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Moral Hazard, Other Minefields Lurk in Mortgage Settlement

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The deal is done. The states and the nation's largest servicers have agreed to a massive settlement to resolve foreclosure abuse claims. The total package will cost the Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and Ally Financial an estimated $25 billion to $32 billion and apply only to loans originated between September 2008 and 2011.

In addition, the five lenders were assessed $766.5 million by the Federal Reserve immediately after the settlement announcement. The fines were for the use of “unsafe and unsound processes and practices in residential mortgage loans servicing and foreclosure processing.”
Who wins and who loses under the settlement? A close look at the details suggests that billions of dollars will flow back to selected borrowers — but not all borrowers. Here are big questions raised by the agreement.

Who gets the big money?
The agreement says that at least $10 billion will go toward reducing the principal on loans for borrowers who are either delinquent or at imminent risk of default and owe more on their mortgages than their homes are worth.

Nothing in the agreement is likely to set off more arguments about fairness, unfairness and moral hazard than this provision. To understand why imagine that Smith and Jones buy matching homes on the same block and for the same price, $400,000. Smith buys with 20 percent down and makes all payments. Jones buys with 5 percent down, uses a no-doc loan application and finances with an option ARM so the size of his mortgage debt increases over time.

The value of both homes declines by 15 percent. Under the servicer agreement, Jones is entitled to as much as $20,000 in principal relief because he's underwater. Smith — who played by the rules — gets nothing because he has equity in the property.

What about refinancing help?
At least $3 billion will go toward refinancing loans for borrowers who are current on their mortgages but who owe more on their mortgage than their homes are worth.

Again, no relief for Smith. Jones winds up with less debt and lower monthly payments.

What about other relief?
The government says “up to $7 billion will go toward other forms of relief, including principal forbearance for unemployed borrowers, anti-blight programs, short sales and transitional assistance, benefits for service members who are forced to sell their home at a loss as a result of a Permanent Change in Station order, and other programs.”
We already have forbearance programs for the unemployed that delay foreclosures for a year and active-duty service personnel cannot be foreclosed. As to “other programs” that's legal speak which says money will be spent on something not made public.

The issue with short sales is very curious.

In a short sale the “lender” is asked to allow a transaction without having the mortgage debt fully repaid. A short sale can make sense for lenders if the alternative is foreclosure and higher cost.

However, the party taking a loss on this transaction is not the servicer nor the “lender” who originated the loan, it is instead a mortgage investor or an insurer such as the VA, FHA or a private mortgage insurance provider.

According to the Financial Times, HUD Secretary Shaun Donovan said a few days before the settlement that bond investors who hold non-government guaranteed mortgages will likely fund a “substantial” portion of the principal reduction.

“If the idea is to have mortgage investors such as pension funds, insurance companies and sovereign funds pay part of the settlement then recent history does not suggest easy sledding,” said Daren Blomquist, vice president at RealtyTrac. “What we have is a partial settlement with more debate and disputes to come.”
In 2008 the Bank of America announced that had agreed with 11 states to create “a proactive home retention program that will systematically modify troubled mortgages with up to $8.4 billion in interest rate and principal reductions for nearly 400,000 Countrywide Financial Corporation customers nationwide.”
Sounds great but the Countrywide loans had been sold to investors. The investors said the Bank of America had no right to saddle them with losses which should be paid by Countrywide or the Bank of America. Four years later, only $237 million has actually been paid out.

Just like the Countrywide situation, look for investor attorneys to be in court protesting the settlement — protests which could span years.

Is the mortgage settlement really like the tobacco settlement?
In 1998 the states agreed to accept $206 billion over 25 years in a tobacco agreement to offset Medicaid costs while the industry received an expansive release from private claims.
The agreement preserved the tobacco industry not because of product love but because tobacco dollars could be used to offset state health costs for decades, tax rates could be held down and vigorous anti-tobacco programs could be funded. But the tobacco agreement was not universal — only 46 states signed. Also, the $206 billion in company payments were just a starting point. The actual payments could be larger.

