Posted on FinReg21 by Isaac Gradman:
On May 21, 2009, President Barack Obama signed into law the Helping Families Save Their Homes Act (Public Law 111-22), a bill with ostensibly noble goals of helping to ease the fallout from the greatest financial calamity since the Great Depression. But behind the grandiose title and the provisions aimed at keeping troubled borrowers in their homes, the bill carried with it powerful protections for influential mortgage lenders—companies whose irresponsible lending had helped fuel the subprime mortgage meltdown and the broader credit crisis that followed. These protections, known as the “Servicer Safe Harbor,” revealed that families were not the only group that Washington was trying to “save.” This article traces how the Servicer Safe Harbor came to be included in P.L. 111-22 based on the actions of a single investor advocate and explores why this legislative parachute for servicers may not be constitutional, let alone just.
In Part I of this article, I explain the role that servicers played in the housing bubble that preceded the meltdown, and how their continued involvement impacts the mortgage market. In Part II, I discuss the massive litigation brought against Countrywide Financial by the Attorneys General of dozens of states, and how this litigation led to one of the largest, and potentially most ill-conceived, legal settlements in history. In Part III, I introduce the pending litigation initiated by William Frey and his firm, Greenwich Financial Services, which seeks to prevent Countrywide from ignoring its contractual obligations in carrying out this settlement. In Part IV, I recount the introduction and passage of the Helping Families Save Their Homes Act. In Part V, I explore the constitutional ramifications of the Servicer Safe Harbor and what it means, not only for Frey’s suit, but also for investors and taxpayers. And, finally, in Part VI, I discuss how an alternative solution could remedy this misguided and potentially unconstitutional reallocation of losses from mortgage modification.
PART I – The Securitization Spire
To understand the importance of the Servicer Safe Harbor, it is useful to know something about securitization, the process at the heart of the explosive growth in mortgage lending over the last decade. Securitization was intended to help normalize the risk of mortgage lending and create safer investments out of residential mortgage loans, which were historically volatile and risky to own. The reason for this was that a bank or other owner of a mortgage loan faced two risks: on the one hand, the borrower could default, forcing the holder of the loan to conduct a costly foreclosure to recoup a portion of the investment, and on the other, the borrower could pay back the loan all at once (known as a “prepayment”), putting the holder of the loan in the undesirable position of having to find someplace else to invest its excess capital.
Securitization, as recounted memorably in Michael Lewis’ Liar’s Poker, was Wall Street’s solution to this problem. The idea was to buy-up large numbers of mortgage loans and sell securities backed by the cash flows from these loans. These so-called mortgage-backed securities made it possible for investors to hold a piece of a diversified pool of several thousand mortgages that would theoretically have a predictable rate of return, and investors loved them.
The process of a securitization went as follows: a large lender or bank (known as the “Originator”) would make loans based on a published set of underwriting guidelines, either directly or through its correspondent lenders and brokers. The Originator would then immediately sell most of these loans to a Wall Street investment bank (known as the “Seller and Sponsor”), while sometimes remaining involved as the “Master Servicer” and earning a healthy yearly fee for servicing the loans. We will come back to the importance of servicers shortly. The Seller and Sponsor that now held the loans (or one of its related entities) would deposit the loans into a securitization trust and market securities based on the income stream from those loans to investors. These securities were divided into tiers or “tranches” and given ratings by the ratings agencies based on their seniority in the cash payment waterfall. Often, mortgage insurance would be placed on the individual loans or loan pool, guaranteeing repayment of a percentage of the loan principal in the event of default, and thereby boosting to investment grade the ratings given to the securities. And large institutional investors, hungry for investment-grade securities providing a significant rate of return, would buy up these bonds as fast as Wall Street could create them.
If structured properly, securitizations can be an efficient and valuable tool to spread risk and increase investment in residential mortgage loans. However, starting in 1995, and continuing for the next decade, the United States experienced the greatest period of home price appreciation in its history, and the proper safeguards that should have been placed on mortgage-backed securitizations were thrown out the window. Demand from investors for mortgage-backed securities outstripped the number of available loans, inducing lenders to loosen their guidelines to create more lending opportunities. “Subprime lending” was seized-upon as a way to generate greater loan volume, broadening a class of low- or no-documentation loans that formerly was reserved for wealthy individuals who did not wish to disclose all of their income sources.
