify the loans within the MBS trusts, the state AGs are also set to get double the impact.

"Instead of modifying $17 billion, they'll do $34 billion because the banks essentially must do double the amount in the private-label trust in order to reach the $17 billion agreement," said an investor familiar with the deal. "It's well designed by the state AGs to maximize the impact to their constituents, which is what they are after. The deal is also well designed for the banks because it allows them to pay with someone else's money."

U.S. Housing and Urban Development Secretary Shaun Donovan told reporters on Feb. 9 in a press conference that "a relatively small share, in the range of 15%, of the principal reduction" for homeowners resulting from the settlement will come from investor-owned loans, noted a Bloomberg report.

"Nothing in it requires any trustee or servicer to reduce principal where it's not allowed legally by the underlying documents," Donovan said. "The misunderstanding somehow that investors will be paying the banks' share is just false."

It is hard to predict what the best solution for investor might be at this point because there are a lot of facts associated with the settlement that remain unclear. According to an attorney who is familiar with the preliminary settlement terms, the individual documents in a transaction might affect the ranks of the investor. "The single biggest issue investors have is that the final documents haven't been done and it could be years before this all gets done," he said. "Everybody is going to be looking for a way to protect their interest in connection with the settlement. One of the things that we do predict will come out of this, unless there is a specific provision in the settlement, it is likely that parties are going to look to protect their own interests."

However, the securitization investor believes that if the AGs were really against servicers using private-label MBS trusts to meet the terms of the settlement, it would have been very simple to put a provision within the agreement saying that it would not be allowed.

The industry has its reasons for suspicion. In 2008, Countrywide Financial Corp.'s (CFC) parent company, Bank of America Corp. (BAC), reached an agreement with 15 state attorneys general to settle claims against CFC regarding predatory lending practices. Under the deal, BAC agreed to modify as many as 400,000 Countrywide loans, reducing payments due on mortgages it services by as much as $8.4 billion. "BAC explicitly stated that they would remedy their actions using private-label trusts to make up the so-called damages, and the state AGs allowed for this provision," the buyside source said.


Investors Take Action

Another securitization partner who has worked on several litigation suits brought on by bondholders of private-label MBS, also believes that banks will look to pass the costs of the latest AG settlement on to the trusts and that investors will be the ones who will pay in the end.

The fact that banks can even contemplate the option shows that investors didn't have a real voice in the proceedings. According to the lawyer, it also highlights how vulnerable an individual investor really is.

"You have to be able to get the majority of your class to vote to do something," he said. "And banks recognize that the likelihood for investors to get enough people to object in a way that will have a legal meaningful effect is very slim."

What investors are likely to do is argue that the banks and servicers have breached their fiduciary duty by settling like this. "If I am a bondholder, I would say that the fact that banks used MERS, a third-party subcontractor that was robo-signing that has nothing to do with us, that is on the bank and the way they perform their function," the securitization lawyer said. "So why then are the banks passing the costs of settling their problems on to the investors?"

The deal documentation within the trusts in many cases stipulates that modification can occur only under certain terms. "There are a number of checks and balances in place; for example, you typically have certain restraints on modifications within the pooling and servicing agreement," explained Jeff Nielsen, a managing director at Navigant Consulting. "The PSAs outline the restraints and requirements that apply to a specific deal, and as far as I know those continue to be in force." Nielsen explained that NPV tests applied to delinquent loans within the trust are designed to evaluate the economics of a modification relative to the alternative of foreclosing on the property. This is to evaluate whether a modification might be economically advantageous to the trust and to the investors relative to the alternative scenario.

Amherst Securities Group analysts said in a research paper that giving servicers credit for settling their claims with the state AGs with money that is not their own made no sense and could possibly compromise the checks and balances within MBS trust documentation. "The fear is that the [NPV] test will be compromised in order to allow servicers to speed up their modifications and satisfy their credits," they said.

If the five servicers, which, according to data from Amherst, service $433 billion in private investor loans, were given credit at 50 cents on the dollar for investor loans, and the banks dedicate the entire $17 billion in credits toward modifying loans in private-label securitizations, the servicers would have $34 billion in write-downs.

Amherst further breaks down the $434 billion in private-label securities serviced by the top five servicers into $225 billion in "always performing loans," or loans that have never been two payments or more behind; $71 billion in "re-performing loans," or loans that have been two payments or more behind but no longer are; and $138 billion in "nonperforming loans," or loans with two or more payments past due.

"It would mean that $137.6 billion of nonperforming loans would be written down by 24.7% (which includes the $78 billion of loans already in foreclosure and REO)," analysts explained in the report. However, they said that since it does little good to write down loans in foreclosure/REO, every one of the $59.6 billion of 60+ and 90+ days delinquent borrowers have to get written down by 57%. To meet this requirement, analysts said that the largest servicers would be performing non-economic principal reductions using investor funds.

The investor who spoke with ASR also noted that while many deals are governed by provisions that prevent an automatic modification, they have essentially been ignored or overwritten unilaterally, "so it provides very little protection," he said."You have only to look at the Countrywide settlement with the AGs. Most of the documents for the private-label, Alt-A loans stated that any modifications were supposed to be bought out at par by the bank, but the mortgages weren't bought and the bank claimed safe harbor. How much recourse on this do investors have is debatable. You have to sue and figure it out."

He believes that the banks and the AGs have been making the calculations all along, that investors will not spend the money to challenge this stuff. "Up to now they have been by and large correct," he said.

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