It was in early October when Bank of America said it would modify 400,000 mortgages originated during past few years by its newly acquired Countrywide subsidiary. Between interest-rate cuts and principal reductions borrowers would save $8.4 billion.
That’s just great, says William Frey, but there’s one problem: Bank of America wants to change the terms of a lot of loans it doesn’t own. To be specific, it wants to change the terms of mortgages owned by Frey.
Frey’s solution to the problem is very simple: BofA can either buy the loans it wants to modify or it must go ahead with foreclosures.
Frey is not in favor of more foreclosures and he doesn’t want to see anyone lose their home. If you’re looking for a stereotypical greedy hedge-fund manager or a predatory lender, Frey’s not your guy.
Frey is the principal and CEO of Greenwich Financial Services, a broker-dealer and not a hedge fund. According to testimony prepared for delivery to Congress, Frey has sold mortgage-backed securities worth billions of dollars. But Frey has not packaged just any mortgages; he doesn’t deal with toxic loans.
In his testimony, Frey says that all of the securities he owns “were originated before 2004 and are not based on subprime or alt-A collateral. The loans backing the securities I own have low loan-to-value ratios (meaning high levels of equity) and are performing well. The borrowers were not tricked by teaser rates or encouraged to misrepresent their incomes. These are securities backed by mortgages secured by the homes of thousands of ordinary hard working Americans who are making their payments as agreed, honoring their contractual commitments.
“The reason I have no exposure to subprime is that I simply did not believe that the credit risk of those securities and collateral was justified. Being involved in making loans to people that cannot repay those loans has never made business sense to me. Contrary to popular opinion, there were some investors in this market that elected not to participate in the unsound securities that triggered to the current economic crisis.”
“If more investors and their advisers had followed Frey’s practices there would be no market for toxic loans,” says Jim Saccacio, chairman and CEO at RealtyTrac.com, the nation’s primary source of foreclosure listings and data. “If there was no market for toxic loans then few lenders would originate mortgages with bad terms and worse underwriting because their goal has not been to own such loans, it’s been to sell them. Knock out investor demand for toxic loans and there would be no mortgage meltdown.”
Frey is now asking that banks and others who service mortgages follow their agreements with investors. In fact, he’s more than asking: He’s suing Countrywide. His suit says the company “is required to purchase every mortgage loan on which it agrees to reduce payments.”
In other words, if BofA wants to give up $8.4 billion that’s fine — as long as no part of the $8.4 billion is being paid by Frey or his investors.
Frey’s suit involves only Countrywide, but the implication is clear: We’ve heard from borrowers, we’ve heard from lenders, we’ve heard from politicians and now we’re hearing from investors, the people and institutions that actually put up the cash that makes much of the mortgage financing system possible. They want to know why they should lose money when loans are modified.
How The System Works
In the modern mortgage system millions of loans are originated each year. Most of these loans are not actually owned by the “lenders” who make them. Instead the loans are usually sold to trusts, the trusts use the loans to create mortgage-backed securities (or “certificates”), and the securities are then sold to investors worldwide, including pension systems, governmental agencies, private investors and insurance companies.
The original lenders may not own the loans, but they often remain in the picture. This happens because the investors who own the mortgage-backed securities don’t typically want to collect monthly mortgage payments, worry about property insurance or deal with late payments. Instead, they hire companies to “service” their loans.
Frey’s point is that Countrywide is merely a servicer and not a loan owner. In a way, a servicer is like a parking lot attendant — the attendant has permission to park the car but not to sell it or take a joy ride. Seen another way, a servicer is like a real estate broker who has been hired to sell a home. The broker cannot change the offering price without permission of the property owner.
Whatever authority a servicer has to act on behalf of the loan owners is outlined in a contract called a Pooling and Servcing Agreement or PSA. Some PSAs allow servicers to modify a given percentage of loans; other PSAs say the servicer has no right to change the terms and conditions of any loan. Whatever the case, in no instance does a servicer have a right to modify a mortgage without authority.
The result of PSAs is that servicers have three options when a borrower gets in trouble:
- The servicer may modify the loan if the PSA allows such modifications.
- If the PSA does not allow modifications then the servicer can take one of two steps: It can foreclose or it can buy the loan. Once it buys the loan, the investor is out of the picture and the servicer — now the loan owner — can modify the mortgage as it prefers.
Winners & Losers
The implications of Frey’s suit are both enormous and complex: All eyes will be on the Countrywide case because it impacts investments worth trillions of dollars. Until it’s settled servicers will not want the liability which could stem from loan modifications.
Frey essentially argues that contract sanctity exists and that everyone who has a contract has the right to enforce its terms and conditions. If Frey wins then servicers will either have to buy the investor loans they want to modify, increase foreclosures or develop new agreements with mortgage owners.
Mortgage servicers cannot begin to buy back large numbers of investor mortgages because they lack the necessary capital. The only solution will be to evolve a new government program that allows borrowers to refinance existing loans with sane rates and terms. Refinancing pays off the investor’s loan and keeps contract sanctity in place.
“Immediately after the Frey suit was filed on Dec. 1, news stories began appearing that suggested that the Treasury Department was considering a plan to refinance millions of mortgages at 4.5 percent,” Saccacio said. “Such a program if done right could keep millions of homeowners out of foreclosure, help restore home prices nationwide and increase the value of mortgage securities.”
A government program could offer financing that resembles FHA loans originated before 1983 — interest rates back then were set by HUD and there was one rate at any given time for all FHA borrowers.
If a federal program to buy out investors does not emerge then lenders could start a massive number of foreclosures. However, this won’t happen for two reasons: First, the political will of the country will not allow it. Even now we see many states short-cutting investor rights with foreclosure moratoriums; a larger number of foreclosures would no doubt set off stronger reactions. Second, millions of foreclosures would devalue mortgage investor holdings to such an extent that investors themselves would want to modify loans in an effort to preserve capital.
But what if Frey loses? In that event we could expect to see loan modifications in vast numbers regardless of investor claims or concerns. This would reduce foreclosure totals but with a huge cost: The United States has always been seen as one of the most secure marketplaces in the world, but if contracts are not reliable then investors both inside the country and outside will take their capital offshore. Given that the U.S. needs investor capital because of its massive debts and deficits, the result of a Frey loss could include levels of unemployment unseen since the Great Depression — as well as vast numbers of new foreclosures.
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.