The outcome of the negotiations between servicers, the group of state Attorneys General and the fledgling Consumer Financial Protection Bureau (CFPB) is extremely important to the future of housing and mortgage lending. The initial documents and press reports, unfortunately, are not encouraging. The proposed Settlement Terms released by the AGs in early March, combined with press reports of enormous fines being sought as part of any settlement, lead to the conclusion that the state and federal governments are together using the scandals arising from the servicing mess as a pretext to redistribute money from banks and investors to homeowners. Aside from issues of fairness, due process and execution, these discussions have enormous ramifications for the future of the mortgage industry and the housing market, particularly in light of the uncertain future of the GSEs.
In no way should these views be taken as a vote of confidence in the servicers, who have performed very poorly over the past three years. Nonetheless, they have been forced to deal with an unprecedented crush of nonperforming loans and crashing home prices. The major differences involved in servicing performing and nonperforming loans must also be kept in mind. Under normal circumstances, servicing is a process where huge numbers of payments are handled by automated processes. Once large numbers of loans become delinquent, the economics are reversed; every delinquent loan becomes a unique situation requiring individual attention, making the industry's automation and operating leverage worse than useless. The industry clearly mismanaged the transition from a market dominated by performing loans to one with huge numbers of seriously delinquent loans requiring individual attention, and is only catching up after years of missteps.
HAMP and the other modification and loss-mitigation initiatives have, however, made the situation worse. Even though most of the programs are ostensibly "voluntary," servicers have been obliged to impose a series of additional screens of nonperforming loans designed to identify those loans for which a modification ostensibly offers a "better" outcome than by foreclosing. Attempting to impose a series of complex and poorly designed dictates without an idea of how they would be implemented served to benefit few borrowers while clogging the foreclosure pipeline. The situation was worsened by the institution of well-intentioned but counterproductive foreclosure moratoria. As a result, huge numbers of delinquent loans remain outstanding. As of last February, for example, Lender Processing Services reported that 2.1 million loans in their database were 90 or more days delinquent; an additional 2.2 million loans were in some stage of foreclosure, with an astonishing 537 average days delinquent. The combined effects of government initiatives have been to interminably extend the foreclosure process, creating a huge overhang of troubled properties and leaving the housing market in a continued state of narcosis.
The steps outlined in the AGs' proposed Settlement would repeat these mistakes by imposing a series of new procedures and requirements without any sense of whether or how they can be effectively implemented. For example, Section D of the Settlement ("Loss Mitigation Communications with Borrowers") requires servicers to "communicate loss mitigation options to all delinquent borrowers." If a loan modification is denied, the servicer must then fulfill a host of requirements, including officially notifying the borrower, implementing a 30-day waiting period, and initiating an internal review before foreclosure proceedings can be commenced. In cases where the servicer is required to obtain investor approval for modifications, the servicer must also provide the name of the investor if a modification request is denied. These onerous procedures would make what Iowa AG Miller called a "dysfunctional system" almost completely unworkable, while also making the current multi-year foreclosure lag a permanent feature of mortgage investing.
Most notably, the Settlement would force the industry to institute broad writedowns of principal reductions for borrowers. As with the proposed foreclosure requirements, little to no guidance is provided regarding the criteria to be used in deciding when and how much principal should be written down. It also does not address the troubling question of how lenders should respond, once principal is reduced, to renewed declines in home prices. The logical extension of widespread and mandatory writedowns of underwater loans is to make mortgage lenders and MBS investors responsible for supporting, if not guaranteeing, borrowers' home equity. This in turn makes the mortgage market increasingly risky and unattractive for private capital, an essential element in housing finance reform.
Even more troubling, however, are the press reports of multi-billion dollar fines being sought by the AGs, supposedly in tandem with the CFPB. Having such an enormous amount of money earmarked for principal reductions would create major issues of fairness and equity. It is unclear how borrowers would be qualified for principal reductions, for example, as well as how much individual loan balances should be reduced. However, the primary issues involve precedence and due process. In my view, the robo-signing scandals and other servicer failings are being used as a pretext for a massive redistribution of assets from banks and investors to homeowners. While the failings of the servicing industry are clearly serious, the proposed settlement terms and fines are totally out of line with the scope of the violations.
There is little doubt that the decline in home prices and the resulting multitude of borrowers with significant negative equity created a huge problem, and that principal reductions may be an effective means of aiding these homeowners. By discouraging investments in mortgage lending and products, however, the widespread confiscation of private shareholder assets would damage the system of housing finance while also creating systemic risks for the banking system. (In addition to the impact of draining $20 billion or so in capital from the financial system, the economic damage that would result from the collapse of a major servicer would be catastrophic. It's ironic, in fact, that these actions are being proposed by a unit of the Federal Reserve.)
In my view, principal reductions should be done through the bankruptcy process. Rather than imposing widespread and unfocused writedowns, principal reductions should be imposed on an individual basis by judges familiar with each borrower's case. Such an approach is the only way to insure that principal reductions are done on a limited but efficient basis, and are granted to those borrowers able and willing to make payments on their reduced balances. Note that the Settlement proposal provides for principal reductions for homeowners when they enter bankruptcy; this is very different from so-called bankruptcy cramdowns, which would give judges the discretion to reduce mortgage balances along with those of other debts.
The actions proposed to remedy the servicing debacle, as well as those designed to punish wayward servicers, are also completely incompatible with the latest efforts toward GSE reform. Combined with aspects of the Dodd-Frank Act, the proposals are extremely unfriendly to non-agency lending. Merely tweaking guaranty fees to create a "level playing field," as proposed in the Obama administration's white paper, will not serve to attract private capital to housing finance, at least not while various governmental agencies are simultaneously trying to wring huge amounts of money out of servicers and investors. Abolishing the GSEs under these conditions risks starving the housing market of the funds necessary to limp along at its current weak pace, no less recover to the point where home prices can begin to appreciate.
In any case, the clearest solution to the problem of negative homeowner equity is for all parties to develop effective policies that support the housing markets and mortgage lending. Rising home prices would have a much greater positive impact on underwater borrowers than any principal reduction plan imposed by regulators. Government officials must also remember that the ultimate goal of all of the mortgage and housing initiatives should be to provide immediate help to troubled borrowers and the housing market without compromising the long-term future of mortgage lending.
Bill Berliner is a mortgage and capital markets consultant based in Southern California. His email is email@example.com and his Web site is www.berlinerconsulting.net.