“Subprime” borrowers are defined by the United States Department of the Treasury as those with “weakened credit histories [and]...reduced repayment capacity.” Under ordinary circumstances, banks would have shied away from lending money to such borrowers. But housing prices increased so steadily from 1995 to 2005, fueled in large part by historically-low interest rates, that the short-term risk of borrower default was dampened significantly. Borrowers struggling to make payments could often refinance their loans at more favorable rates, or if they defaulted, their homes could be sold at a price that recouped most of, or even more than, the original principal of the loan.
Under these conditions, all of the players in the securitization cycle stopped caring as much about whether these loans were being made wisely, i.e., to borrowers who actually had the ability to pay them back. Instead, lenders began originating greater and greater volumes of loans regardless of the credit risk: loans which they could immediately turn around and sell off their books to Wall Street, which could likewise turn around and sell slices of that risk to investors. And as long as home price appreciation continued, this game of hot potato proved very profitable. But so dependent was this game on the idea that housing prices would continue to rise, that when home prices simply leveled-off at the end of 2005 and the beginning of 2006, the music stopped, and the market for mortgage-backed securities disappeared with it.
Part II – The Greatest Trick Bank of America Ever Pulled
When the dust from the greatest financial meltdown since the Great Depression had cleared, what was left at the center was a giant pool of so-called “toxic” assets—mortgage-backed securities and derivatives that could not be properly valued because the underlying mortgages were defaulting at rates previously unknown and difficult to project. In its early attempts to curtail the fallout from this crisis, Washington passed legislation designed to reduce foreclosures by encouraging loan modifications to allow borrowers to continue to meet their payment obligations. Loan modifications are also known as “workouts,” because they are new payment plans servicers “work out” with distressed borrowers to allow them to stay in their homes, usually by lowering interest rates, reducing principal amounts, or extending loan terms (i.e., the borrower would have more years to pay off the loan, thus lowering monthly payments). Federal bills such as the HOPE for Homeowners Act and programs such as Making Homes Affordable took stabs at encouraging workouts, but these attempts were largely unsuccessful. When Washington probed into the reason for this failure, legislators discovered that the servicer, the only party with the legal right to authorize a workout, was often not cooperating.
As described above, the servicer was often the lender that had originated the loan but then sold it off, and now held the rights to service the loan. Servicers were paid a fee by the securitization trust in return for interfacing with the borrower, collecting payments, and forwarding these payments to the trust. The securitization trust agreements, commonly known as pooling and servicing agreements, obligated servicers to act on behalf of the ultimate bondholders, and thus to maximize the money coming into the securitization structure. The pooling and servicing agreements would also authorize servicers to negotiate a loan modification if the borrower were in danger of default, but generally only when investors agreed or when the net present value to investors was maximized by a workout rather than a foreclosure sale. Fearful of offering loan modifications without investor approval or without substantial proof that the workouts would bring more money to investors in the long run, servicers were reluctant to offer the large-scale, and extremely costly, loan modifications that Washington was encouraging.
At the same time, horrific tales of irresponsible lending practices were coming to light, putting large lenders/servicers like Countrywide squarely in regulators’ sights. On June 26, 2008, California Attorney General Edmund “Jerry” Brown sued Countrywide, its CEO Angelo Mozilo, and its president David Sambol for allegedly pushing California borrowers into mass-produced, risky loans for the sole purpose of earning enormous profits by reselling these loans on the open market. The suit sought restitution, injunctions, and civil penalties for Countrywide’s allegedly “predatory” lending practices. That same day, Illinois’ Attorney General Lisa Madigan filed a similar suit on behalf of the residents of her state. By the end of September 2008, 11 states had filed related suits against the country’s former number one home mortgage lender.
These suits were eventually consolidated, and on October 6, 2008, Jerry Brown announced, with great fanfare, that Countrywide had agreed to settle all actions to the tune of over $8.4 billion. The Attorneys General involved hailed the deal as a model for the rest of the country in solving the housing crisis, and Brown called it “the biggest mandatory loan modification in American history.” The settlement included provisions halting foreclosures while modifications were worked out, cash payments to borrowers who were victimized by predatory lending practices, and loan modification assistance for an estimated 400,000 borrowers in danger of losing their homes. Bank of America, which had acquired Countrywide in July 2008, described the settlement as a win for investors, borrowers, and the mortgage market as a whole.
But with regulators, industry executives, and commentators tripping over themselves to praise the accord, few seemed to realize (or at least acknowledge) what a huge win the settlement was for Bank of America itself. This was because, as was typical in the securitization cycle discussed above, though Countrywide had originated the loans at the center of these lawsuits and the settlement agreement, it no longer owned those mortgages. Instead, it retained only servicing rights to these loans, and thus would not bear the costs of loan modifications arising from lowered monthly payments, principal amounts, or interest rates. It was the ultimate bondholders, who had invested in the securities backed by these loans, and who had carefully negotiated protections against unfettered loan modifications in the pooling and servicing agreements, who instead would be on the hook for the overwhelming majority of the $8.4 billion Countrywide promised to aid distressed borrowers.
