Foreclosure Challenges Raise Questions About Judicial Role

Original posted in the Wall Street Journal by Amir Efrati:

A group of state and federal judges presiding over foreclosures are wiping away borrowers' mortgage debt, invalidating foreclosure sales and even barring some foreclosures outright.

The decisions in recent months by a handful of judges in states including Massachusetts, New York and Texas mark a new phase in the judiciary's battle to stem the rising tide of foreclosures by punishing mortgage companies for paperwork mistakes and alleged mistreatment of borrowers.

The number of judges taking such action remains small, and most foreclosures go through without a challenge.

But the growing number of rulings against lenders' claims is raising questions among some legal experts about judges' impartiality.

"The question is whether judges are changing the rules in the middle of the game...just because there is a financial crisis," says Todd Zywicki, a law professor at George Mason University and a critic of policy initiatives aimed at curtailing lenders' ability to foreclose.

As early as 18 months ago, several judges in California, New York, Ohio and elsewhere would dismiss foreclosure cases if they could find reason to do so. But those judges often allowed the mortgage companies to refile their foreclosure claims after attesting to their ownership of the mortgage in the county in which the homeowner lives.

Now, after the country has been mired in a housing crisis for more than two years, more judges are calling these companies on their paperwork glitches, and in some cases going much further in their efforts to help homeowners.

It makes sense for judges to demand that mortgage companies follow the rules to the letter if they want to win foreclosure cases in court, says Raymond Brescia, an assistant professor at Albany Law School who has written about the role of the courts in the financial crisis. "I don't think that's a crazy idea," he says. "To expect plaintiffs to prove their case is what the judicial system is founded on."

But if judges decide to help borrowers in ways that overlook the merits of individual cases, Mr. Brescia adds, that would "undermine the integrity of the judiciary, and that's not going to help anybody." Instead, he says, it might trigger a backlash from legislators or regulators to rein in activist jurists.

At the heart of some of the court rulings is what became a common practice among mortgage companies: filing a foreclosure claim without showing proof that they actually own the mortgage and have the right to foreclose. This occurs in part because mortgages change hands multiple times after the original loan is made, but the mortgage documents and the contracts between borrowers and lenders are never altered to reflect those changes. Years later, it can be difficult to verify who is the owner of the mortgage.

That played a key role in a ruling in October by Keith Long, a state-court judge in Massachusetts. He invalidated two foreclosure sales that had occurred more than two years ago. The judge affirmed his own prior ruling that said units of U.S. Bancorp and Wells Fargo & Co. never had the right to sell the homes.

Judge Long ruled that even though the companies physically held the relevant mortgage documents, the mortgages were never legally assigned to them and recorded with the state.

"They're selling something they don't own," says attorney Paul Collier, who began representing the borrowers in the case last year.

Walter H. Porr, a lawyer for the companies, which are appealing the ruling, says his clients "operated in what had been an accepted industry fashion for the better part of 15 or 20 years." He adds: "We owned those mortgages."

In October, a federal bankruptcy judge in White Plains, N.Y., rejected a claim by a mortgage company that the debtor owed $460,000. The judge, Robert D. Drain, said the company, PHH Mortgage Corp., couldn't prove it owned the debt.

A spokeswoman for PHH, which is appealing, said the company is trying to resolve the case.

And in a prominent case in New York's Suffolk County on Long Island, Jeffrey Spinner, a state-court judge, canceled $292,000 in mortgage debt after he ruled the borrowers were mistreated by IndyMac Bank.

The judge said in a November ruling that the bank displayed "harsh, repugnant, shocking and repulsive" behavior by making no attempt to negotiate a settlement with Diane Yano-Horoski after she and her husband fell behind on payments, despite a state law requiring the company to try.

OneWest Bank, which purchased the debt from IndyMac, plans to appeal. In a statement, it said the ruling, "if allowed to stand, has sweeping and dangerous implications."

At least one judge has been admonished for appearing to favor borrowers. In September, a Florida state appeals court ruled that a lower-court judge, Valerie Manno Schurr, erred in routinely delaying foreclosure sales by several months. Her reasoning put concern for the homeowners ahead of the law, the appeals court said.

Judge Manno Schurr didn't respond to requests for comment.

Homeowners Get More Time for Home-Loan Modifications

Original posted on Bloomberg by Jodi Shenn:

Mortgage servicers must give U.S. homeowners more time before kicking them out of the government’s loan-modification program, reflecting further struggles in the execution of the plan.

Servicers can’t cancel an active Home Affordable trial modification scheduled to expire before Jan. 31 for any reason other than property eligibility requirements, according to a posting today on a government Web site. They must write to borrowers to inform them about missed payments or needed documents, and give them at least 30 more days to submit them.

