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Mortgage Magic or Mortgage Mayhem?

Posted by Larry Doyle on May 5, 2009 7:02 AM |

Are the largest banks in the land ready to defy the rule of law and self-deal with Uncle Sam’s blessing in the name of providing mortgage relief to homeowners currently strapped by first and second mortgages? The WSJ reports How Big Banks Want To Game The Mortgage Mess

Is this another game of chance in which Uncle Sam wants to prime the pump in hopes of luring private capital into the economy? No, anything but. In fact, this is no game at all. Uncle Sam is proposing legislation which would protect mortgage servicers from being sued for not performing their duty to protect the property rights of mortgage investors (including pension funds, mutual funds, insurance companies). What does all this mean?

Investors in mortgage securities backed by first mortgages are entitled and expect protection of their capital by the performance of mortgage servicers handling the monthly payment of mortgage principal and interest. In fact, if the mortgage servicers do not perform the investors will and should sue. 

The investors or holders of second mortgages will only receive a return if and when the first mortgage is current on its payment.

Will Congress pass legislation which would unintentionally incentivize large banks, which also happen to be large mortgage servicers, to game the mortgage modification process for their own benefit but at the expense of investors holding the first mortgages? The WSJ highlights:

Given the current housing crisis, there is wide support for measures to make it easier for homeowners to modify their mortgages. That is understandable. Nobody likes seeing the wave of foreclosures. Plus, mortgage modifications may help stabilize home values.

But in the rush to do something, Congress is showing a regrettable willingness to adopt constitutionally suspect legislation that runs roughshod over the Fifth Amendment of the Constitution, which prohibits the taking of private property without just compensation.

Ever since this current foreclosure crisis began, Congress has complained that the companies administering mortgages — “servicers” — have not done enough to modify home loans in ways that might prevent foreclosures. Why? Because, it is said, the servicers fear being sued by those who have invested in mortgage-backed securities.

To put a halt to such lawsuits, Rep. John Conyers (D., Mich.) is pushing legislation — the Helping Families Save Their Homes in Bankruptcy Act — that Congress is likely to pass in some form this year. The bill would grant servicers immunity from lawsuits so long as they can claim that investors will be better off — even by a penny — under a modified mortgage.

The problem is that servicers also get a free pass to game the system. Distressed homeowners often have both a first mortgage and a second mortgage (like a home-equity loan), which by the legal standard in any bankruptcy is junior to the first loan. The four biggest banks in the country — Bank of America, Citigroup, Wells Fargo, and J.P. Morgan Chase — hold a combined $441 billion worth of second-mortgage loans. By contrast, these banks are not big investors in first mortgages. They therefore would prefer to see first mortgages modified in a way that makes it more likely that second mortgages are paid.

And they are in perfect position to make sure that happens. These four banks — the “Top of the TARP” — service more than half of all first mortgages. The result is a huge incentive for self-dealing by servicers to rewrite the investor-owned first mortgages in ways that increase the value of their affiliated bank-owned second mortgages. Favoring second mortgages in this way turns upside-down the basic legal standards governing lenders, both inside and outside of bankruptcy.   

Has our government become so desperate to provide measures of support to housing that it would pass legislation which will promote activities inconsistent with the protection of our markets? They have done it before in the late ’80s and paid billions to settle lawsuits as a result.

The real cost of this program would be borne by future homeowners. Why? Mortgage investors will not buy a product in which their rights are not protected. In the process, mortgage rates will move  higher. In fact, that is what was happening just yesterday.     

I will ask again: Is the rebound in housing an indicaton of a legitimate return of private capital and the entrepreneurial spirit of prospective American homeowners? Or is it somewhat of a facade created by the magic of government mortgage finance? Yesterday I wrote Uncle Sam Guaranteeing Sub-Prime Loans and Uncle Sam and State Brethren Are Now Mortgage Brokers.  Each post highlights how the government is increasing the risks on its own balance sheet by providing or guaranteeing mortgages of questionable credit quality. The likelihood of default on these mortgages is already showing signs of being very high.

If Conyers’ proposed legislation is a cover for banks/servicers to game the system, it is a VERY DANGEROUS one at that.  

I will again quote KD of 12th Street Capital, “It’s Utter BS…at some point they have to understand some people just can’t afford it.”


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