If the Attorneys General were truly hoping to punish Countrywide for its irresponsible lending practices, foisting the cleanup costs on innocent investors was a remarkably ill-conceived way to do it. On the other hand, if regulators had no intention of holding Countrywide financially accountable, the settlement was pure political lip service. But regardless of whether this cost-shifting was understood by regulators and simply ignored for political reasons, or whether regulators simply did not understand the ownership structure underlying securitizations, the fact that Countrywide and Bank of America had passed the financial liability for their allegedly predatory practices onto investors was not lost on the bondholders themselves. Yet, no investor had the appetite to stand up to the influential Bank of America, let alone the political momentum that had gathered behind the aggressive pursuit of loan modifications, as more than a dozen states had now signed on to the Countrywide settlement. Two months later, investors would find their voice in the form of one individual who had the stomach to battle Countrywide in court, and bear the brunt of the political backlash that followed.
Part III – A Lone Voice for Investors
On December 1, 2008, broker-dealer Greenwich Financial Services LLC (Greenwich Financial) filed a lawsuit in New York State Supreme Court for the County of New York, asking for a declaration that Countrywide be forced to repurchase the loans it modified pursuant to its settlement with the Attorneys General (now involving 15 states), at a price not less than the full unpaid principal balance (UPB) of the loans. The complaint in Greenwich Financial Services, et al. v. Countrywide Financial Corp., et al. (the “Complaint”) opens with the following allegation:
"To settle allegations of widespread predatory lending made against it by the Attorneys General of at least 15 States, Countrywide Financial Corporation has agreed to reduce payments due on hundreds of thousands of mortgage loans by a total of up to $8.4 billion. Most of these loans are owned not by Countrywide, but rather by trusts to which Countrywide sold the loans in the process of securitization…Countrywide plans not to absorb the $8.4 billion reduction in mortgage payments itself (even though it was Countrywide’s own conduct of which the Attorneys General complained in the proceedings that Countrywide has now settled), but rather to pass most or all of that reduction on to the trusts that purchased mortgage loans from Countrywide. (Complaint ¶1)"
The Complaint is styled as a class action and seeks relief on behalf of the “thousands” of persons or entities who hold certificates in one or more of the 374 affected securitizations.
The moving force behind this class action was Greenwich Financial CEO William Frey, a self-styled advocate for investors’ contractual rights, who had up to that point used the fund only to manage his family’s holdings. Since March of 2008, Frey had been vocal in his opposition to conducting loan modifications without investor approval and had received an “outraged” letter from six members of the U.S. House of Representatives on October 24, 2008, that “strongly urge[d Frey] to reverse” his decision to oppose their legislative efforts to encourage loan modifications. Though Greenwich Financial specialized in the structuring and distribution of mortgage-backed securities, it had never been involved in subprime transactions and had not been involved in so-called Alt-A transactions (generally referring to loans with less than full documentation of the borrower’s income and/or employment) in the past five years, as Frey had deemed the underlying collateral “junk.” But that all changed when Frey was approached by a bondholder that desired to challenge Countrywide’s actions under the cloak of anonymity.
A Wall Street Journal article published on the day the Complaint was filed stated that while Frey did not initially hold any of the Countrywide bonds that were the subject of the settlement, he subsequently set up a fund (called “Distressed Mortgage Fund 3”) to accept “substantial holdings” in Countrywide bonds from one investor who “wanted to challenge the company’s actions while staying out of the spotlight.”1 Frey refused to disclose any information about this investor, explaining that, “[t]his is a vehicle designed to put me in charge of resolving these pools.”
Soon, it became clear why this anonymous investor had wanted to remain in the shadows. On February 8, 2009, 300-400 protestors converged on the front lawn of Frey’s home in Greenwich, Connecticut, wearing yellow shirts with “Stop Loan Sharks” emblazoned on the front and dragging furniture onto Frey’s lawn to symbolize the dislocation felt by borrowers who had been foreclosed upon and forced from their homes. The protest was part of a three-day “homeowners’ workshop” sponsored by the Neighborhood Assistance Corporation of America (NACA) and aimed at several top executives of companies who refused to allow NACA to renegotiate the terms of loans on behalf of its members.