“The Treasury Department believes that this further guidance and associated requirements will provide more certainty and transparency regarding the final determination of eligibility for borrowers in trial modifications,” Meg Reilly, a department spokeswoman, said in an e-mailed statement.

The extension follows the Obama administration announcing a “Mortgage Modification Conversion Drive” on Nov. 30, meant to aid borrowers with trial plans set to expire at year end. The drive began after servicers struggled to acquire the documentation from homeowners required by the government to make loan changes permanent under its $75 billion program. Officials have placed some of the blame on both servicers and borrowers.

In October, the U.S. loosened documentation requirements and said an initial round of trial modifications could be completed over an extra two months, rather than the three-month standard.

Through November, servicers have permanently modified 31,382 of as many as 4 million mortgages targeted by the Home Affordable program, the Treasury said Dec. 10. A total of 728,000 were under way. The Treasury said last month that 375,000 trial modifications were scheduled to be converted into permanent repayment plans or expire by the end of the year.

“Servicers have made substantial progress in staffing up and dedicating further resources in support of HAMP,” Reilly said.

The official message can be downloaded here.

Second Chances: Subprime Mortgage Modification and Re-Default

By Andrew Haughwout, Ebiere Okah, and Joseph Tracy:

Abstract: Mortgage modifications have become an important component of public interventions designed to reduce foreclosures. In this paper, we examine how the structure of a mortgage modification affects the likelihood of the modified mortgage re-defaulting over the next year. Using data on subprime modifications that precede the government’s Home Affordable Modification Program, we focus our attention on those modifications in which the borrower was seriously delinquent and the monthly payment was reduced as part of the modification. The data indicate that the re-default rate declines with the magnitude of the reduction in the monthly payment, but also that the re-default rate declines relatively more when the payment reduction is achieved through principal forgiveness as opposed to lower interest rates.

The paper can be downloaded here.

Hamp, what is it good for?

Original posted on FT Alphaville by Tracy Alloway:

In addition to the difficulty of converting temporary mortgage modifications into permanent ones, one of the big question marks hanging over the US Treasury’s Home Affordable Modification Plan is the redefault rate. That is, the percentage of homeowners who redefault on their modified mortgage.

FT Alphaville has mentioned before that in cases of severe negative equity, it might make more sense for a homeowner to make a couple of Hamp-reduced interest payments on his or her mortgage and then walk away. The US Treasury hasn’t given an official default rate for the programme yet, but figures like 25 per cent and 50 per cent have been bandied about.

In their US Securitised Product Outlook for 2010, however, Barclays Capital take a slightly more negative outlook on the redefault rate. It might be better than previous mortgage modification plans — but it’s still likely to be pretty dismal, they say:

Re-default performance for loans modified in Q3 08 has been dismal, with more than 60% relapsing into deep delinquency already. However, HAMP has been more aggressive than earlier mods – reducing borrower payments by 30-40%, compared with earlier modification efforts that typically reduced monthly payments by 15-20%. As Figure 6 shows, higher payment reductions reduce re-default rates, but only by 5-10% for that magnitude of payment change . . .

On the flip side, HAMP does not address the issue of negative equity, which is one of the primary drivers behind default . . . Taking these factors into account, we expect overall HAMP re-default rates to show not more than a 10-20% improvement over the default rates seen in past mods.

With the redefault issue then, plus the conversion rate for permanent modifications and various servicer problems, BarCap thinks we’ll see some sort of revision or significant tweaking of the programme.

Possible changes could include further streamlining the documentation requirement for Hamp applications, creating a lower debt-to-income target or second-lien programme, or, perhaps most significantly, starting principal forgiveness instead of just forbearance.

Here’s a summary:

Finally, watch out for new policy changes from Washington on the mortgage front. If HAMP does not work well (as we expect), and foreclosures keep rising, Congress might revisit some of the more radical suggestions from earlier this year, such as cram-downs, forced debt forgiveness, etc. On the agency MBS side, one tail risk is the prospect of an off-market, low mortgage rate provided by the government. MBS investors fearful of this shift compressed the coupon stack sharply in Q1 09 – if such an off-market rate is actually offered by the government, it could greatly hurt premiums and, thus, all agency MBS valuations

. . .

A greater share of debt forbearance mods would lead to upfront losses on the pool, in turn leading to higher initial [constand default rates]. However, since debt forgiveness mods typically perform better than comparable rate reduction mods, re-default rates would be lower (Figure 27). Higher losses upfront on the forgiven amount would imply that subordinates would be written down faster on subprime deals, causing crossover to occur sooner. This would benefit the second and third cash flows at the expense of the first cash flow bond as the principal waterfall switches from sequential to pro rata.