For the tobacco industry the agreement changed everything. Money that could no longer be spent on advertising in the U.S. reduced costs and was used to acquire companies in other fields. Further litigation was avoided. Sales overseas were not impeded. The companies became enormously profitable.

Does the settlement resolve all robo-signing claims?
No. The government said $1.5 billion will be paid to 750,000 “borrowers who lost their homes to foreclosure with no requirement to prove financial harm and without having to release private claims against the servicers or the right to participate in the OCC review process.”
However, the deal only applies to loans originated between September 2008 and 2011. There were millions of foreclosure filings made before 2008. Many if not most of these filings were based on loan notes which were bought, sold and assigned electronically, a process which raises the same issues as loans originated after 2008.

How far back should we allow borrower claims? Residential buyers and investors buying foreclosures want to know the title is good and that a former owner cannot come back into the picture.

Can't happen?

The Massachusetts Supreme Court ruled last year in the Ibanez decision that at least in its jurisdiction homeowners who have been improperly foreclosed can get their house back — even if it has been re-sold by the lender.

“In the Ibanez case,” said attorney Rich Vetstein, “the mortgage assignment, which was executed in blank, was not recorded until over a year after the foreclosure process had started. This was a fairly common practice in Massachusetts, and I suspect across the U.S. Mr. Ibanez, the distressed homeowner, challenged the validity of the foreclosure, arguing that U.S. Bank had no standing to foreclose because it lacked any evidence of ownership of the mortgage and the loan at the time it started the foreclosure.”
Usually in foreclosure disputes a homeowner gets cash if he or she wins. However, in this case the house was returned to the borrower. The decision is unusual because returning title can damage the interests of an otherwise uninvolved current owner.

“Despite pleas from innocent buyers of foreclosed properties and my own predictions, the decision was applied retroactively, so this will hurt Massachusetts homeowners who bought defective foreclosure properties,” said Vetstein.

“If you own a foreclosed home with an ‘Ibanez’ title issue,” says the Massachusetts attorney, “I’m afraid to say that you do not own your home anymore. The previous owner who was foreclosed upon owns it again. This is a mess.”
Will other states adopt the same idea? Does the mortgage settlement stop past claims against servicers? At this early moment there's no sure answer.
Couldn't the government have gotten more?
The spectrum of possible financial settlements has ranged in public from as little as $5 billion to as much $750 billion.

But the real number had to be at the low end of the scale because a bigger settlement could demolish the nation's leading financial institutions — and with them much of the economy. Already, says Bloomberg News, lenders have paid out $72 billion for “faulty” mortgages.

RealtyTrac's Blomquist says “the entire financial system remains weak and vulnerable in large measure because of the mortgage meltdown. While a bigger settlement might have been possible, it may also have destabilized the financial system, a result no one would want.”
Was it important that all states signed onto the agreement?
Not really — the tobacco settlement was not unanimous. What counts is that New York and Delaware were part of the deal. Here's why:

Delaware is the state where most major organizations are incorporated while New York law is the basis for most mortgage-backed securities.

Without the agreement of New York and Delaware, major lenders would remain open to vast additional claims. Already New York is suing the Bank of America, J.P. Morgan Chase, Wells Fargo and MERS — the electronic system used to record loan sales and assignments — regarding allegations that they participated in deceptive and fraudulent foreclosure filings. Both states have also agreed to a joint investigation into mortgage servicing practices that effectively involves loans nationwide.

A partial settlement — and that's what we've got instead of a universal agreement that ends all possible litigation — means state officials will be able to concentrate more resources on the claims not covered by the agreement.
For distressed-property buyers — those looking at short-sales and foreclosed properties — the end result of a national foreclosure settlement is likely to be more and quicker sales as lenders try to clear weak loans from their books and rid foreclosed homes from their inventories. That could mean substantial discounts as distressed properties are sold off.

As to who really won think about it this way: We've moved the ball down the field, both lenders and government officials gained some yardage, but there's more time on the clock.
 Peter G. Miller is syndicated in newspapers nationwide and operates the consumer real estate site,

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