While these protestors were not entirely blameless themselves, as many had contributed to the mortgage crisis by borrowing beyond their means, their demonstration on Frey’s front lawn generated considerable negative publicity for Frey and his lawsuit.2 Yet, Frey believed he was the only person who was willing and able to act as an advocate for bondholders who had no say in the Countrywide settlement (which had now been joined by over 30 state Attorneys General), and he was willing to forego popularity to continue pursuing this cause. Moreover, it appeared that Frey had a strong case, as investor contract rights in the pooling and servicing agreements underlying the securitizations at issue made it clear that modified loans had to be repurchased at a price equal to the unpaid principal balance by the servicers effectuating those modifications. Analysts began to speculate that a win for Greenwich Financial in the lawsuit would spell doom for Bank of America and the other large servicers facing enormous liabilities from the mortgage loans they originated, held, or serviced. What analysts and Frey failed to anticipate, however, was that Congress would come along and pull investors’ contract rights out from under their feet.
Part IV – Friends in High Places
While Greenwich Financial v. Countrywide moved forward in the New York State courts and homeowner advocacy groups were organizing to protest Frey’s actions, a new front in the battle over loan modifications emerged in Washington, D.C. Since the initiation of Frey’s suit, Bank of America had been using its best efforts to lobby legislators in the nation’s capitol for legal protection. Though no single entity ever has a monopoly on political influence, it appears that Bank of America’s lobbying efforts paid tangible benefits when, on March 5, 2009, the U.S. House of Representatives passed H.R. 1106, known as the “Helping Families Save Their Homes Act of 2009.” The bill had been introduced by representatives Paul E. Kanjorski (D-PA), who was the second biggest recipient of Countrywide campaign contributions since 19893, and Michael N. Castle (R-DE), whose second largest contributor during the 2007-08 election cycle had been Countrywide/Bank of America,5 making Castle one of the top ten beneficiaries of Bank of America in the prior year (behind mainly presidential candidates). The bill could not have been better for Countrywide in its lawsuit with Greenwich Financial if the text had been written by Bank of America itself.
Section 201 of H.R. 1106, entitled “Servicer Safe Harbor For Mortgage Loan Modifications,” contained a provision that essentially relieved Countrywide and other servicers from liability for complying with the settlement with the Attorneys General and performing large-scale loan modifications. With respect to any residential mortgage loan for which default was reasonably foreseeable, the borrower was living in the home, and the servicer reasonably believed that modification would generate a higher net present value recovery than foreclosure, Section 201(a)(2) stipulated that:
"Notwithstanding any other provision of law, and notwithstanding any investment contract between a servicer and a securitization vehicle or investor, a servicer—
(i) shall not be limited in the ability to modify mortgages, the number of mortgages that can be modified, the frequency of loan modifications, or the range of permissible modifications; and
(ii) shall not be obligated to repurchase loans from or otherwise make payments to the securitization vehicle on account of a modification, workout, or other loss mitigation plan for a residential mortgage or a class of residential mortgages that constitute a part or all of the mortgages in the securitization vehicle…"
In other words, Frey’s contracts would no longer be worth the paper on which they were printed. As if that were not enough, H.R. 1106 provided that servicers would be given cash incentives of $1,000 for each loan modified, as a further encouragement to conduct workouts. This meant that the same servicers that had often irresponsibly originated these problematic loans in the first place would be paid to correct their own mistakes.
In response to this sudden shift in the legal landscape, Frey tried to fight back with a lobbying campaign of his own. On March 25, 2009, Frey gave a talk in Washington to more than 30 money managers with stakes in the $6.7 trillion mortgage bond market, warning them that government efforts to assuage the housing crisis would undermine debt contracts and do more harm than good. Also presenting at the bond investor conference, which was attended by, among others, representatives from Royal Bank of Canada's Voyageur Asset Management Inc. and Thrivent Financial for Lutherans, were David Grais, the lawyer representing Frey in his suit against Countrywide, and Laurie Goodman, an analyst at Amherst Securities and UBS AG’s former fixed income research chief. As a result of this meeting, a group of investors with residential mortgage-backed securities holdings totaling more than $100 billion hired Patton Boggs LLP, Washington’s biggest lobbying firm, to gear up for the fight in Washington over the pending legislation.6
But Frey and his fellow investors had showed up too late to the lobbying party to nip the Servicer Safe Harbor in the bud. Though their lobbying efforts were able to generate some positive press in the mainstream news media7 and some softening of the bill in the Senate (while an amendment introduced by Senator Bob Corker (R-TN) to significantly limit the Servicer Safe Harbor was promptly defeated by a 2-to-1 margin), the bill simply had too much political momentum behind it. On May 6, 2009, the Senate passed a version of the Helping Families Save Their Homes Act (S. 896) containing a more moderate version of the Servicer Safe Harbor, by a vote of 91-5. On May 19, the House passed the Senate’s version of the bill by a 367-54 margin, and two days later, President Obama signed it into law (P.L. 111-22).