Given all of the above, readers might well be scratching their heads as to what the Hamp is actually good for. And on that point Barclays is very clear — shadows and cans:

To be clear, the modification program (HAMP) is not a silver bullet. As Figure 6 shows, historical re-default rates for all types of modifications are high – HAMP should be better, but not hugely so. But the process of modification buys time. It increases the number of months between the borrower turning delinquent and the home hitting the market. This is shown in the REO (real estate owned) line in Figure 5; even as foreclosures keep rising, the REO bucket has gone down. So kicking the foreclosure ‘can’ down the road has helped prices stabilize.

Intuitively, if there are millions of foreclosures to still work through the system, it is better to spread them over a few years than have them hit the market in six months – this prevents prices from over-correcting to the downside. And with the Administration focused on modifications, we expect long delinquency-to-liquidation timelines to help home prices.

As a result, our forecast calls for prices to drop 8% from current levels, before stabilizing in Q2 2010. The macro impact of this decline should be muted. After all, a house worth $100 is now worth $67 (prices have fallen around 33% from peak in Case Schiller). A further 8% decline from current levels is simply another $5.3. As every month passes without a sharp increase in the REO bucket or a sharp drop in home prices, the tail risk posed by housing declines ever so further.

`Real estate owned’ means the properties owned by banks and mortgage companies — the stuff we call `shadow housing inventory‘ since it’s not included in official measures of unsold housing inventory.

Reducing the shame of default

Original posted on Reuters by Felix Salmon:

Steve Waldman has been doing a spectacularly good job of teasing out the moral and financial implications of homeowners walking away from their mortgage obligations, and delivers another great post today:

I think that underwater homeowners ought to walk away from their loans for the very same reason McArdle want us to consider them jerks for doing so. We both want to see norms we consider valuable enforced. I think that banks violated a great many norms of prudence and fair dealing in their practices during the credit bubble, and that they violate the fundamental norm of reciprocity by fully exploiting their own legal rights while insisting that borrowers have a moral obligation not to exercise a contractual option. In order to strengthen norms I consider crucial, I hope transgressors face legal and social consequences (strategic default and reduced shame attached to default) that will alter their behavior going forward…

McArdle favors a world with both easy credit and easy bankruptcy. I favor the easy bankruptcy, but not the easy credit. I think that debt arrangements are hazardous and should be entered into only with great care. I don’t consider increasingly leveraged homeownership and aggressively accessible consumer credit to have been positive developments. As a practical matter, I think we must rely on creditors rather than potential debtors to differentiate between wise and unwise loans. So I consider it a feature rather than a bug that holding creditors accountable will encourage them to think twice before sending out convenience checks.

While you’re chez Steve, you should also check out the letter he got from a soldier on the same issue. The basic insight here is that if a large number of morally serious individuals refuse to walk away from their debts, then we as a society are essentially letting banks off the hook for systemically-dangerous atrocious underwriting. Meanwhile, the banksters are grinning from ear to ear: to the extent that they haven’t been bailed out by the government, they can happily get bailed out by individuals who will end up paying hundreds of thousands of dollars just so they don’t need to worry about being considered to be “jerks”.

If there’s less shame attached to default, we will end up with exactly what we want — less badly-underwritten credit, a more solvent society, and much less tail risk. We went far too many years believing without really analyzing the proposition that credit is nearly always a Good Thing. Now that we’ve learned just how harmful it can be, it makes sense to reorient our aspirations and norms in the direction of a world where credit is both rarer and safer than it is right now.

Estimated Impact of the Fed’s Mortgage-Backed Securities Purchase Program

By Johannes C. Stroebel and John B. Taylor

Abstract. We examine the quantitative impact of the Federal Reserve’s mortgage-backed securities (MBS) purchase program. We focus on how much of the recent decline in mortgage interest rate spreads can be attributed to these purchases. The question is more difficult than frequently perceived because of simultaneous changes in prepayment and default risks. When we control for these risks, we find evidence of statistically insignificant or small effects of the program. For specifications where the existence or announcement of the program appears to have loweredspreads, we find no separate effect of the size of the stock of MBS purchased by the Fed.

Download the paper here.

