As part of their $25 billion settlement in 2012 of lending abuse claims, five of the nation’s largest banks agreed to modify mortgages for borrowers struggling to make their original monthly payments. To the consternation of many investors, the settling banks were given credit not only for modifying loans that they held in their own portfolios, but also for modifying loans that they serviced but that were actually owned by investors.
In June 2014, the Association of Mortgage Investors (AMI) appealed to Attorney General Eric Holder to eliminate investor’s loans from future settlements.
While there is considerable merit to investors’ concerns, AMI’s solution goes too far.
How much of the settlement was paid with “other people’s money”?
That depends on the bank. Earlier this year, in our commentary about the $25 billion national mortgage settlement, we found that while none of Wells Fargo’s or Citi’s credits came from investor-owned loans, Bank of America and JP Morgan Chase used a significant number of investor-owned loans. The settlement does not disclose, however, exactly how many loans were modified, and to what extent.
In this national settlement and more recent settlements between JP Morgan Chase and the Justice Department and Citi and the Justice Department, banks received about half the credit for modifying with investor-owned loans than the loans in their own portfolio.
Why do investors care?
In theory, investors should be pleased if their loans are modified. Each settlement agreement provides that the expected value of the modified loan should be greater than the expected value of the current, unmodified loan—or net present value (NPV) positive. But in reality, investors are deeply suspicious about the accuracy of the NPV models used in these settlements, and question whether the modified loans are actually more valuable than they would have been if left alone.
A modified loan that is worth more than the original may seem counter-intuitive, but the increase in value comes from the borrower’s increased likelihood of paying off the loan once modified—supposedly a win-win-win, with benefits to the investors, the settling servicers, and the borrowers.
Investors argue, however, that the banks should be doing NPV positive modifications as a best practice regardless and shouldn’t get settlement credit. A similar argument applies to portfolio loans, but the settlements strongly suggest that the business imperative isn’t powerful enough.
Eliminating investor loans in settlements is too far.
While we sympathize with AMI’s concerns, legitimate NPV positive modifications accrue significant benefits to all of the involved parties and help ease the debt overhang that still troubles the recovery. Rather than abandoning the opportunity to modify the large number of troubled loans that happened to fall into MBS pools, it would be more sensible to provide safeguards to ensure that the NPV calculations are legitimate and place limitations on the amount of investor funds that can be used.
Greater clarity and transparency is better.
Settlements should continue to include investor loans, but should adopt three conditions:
- Clarify limits. The settlement should stipulate up front the maximum percentage of consumer relief that can be granted with investor funds. The percent should be made public prior to finalizing the settlement, so investor objections can be considered.
- Clarify method. Similarly, the method used to calculate the NPV and the re-default rates should be made public prior to finalizing the settlement, so that investor objections can be considered.
- Require disclosure. Servicers should be required to disclose to settlement monitors the individual loan NPV calculations in their reports, and settlement monitors should be required to disclose those calculations to the public, to the maximum extent possible consistent with privacy concerns. This can certainly be done by aggregating small groups of loans in a specific private label security.
While investors are right to be concerned about both how much of their assets are being written down in these settlements and the way in which they are being written down, the best solution isn’t to ban modifications of their loans. Rather, the Justice Department, state attorneys general and other settling parties should set limits on the use of these loans and ensure that the NPV tests are transparent and public.
Photo: Attorney General Eric Holder on July 14, 2014 announces a $7 billion settlement with Citigroup related to risky subprime mortgages. (AP Photo/Pablo Martinez Monsivais)