Though the final version of the Servicer Safe Harbor is watered-down from the original version proposed in the House, the legislation still operates to undermine bondholders’ contract rights and relieve from liability the very entities which were often responsible for creating these distressed loans. The final version of the Section 201(b) Servicer Safe Harbor stipulates that, “[n]otwithstanding any other provision of law, whenever a servicer of residential mortgages agrees to enter into a qualified loss mitigation plan” and “reasonably determine[s]” that such workout will benefit investors and interested parties on the whole, that servicer “shall not be subject to any injunction, stay, or other equitable relief to such [interested] party, based solely upon the implementation by the servicer of a qualified loss mitigation plan.” The “Rule of Construction” of Section 201(b) further provides that servicers would still be liable for “actual fraud in the origination or servicing of a loan or in the implementation of a qualified loss mitigation plan, or for the violation of a State or Federal law, including laws regulating the origination of mortgage loans, commonly referred to as predatory lending laws.”
Part V – Will Servicers Be Let Off the Hook?
So what does this bill mean for Frey’s suit and investment in mortgage-backed securities in general? In a conversation with Frey over lunch in New York last month, Frey told me that “the lawsuit is not dead—we believe we can still pursue our contract rights.” Frey bases this belief on the fact that legislators removed the phrase “notwithstanding any investment contract between a servicer and a securitization vehicle or investor” from the preamble to the House version of Section 201, leaving only the phrase “[n]otwithstanding any other provision of law.” Frey interprets this to mean that the Servicer Safe Harbor cannot operate to abrogate contract rights. While Frey is correct that the final Servicer Safe Harbor does not provide servicers the sweeping relief from liability featured in the original version in the House, it certainly muddies the waters. The absence of a specific provision allowing servicers to disregard contract rights is not nearly as strong for Frey as a provision explicitly protecting those rights would have been, and it sounds like an uphill fight to convince any court that, based on the bill’s legislative history, this federal legislation should not be interpreted to trump private contracts.
If the bill is indeed interpreted to bar investors from insisting upon the repurchase of loans modified by servicers, investors could still attempt to force repurchase by arguing that servicers are not acting within the terms of the Servicer Safe Harbor. One potential avenue of relief could be the provision of Section 201(b) requiring servicers to modify only when they have determined that such workout would “likely provide an anticipated recovery on the outstanding principal mortgage debt that will exceed the anticipated recovery through foreclosures.” The question is whether investors can force servicers to repurchase loans they modify without showing that the expected net present value (NPV) from modification exceeds the expected NPV from foreclosure. The bill seems to allow servicers to "reasonably determine" on their own when the anticipated recovery from modification will "likely" exceed the anticipated recovery from foreclosure, irrespective of any NPV analysis. This creates a serious conflict of interest due to servicers’ considerable holdings in second-lien mortgage loans that they would otherwise have to modify before the first liens held by investors, and courts may force servicers to take investors’ interests into account to the same degree as their own.
However, if, as seems likely to me, investors are not able to argue around the application of the Servicer Safe Harbor, resulting in a massive transfer of wealth from investors (including pension funds, retirement funds, and other bondholders) to banks, Frey and other investors would have a cognizable challenge to the Helping Families Save Their Homes Act on constitutional grounds. Though they would like to be able to argue that the legislation abrogates contracts in contravention of the Constitution’s Contracts Clause (Article I, Section 10, clause 1), that clause only provides that “No State shall. . .pass any. . .Law impairing the Obligation of Contracts”; it does not limit the rights of the federal government. Instead, investors will have to seek shelter under the Takings Clause of the Fifth Amendment, a notoriously difficult road to hoe.
The Takings Clause states simply: “[n]or shall private property be taken for public use, without just compensation.” In the landmark case of Pennsylvania Coal v. Mahon, 260 U.S. 393, 415 (1922), the Supreme Court articulated the traditional formulation of the Clause: “while property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking.” More recently, the Court has held that the purpose of the Clause is “to prevent the government from forcing some people alone to bear public burdens which, in all fairness and justice, should be borne by the public as a whole.” Eastern Enterprises v. Apfel, 524 U.S. 498, 522 (1998). Yet, the question of how the dozen words of the Clause and this stated purpose apply to particular government action has engendered a mountain of impenetrable Supreme Court precedent that makes it next to impossible to predict what regulations the Court will find go “too far.”