Securitization: BIS Examines New Century Capital

Original posted on Prefbog:

The Bank for International Settlements has released a working paper by Allen B Frankel titled The risk of relying on reputational capital: a case study of the 2007 failure of New Century Financial:

The quality of newly originated subprime mortgages had been visibly deteriorating for some time before the window for such loans was shut in 2007. Nevertheless, a bankruptcy court’s directed ex post examination of New Century Financial, one of the largest originators of subprime mortgages, discovered no change, over time, in how that firm went about its business. This paper employs the court examiner’s findings in a critical review of the procedures used by various agents involved in the origination and securitisation of subprime mortgages. A contribution of this paper is its elaboration of the choices and incentives faced by the various types of institutions involved in those linked processes of origination and securitisation. It highlights the limited roles played by the originators of subprime loans in screening borrowers and in bearing losses on defective loans that had been sold to securitisers of pooled loan packages (ie, mortgage-backed securities). It also illustrates the willingness of the management of those institutions that became key players in that market to put their reputations with fixed-income investor clients in jeopardy. What is perplexing is that such risk exposures were accepted by investing firms that had the wherewithal and knowledge to appreciate the overall paucity of due diligence in the loan origination processes. This observation, in turn, points to the conclusion that the subprime episode is a case in which reputational capital, a presumptively effective motivator of market discipline, was not an effective incentive device.

The end of the road for New Century came when:

Purchasers of New Century’s loan production normally conducted a due diligence examination after a sales agreement had been reached. The investor, or a due diligence firm hired by the investor, would review loan files to determine whether the loan was underwritten according to the pool’s guidelines. Loans not meeting guidelines could be excluded from the loan bundle (kicked out) and returned to the originator.

Once kicked out, the mortgages were known as a “scratch and dent” (S&D) loans, which were purchased by specialised investors at a large discount to their principal balance. Consequently, one measure of the deterioration of the quality of New Century’s loan production is the percentage of S&D loan sales. In 2004 and 2005, such sales amounted to less than 0.5% of New Century’s secondary market transactions. By contrast, in the first three quarters of 2006, S&D loan sales accounted for 2.1% of such transactions (Missal (2008, p. 68)).

The upsurge in loan repurchase requests to New Century coincided with a change in the methodology employed to estimate its allowance for loan repurchase losses. New Century’s board learned of the change after a considerable delay. This discovery was followed, after a few days, by a public announcement on 7 February 2007 that New Century’s results for the three quarters of 2006 needed to be restated. It also noted an expectation that losses would continue due to heightened early payment default (EPD) rates.

New Century’s announcement prompted margin calls by many of its warehouse lenders and requests for accelerated loan repurchases. Soon, all of New Century’s warehouse lenders ceased providing new funding. Because simultaneous margin calls by its warehouse lenders could not be met, New Century filed for bankruptcy on April 2, 2007. It ceased to originate mortgages and entered into an agreement to sell off its loan servicing businesses.

Amusingly, in the light of the current bonus hysteria:

The examiner’s access to internal New Century documents provided valuable insights into how the appearance of the warning flags influenced, or did not influence, management. For example, the examiner could find no reference to loan quality in the internal documents that described New Century’s bonus compensation system for regional managers for 2005 and 2006 (Missal (2008, p. 147)). The examiner says that the compensation of New Century’s loan production executives was directly and solely related to the amount of mortgage loans originated, loans that, in turn, were subsequently sold or securitised.32 Likewise, the examiner found no mention of penalties (reduced commission payments to loan production staff) that would be assessed against defective loans that required price discounts for secondary market sale.

Heightened investor concerns about the performance of subprime loans were reflected in changes in their due diligence processes (Missal (2008, p. 165)). Historically, investors would ask due diligence firms to examine, on their behalf, only a small sample of loans in a particular pool. The character of the process first changed in 2006 when most investors began to look at the appraisal documents in all loan files in a loan pool. Investors then increased the share of loan files examined. This intensification of due diligence efforts was responsible for a sharp increase in New Century’s kickout rate from 6.9% in January 2006 to 14.95% in December 2006 (Missal (2008, p. 161)).

The author concludes:

The examiner’s report suggests that some of the actions undertaken to improve loan quality in late 2006 and early 2007 were designed to anticipate new credit risk concerns among New Century’s counterparties. Nonetheless, when New Century announced a need to recast its financial reports, there had not yet been a defection by any of its largest counterparties. Not surprisingly, defections ensued immediately after the announcement. In those circumstances, the bunching of defections probably signalled an absence of attention on the part of counterparties to the mounting risks of ongoing transactions with New Century. In turn, the evidence of ineffective counterparty risk management has led to concerns about the effectiveness of existing governance structures (corporate and regulatory) and, in particular, reputational capital as an incentive device. Can those structures now be relied on to discipline the risk-taking incentives of those involved in underwriting securities backed by subprime (and other risky) assets?