Mortgage-backed securities investors are starting to boil over with righteous indignation after details on the $25 billion national mortgage settlement emerged last week. The settlement confirmed that they might have to forfeit $17-$20 billion to pay for most of the deal. As was long suspected (and covered in this space on Feb 23, 2012 in "A Highly Unjust Mortgage Settlement"), the headline figure of banks paying $25 billion for their robosigning of foreclosure documents is bogus, and banks may only wind up paying $5 billion in cash of the overall deal.
It is understandable that MBS investors are upset about this, but do they have a case in court? Let's consider the arguments that bondholders are likely to make in filing amicus briefs in opposing judicial approval of the settlement.
The first complaint from MBS investors will be that they were ignored. Each of the five settlements filed with the U.S. District Court for D.C. last week includes an "Exhibit D" that clearly states banks can get credit towards their portion of the $25 billion payout for modifying mortgages in private-label securities. But at no point during the negotiations of the national mortgage settlement were the investors included in these talks.
This is a problem, especially with the billions of dollars of MBS investor money on the line. Chris Katopis, executive director of the Association of Mortgage Investors (AMI), says that MBS investors feel as abused as the homeowners in this process since the banks have a responsibility to properly service the mortgages they've invested in. As public stakeholders in the settlement, the MBS investor complaint about being excluded from the table has merit.
The second complaint from MBS investors will be that they are innocent of any wrongdoing in this matter. There are eight counts in the complaint filed against the banks for the mortgage settlement including: unfair and deceptive loan servicing, foreclosure processing, and loan origination practices, violations of the False Claims Act and Servicemembers Civil Relief Act, and various misconduct relating to homeowners in bankruptcy.
MBS investors have no authority over how foreclosures are processed or whether the right fees are being charged. The investors rely on the servicers to do their job as much as the homeowners. It is purely the banks at fault in this regard (even if the overall settlement fine doesn't fit the crime). Vincent Fiorillo, a portfolio manager at DoubleLine Capital and AMI's board president, says, "The banks are trying to pay [their] fines with our money."
If it is true that investors were not responsible for any of these process abuses or failures, then banks are shifting their liability on to an innocent party.
Then there's the third point MBS investors will make: the national mortgage settlement wrongly incentivizes banks to modify private securitized mortgages before modifying loans on their own balance sheets.
While only one-fifth of the mortgage settlement is cash payments from the banks to a trustee - mostly a $1.5 billion pool of cash to write $2,000 checks for robo-foreclosed borrowers and a $2.5 billion slush fund for state AGs to spend - $20 billion of the settlement is "consumer relief" efforts including writing down principal, refinancing loans, and funding short-sales. The settlement draws up a "menu" of different ways that banks can get "credits" towards their portion of the consumer relief efforts. For example, banks will get a $1 credit for every $1 of principal reduced on mortgages in their own portfolio and a $0.45 credit for every $1 of principal reduced on an investor owned mortgage.
The structure was intended to incentivize banks to favor their own mortgages for principal, but there are some serious conflicts of interest. Banks may naturally favor writing down as much investor principal as they can to avoid taking losses on their own balance sheets. Moreover, most second lien mortgages are owned by banks, while most first liens are owned by investors. As such, banks may look to strengthen their own financial position by writing down investor principal.
It turns out that the incentive structure suggests that banks would prefer to write down more than double the amount of investor principal for the same credits while strengthening their own balance sheets and avoiding increased losses.
This does not mean that Wells Fargo, which has agreed to $3.4 billion worth of principal reductions as part of the settlement, will use all of its credits modifying investor mortgages. But the AMI and other bondholders have legitimate reason to be concerned with the structure of the settlement. The court will have to consider why any credit should be given to banks for writing down principal on investor-owned mortgages.
MBS investors will further argue that the national mortgage settlement does not properly account for their interests regarding which mortgages receive principal reductions.
AMI points out that while the settlement does explicitly say that pooling and servicing agreements (PSA) must be honored, they are concerned with the way those PSAs are interpreted. PSAs require that all servicing actions be done in the best interest of the MBS trust. But one of the decision making factors in addressing whether a modification will be more beneficial for the investors than a foreclosure is an assessment of the net present value (NPV) of the mortgage.
AMI contends that the NPV model incorporated into the settlement does not properly consider borrowers debt and lacks transparency. From the investor perspective, there are much fewer mortgages that would benefit from a modification than from the perspective of the Department of Housing and Urban Development (HUD). In disputing the methodology, AMI is pointing out that investors have a financial interest in mind when making assumptions in their NPV model, whereas regulators have political interests in considering mortgage NPV.
HUD Secretary Shaun Donovan is on record countless times arguing that investors will be better off with principal modifications. The documents accompanying the settlement tout the value that modifications will bring to investors and the housing market broadly speaking. But the reality is that principal reductions and refinances of underwater mortgages are not guaranteed solutions. There is high risk of redefault - as has been the case in the government's largely failed Home Affordable Modification Program and Home Affordable Refinance Program.
It is possible that investors will be better off, but that is not a decision for HUD or state attorneys general to make. The investors argue that they should be the ones to determine when mortgages they've invested money in should be modified. They want their risk assessment methods to be honored over the politically charged modification benefit measures in the mortgage settlement.
Collectively, these arguments would give MBS investors a credible case that the national mortgage settlement unjustly excluded their participation in the talks, that it unfairly asks them to pay for robosigning failures they had nothing to do with, and that it improperly incentivizes banks to pass losses on to them rather than bite the bullet themselves.
Anthony Randazzo is the Director of Economic Research at the Reason Foundation. He can be reached at email@example.com. This commentary originally was published by RealClearMarkets on March 22, 2012.