In Connolly v. Pension Benefit Guaranty Corp., 475 U.S. 211, 224 (1986), the Court revealed that, in the “regulatory takings” context (when a law or regulation indirectly causes an alleged taking, rather than a “classic taking” involving direct government appropriation of private property), this shifting nature of Takings Clause jurisprudence was intentional:
"we have eschewed the development of any set formula for identifying a “taking” forbidden by the Fifth Amendment, and have relied instead on ad hoc, factual inquiries into the circumstances of each particular case."
However, to aid in this determination, the Court has identified three factors of “particular significance”:
"(1) the economic impact of the regulation on the claimant; (2) the extent to which the regulation has interfered with distinct investment-backed expectations; and (3) the character of the governmental action. (Connolly, 475 U.S. at 225 (internal quotation marks omitted).)"
Eastern Enterprises provides the best recent example of how this standard has been applied to alleged regulatory takings and illustrates how the Court might evaluate a challenge to the Servicer Safe Harbor. In that case, Eastern Enterprises, a former coal operator, challenged the Coal Act’s requirement that it contribute premiums to stabilize a health care fund for retired coal workers based on its participation in the coal industry some 30 years prior. In the majority opinion, written by Justice Sandra Day O’Connor, the Court first noted that while “a strong public desire to improve the public condition is not enough to warrant achieving the desire by a shorter cut than the constitutional way of paying for the change” (id. at 523), “the fact that legislation disregards or destroys existing contractual rights does not always transform the regulation into an illegal taking.” Id. at 527.
Analyzing the regulation under the three factors articulated above, the Court found that the first factor—economic impact—was met because the Coal Act imposed a burden on Eastern Enterprises of $50 to $100 million. Id. at 529. Under the second factor—interference with reasonable investment-backed expectations—the Court found that the Coal Act’s allocation scheme reached back 30 to 50 years to “attach[ ] new legal consequences to an employment relationship completed before its enactment,” and thus interfered with Eastern Enterprises’ expectations. Id. at 532 (internal alterations and quotation marks omitted). Finally, as to the nature of the governmental action, the Court found that, while it was understandable that Congress would seek a legislative remedy to what it perceived to be a significant problem,
"when…that solution singles out certain employers to bear a burden that is substantial in amount, based on the employers’ conduct far in the past, and unrelated to any commitment that the employers made or to any injury they caused, the governmental action implicates fundamental principles of fairness underlying the Takings Clause. (Id. at 537.)"
Based on these findings, the Court held that the Coal Act’s allocation of liability ran afoul of the Takings Clause, and that the Act’s operation should be enjoined as applied to Eastern.
The makeup of the Court has changed since Eastern Enterprises was decided in 1998 and will likely experience further change before any challenge to the Servicer Safe Harbor is to be taken up by the Court. This, combined with the fact that the Court has shifted directions on similar regulatory takings challenges (see Connolly, 475 U.S. at 224 (holding that the Coal Act’s nullification of a contractual provision limiting liability was not a taking)), means the outcome of any such challenge would be a crapshoot. However, applying a similar analysis to the Servicer Safe Harbor as was applied in Eastern Enterprises, I believe that legislation would also run afoul of the Takings Clause.
First, the economic impact of the legislation is tremendous—the large majority of $8.4 billion in losses from loan modifications would be dumped onto the laps of investors rather than born by the servicers who were contractually obligated to absorb those losses. Second, the Safe Harbor obliterates the reasonable investment-backed expectations of investors. These investors specifically sought to include provisions in the pooling and servicing agreements underlying the bonds they were investing in, which prevented servicers from modifying the terms of these mortgages without paying for them. Allowing the government to abrogate these contractual rights without just compensation would work a significant injustice against the investors who believed that their contracts protected them against this very risk (not to mention discouraging future investment in the U.S. mortgage-backed securities market). Finally, just as in Eastern Enterprises, the nature of the government action in this case singles out an isolated group of persons and entities to bear a substantial burden that is largely unrelated to any commitment they made or to any injury they caused. Indeed, it would be difficult to argue that the investors who purchased these distressed loans were somehow more responsible for their existence than the lenders who originated them. Overall, it seems that allowing the Servicer Safe Harbor to stand would contravene the Court’s statement that “justice and fairness require that economic injuries caused by public action must be compensated by the government, rather than remain disproportionately concentrated on a few persons.” Eastern Enterprises, 524 U.S. 498 at 523 (internal alterations and quotation marks omitted).8 Fairness would seem to require that the costs of a financial crisis of this magnitude, with its broad-reaching causes and effects, be borne by the society as a whole, and not by an insular minority.
