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How Congress Failed on Foreclosures

August 7, 2009 - by Donny Shaw

Karen Weise has an excellent piece at ProPublica about the secondary mortgage market’s stranglehold on Obama’s Making Homes Affordable program. A major component of the program is supposed to be designed to encourage loan servicers to modify mortgages that are at risk of foreclosure. By all accounts, it’s off to a very slow start.

One of the main reasons for its failure so far, Weise explains, is that a disproportionately large amount of at-risk mortgages get bundled into mortgage-backed securities and sold off to investors. The investors would rather see a house foreclosed than mortgage payments and fees reduced, and they have enforced their preference in the past by suing servicers who do too much modifying. When servicers sell mortgage to investors, they enter into a contract known as a “pooling and servicing agreement” (PSAs) that specify what the servicer can do in the way of modifications. These PSA are often cited by servicers as the reason they can’t do anything to help homeowners on the verge of foreclosure.

In reality, though, mortgage servicers’ deference to the investors and the PSAs may be unfounded:

In a study due out this month, researchers at UC Berkeley’s law school looked at the contracts covering three-quarters of the subprime loans that were securitized in 2006. The researchers found that only 8 percent prohibited modifications outright. About a third of the loans were in contracts that said nothing about modification, and the rest set some limits but generally gave the servicers a lot to leeway to modify, particularly for homeowners that had defaulted or would likely default soon.

Despite the leniency written into a lot of PSAs though, mortgage servicers have in fact been sued by investors. Bill Frey of Greenwich Financial Services has sued both Countrywide and Bank of America over modifications. From the article, here’s his take on helping out troubled homeowners: “It is not the job of the person running the investment to worry about whether the homeowners or the bank that created the loan is happy with the transaction.” Needless to say, servicers are timid to do modifications for fear of facing a lawsuit:

“Servicers have indicated that they … are very concerned that if they do overmodifications of mortgage loans, that they would be subject to lawsuits,” Tom Deutsch, the deputy executive director of the American Securitization Forum, said in a congressional hearing in November.

The contracts can be vague, and different investors often have different interests in the securities. “It causes the servicer to want to watch their back more,” says Kurt Eggert, a law professor at Chapman University in Orange, Calif. Doing little or nothing can be safest.

Congress was told about this problem, and they had a chance to fix it. But, ultimately, they buckled to investment lobbyists and failed:

In late May, President Barack Obama signed a bill that included a “safe harbor” provision designed to protect servicers from being sued by investors. The original draft of the legislation included a clause that provided protection “notwithstanding any investment contract between a servicer and a securitization vehicle or investor,” but after lobbying efforts by Frey and other investors, Congress removed that clause from the final version of the law.

The House of Representatives actually did approve the contract-inclusive safe harbor provision by a mostly party-line vote of 234-191. It was the Senate that stripped the contract language in their version of the safe harbor provision, which was the one that ultimately became law.

The change went mostly unnoticed at the time because the debate over the bill was focused almost exclusively on cram down, a provision, which was removed, that would have empowered bankruptcy judges to modify troubled mortgages for principal residences. Therefor, it’s hard to track down much information on who, exactly, was behind changing the safe harbor provision.

In the video below, Senate Finance Committee Chairman Sen. Chris Dodd [D, CT] indicates that the change was made at the behest of investors:

(If you’re not seeing the video, click here)

As others have noted as well, the negotiations over the whole bill had a strange element of direct negotiation with the banks. Not with the senators whose votes were needed to pass the bill, but with the banks that would be affected by it. Back in January, for example, the AP reported that “Democratic lawmakers [had] reached a deal with Citigroup Inc. on a plan to let bankruptcy judges alter home loans.” I guess the subtext in the AP’s reporting was, as Sen. Dick Durbin [D, IL] has stated openly, that the banks “own” the Congress. It’s just weird to have the Senate wearing that on its sleeve.

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