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Under Foreclosure Fraud Settlement Proposal, Investors – Not Banks – On the Hook for Penalties

A principal write-down is a better idea (photo: naillkennedy)

The latest from the never-going-to-happen foreclosure fraud settlement – and I think a good New Year’s resolution would be to stop writing about this folly until it actually happens – concerns the disposition of the roughly $19-$25 billion “penalty.” As discussed, this is not really a penalty at all in the sense of a monetary fine paid for by banks to homeowners. The money represents “credits” that will get put toward principal reductions on mortgages. If you take the position that it makes good business sense for the banks to give principal write-downs anyway, considering that they grant them on almost all other types of credit, and that if a lack of principal reduction leads to a foreclosure, the banks end up with far less in a short sale than they would in a modification, I don’t know how you can call these credits a penalty at all. But Shahien Nasiripour finds that it’s actually worse than this. Some of the costs of these credits will actually get borne by investors in mortgage backed securities:

Investors in US home mortgage bonds may have to swallow losses as part of a wide-ranging settlement being discussed between leading banks and the Obama administration to resolve allegations of foreclosure misdeeds […]

According to the terms of the settlement currently under discussion, each of the banks involved will have to meet a certain dollar target to fulfil their end of the deal. Each dollar of reduced payments or overall loan balances would be treated like a credit. A dollar of principal reduction on loans held on the banks’ own books would get a higher credit – for example, 100 cents on the dollar – than reducing a dollar of loan principal on mortgages owned by bond investors.

The servicers would have to determine that a mortgage restructuring would be more beneficial to the investor than a foreclosure, and the contracts governing the mortgage securities would have to allow for loan modifications. Investors probably would have no say in the decision, according to people familiar with the matter […]

Officials have discussed giving the banks credit to the tune of roughly 50 cents on the dollar for cutting the principal on mortgages owned by bond investors.

Because the banks would get less credit for reducing the principal on bond investors’ mortgage holdings, some officials expect that the banks would mostly cut principal balances on their own mortgages.

I’m not so sure about that last part. If the banks reduce principal on the investors’ holdings, they get credit for a “penalty” that they don’t pay. Plus, more mortgages are held by investors than are held by the banks themselves. It would make sense from the banks’ perspective to use the MBS loans for principal reduction. Yves Smith agrees. [cont’d.]

In fact, I can tell you exactly what will happen: all the mortgage mod money will come out of investors, and it will come out of the very biggest loans, since the bigger the loan, the fewer the number of mods the bank has to make (the cost of making a mod is not related to the size of the loan). So that means that this approach assures that the mods will go to comparatively few people in big ticket homes and will do nada to help middle and lower middle class people.

To be clear, a substantial number of investors would support principal reductions. They’ve come out and said so. They often end up in a better place with them than with foreclosure sales. But they would not have any say in the matter, according to this proposal, and the banks would get off scot-free for their fraudulent activities. The losses in the system would incur to the homeowners and the investors. And only one type of investor – Fannie Mae and Freddie Mac MBS holders would not be part of this scheme, and not eligible for principal reduction (though FHFA may introduce their own principal pay-down plan, separate from this settlement).

Of course, investors have their own ways to fight back, through repurchase lawsuits, and I would expect that if this comes to pass the investors would redouble their efforts to throw all these loans on the banks. That litigation will take a long time, however.

In the meantime, not only is the $19-$25 billion figure inadequate to deal with the massive foreclosure crisis or the extent of the fraud perpetrated, but banks would have a way to wriggle out of some of the charges. And these charges are the least you could do to stop this ongoing criminal enterprise from the banks. This horror story from a Citi Mortgage loan is just another taste of that.

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David Dayen

David Dayen