Part VI – What’s the Answer?
Anyone who claims to have an easy solution to the foreclosure crisis is not being honest. While it is clear that distressed mortgage-backed securities, or “toxic assets,” are causing significant destruction to our economy because they exist in a state of limbo—in which they cannot be properly valued, sold, or reengineered—cleaning up the mess is no simple matter. Due to the number of different players with varying interests that are involved in any securitization, any plan to unwind these toxic assets and allocate losses will be inherently complex and costly. Governmental efforts to date have sought to utilize broad strokes and blunt instruments to fix the problem. A more rational approach must involve a case-by-case, loan-level analysis. Thus, in the event that the Servicer Safe Harbor is ultimately amended by Congress or struck down by the Supreme Court, I offer some suggestions for dealing with this crisis in a manner that takes its causes into account.
As an initial matter, it must be recognized that every loan is unique, with its own set of circumstances that control what solutions are feasible. Thus, there is no way to avoid the harsh reality that somebody must review every mortgage for which payments have stopped and determine how to resolve it, either by inducing the borrower to make reduced payments or by liquidating the asset. The most logical actor to oversee this process is not the servicer or the investor, both of which have inherent conflicts of interest, but, unfortunately, the federal government. Whether the government would enlist Freddie Mac or Fannie Mae to oversee this process or create a new agency, the reality is that the foreclosure crisis is a matter affecting the nation as a whole, and the reconciliation process must be carried out by an entity with the public interest in mind.
In order to oversee the process of resolving distressed mortgage loans, the government must take control over the securities that are backed by these loans. To this end, the solution initially proposed of using Troubled Asset Relief Program (TARP) funds to purchase these toxic assets still makes sense. If dampening the effects of the foreclosure crisis is truly in the public’s interest, using taxpayer dollars to do so seems fair and logical. Furthermore, by using this significant capital outlay to buy these assets from investors and banks (at some amount that takes into account their depressed value but still constitutes “just compensation” so as not to run afoul of the Takings Clause), those entities would no longer be stuck in financial purgatory, holding onto illiquid assets that cannot be properly valued.
Once the government takes control of these securities, it must, with the cooperation of mortgage servicers, investigate every delinquent or defaulted mortgage loan to determine which of three categories the loan falls into. Category I would consist of mortgages that appear to be the product of fraud on the part of the borrower. So, for example, if the borrower lied about his or her income, there was no arms-length sale, the borrower never existed, or the borrower never intended to occupy the premises and was merely a speculator, this loan should be foreclosed-upon immediately. Foreclosure is undoubtedly a costly process to be avoided, if possible; but besides being politically unpalatable to subsidize lying borrowers staying in their homes, there is no way to implement a workout if the borrower never intended to pay the loan back.
Category II would be for loans that the government determines were a product of negligence, misrepresentation or improper/illegal lending practices on the part of the lender (or its correspondent lender or broker) that originated the loan, e.g., the lender falsified the borrower’s income without the borrower’s participation, induced the borrower into a riskier or more costly loan than necessary, or engaged in any number of other predatory practices. In these cases, the loan should be modified at the expense of that lender. These lenders made considerable representations and warranties when originating and selling off the loans at issue and promised that the loans would meet certain guidelines and comply with the law. They profited handsomely off of the sales of these loans, made on the premise that lenders would stand behind loans if they did not meet the concrete lending guidelines they agreed to follow. If it turns out these representations were false, it should be that lender, not the investor or the taxpayer, who should bear the cost.
Finally, for the overwhelming majority of troubled loans that the government determines were made in good faith, but the borrower lost his or her job, took a cut in pay, or got in over his or her head for any number of legitimate reasons, the government must place them in Category III—for loans requiring a closer look. If the borrower could likely remain in his or her home with a reasonable modification to the terms of the mortgage, this workout should be effectuated; and the cost should be borne by the taxpayer, as it is in the public’s best interest that foreclosure rates decrease, and borrowers continue to make payments on their mortgages and remain in their homes. If the borrower would require a modification that would be so significant as to not be reasonable (e.g., the borrower can afford a mere fraction of the monthly payment or would have to be placed on a 60-year plan to pay it off), the reality is these loans should also be placed in foreclosure. Determining where to draw the line of “reasonableness” in the amount of a modification would be a difficult decision, but the line must be drawn. Due to the considerable loosening of lending standards over the past decade, many borrowers qualified for loans that they could not afford and never should have been able to purchase the homes they did. It cannot be good public policy for the taxpayer to continue to subsidize individuals living beyond their means.
There is precedent for such a solution, and it may not ultimately require the enormous capital outlay that some commentators have predicted. Those familiar with the example of the Home Owners’ Loan Corporation (HOLC) will recall that the government established just this sort of vehicle in 1933 to refinance the loans of distressed borrowers to help avert foreclosures. The HOLC came to own nearly one fifth of the home loans in America but was ultimately able to sell off the loans and any underlying properties acquired via foreclosure—and even turned a small profit—when the market stabilized. In the present case, there is good reason to believe that an entity that could afford to hold these loans for long enough could recoup a significant portion of its investment (or even a profit) when the housing market recovers.
In this manner, though the process may take several years, we ultimately may be able to unwind these toxic assets and free up our credit markets to once again make reasonable loans to borrowers who actually can pay them back. Hopefully, this time we will ensure that tighter lending guidelines are enacted and followed, that borrowers maintain sufficient equity in their homes so they are incentivized to continue making payments, and that lenders maintain enough “skin in the game” so that they are not incentivized to churn out ever-increasing numbers of loans that can be quickly sold off their books. Only in this way can we prevent the next credit crisis from emerging during the next period of growth and expansion in the housing market. In the meantime, everyone who participated in this crisis must bear a share of the cost to clean it up—even the servicers.
Isaac Gradman is an attorney at Howard Rice Nemerovski Canady Falk & Rabkin, in the firm's Litigation Department. Gradman has been involved in the litigation arising from the subprime mortgage crisis, and is the author of a law blog called The Subprime Shakeout. The views and opinions expressed herein are solely those of the author, and do not reflect those of Howard Rice Nemerovski Canady Falk & Rabkin or any other organization.
1 Ruth Simon, "Mortgage-Bond Holders Get Voice: Greenwich Financial’s William Frey Challenges Loan Servicers Like Bank of America," Wall Street Journal, December 1, 2008.
2 See, e.g., Amanda Norris, "Protest targets ‘predator.’"The Stamford Times, February 11, 2009.(available at http://www.thestamfordtimes.com/story/464902); Paul Jackson, "NACA Targets Mortgage Investor as ‘Predator.’" (Housingwire.com, February 12, 2009) (available at http://www.housingwire.com/2009/02/12/naca-targets-mortgage-investor-as-predator/)
3 Previously available at http://www.opensecrets.org/news/2008/06/countrywides-campaign-contribu.html, but Countrywide contributions are no longer segregated from those of Bank of America. Kanjorski’s fourth largest contributor for the 2007-08 election cycle was Bank of America http://www.opensecrets.org/politicians/contrib.php?cycle=2008&type=I&cid=N00001509&newMem=N&recs=20.
6 Jody Shenn, "Mortgage Investors Form Battle Lines Over Housing Aid." Bloomberg, April 23, 2009(available at http://www.bloomberg.com/apps/news?pid=20601109&sid=aJJ9n3NhQa1s&refer=home#).
7 See Gretchen Morgenson, "A Reality Check on Mortgage Modification," New York Times, April 25, 2009, and Eric Brenner and Hamish Hume, "How Big Banks Want to Game the Mortgage Mess," Wall Street Journal, May 4, 2009.
8 The strongest counterargument to this analysis, and possibly the saving grace of the Servicer Safe Harbor, is likely its language stipulating that a servicer may not be held liable “based solely upon the implementation by the servicer of a qualified loss mitigation plan.” This, combined with the provision’s “Rule of Construction” protecting investors’ rights to pursue repurchases if the servicer violated a predatory lending law or originated a loan in a fraudulent manner, indicates that servicers cannot be relieved from liability for fraud and predatory lending by modifying the loan. Supporters of the Servicer Safe Harbor may argue that this means that the law does not effect a “complete taking” and still allows servicers to be held liable if their fraudulent actions engendered the troubled loan. Still, the Act is silent as to whether servicers may continue to be held liable or forced to repurchase loans that they originated negligently, a much more common issue with a much lower threshold of proof. As described above, during the housing boom, lenders often looked the other way and ignored red flags regarding the legitimacy of borrower statements or their ability to pay back loans. If investors are no longer able to enforce their contract rights to put such loans back to the lenders, lenders would have a strong argument that the bill is not consistent with what “justice and fairness require.” See Eastern Enterprises, 524 U.S. 498 at 523.