A Reality Check on Mortgage Modification

By GRETCHEN MORGENSON

WE are almost two years into the housing storm and foreclosure floodwaters continue to rise. A record 800,000 homes received a default or auction notice in the first quarter, an increase of 9 percent from the fourth quarter of 2008, according to RealtyTrac. And one in five mortgage loans exceeded the value of the underlying property at the end of 2008, according to data from American CoreLogic Inc.

With figures like these, it’s only natural that many in Congress want to lend a hand to troubled borrowers. And so legislators have put together the Helping Families Save Their Homes Act of 2009, a bill that aims, among other things, to prod financial companies into modifying more troubled home loans.

Mortgage modifications are, in theory, appealing. But in reality, the most popular types of modifications — where delinquent amounts are simply tacked onto the mortgage — tend to default again later with distressing regularity.

Still, pushing loan modifications is a Congressional priority. The bill, which passed the House on March 5, may soon come to a vote in the Senate.

Unfortunately, the bill would not only pay institutions handsomely for each modification they do — at $1,000 each, a bounty that could reach $10 billion — but it would also create opportunities for mortgage servicers to profit at the expense of investors who own the loans.

And who are these investors? Sure, they include big-time speculators and market sophisticates. But because so many of these securities also found their way into portfolios of mutual funds and other professionally managed accounts, individual investors could be harmed if the bill becomes law.

Mortgage securities have covenants — known as pooling and servicing agreements — that define their terms. They require loan servicers to act in the best interests of investors when they make decisions about how much forbearance to give troubled borrowers. This requirement has led some servicers to reject loan modifications. Changing the terms of the mortgages, they contend, can hurt investors by reducing interest payments. Lawsuits could follow.

To deal with this, the new Congressional bill would protect servicers from potential suits brought by mortgage investors if loans were modified. The bill also says that servicers wouldn’t be obligated to repurchase loans from a pool because of a modification.

The danger, some investors and securitization lawyers say, is that these provisions might allow some financial companies that engaged in improper lending — and also happen to be loan servicers — to escape legal punishment.

For example, if the servicer of an abusive loan was also the initial lender, the bill would take that company off the hook for any future predatory lending suits. The safe harbor, therefore, could encourage servicers to modify their most poisonous loans, even if they are not yet near default, just to reduce their legal exposures.

And allowing servicers to void buyback requirements on loans they modify would eliminate any liability for breaches in representations and warranties on the loans they made to investors who subsequently bought into the pools.

“Main Street investors need to know that banks who received their tax money through government bailouts are going to profit again from the safe-harbor loan modification provisions at the expense of their mutual funds, 401(k)’s and pension investments,” said Thomas C. Priore, chief executive of ICP Capital, an investment firm that specializes in credit markets.

Another perverse incentive that the bill would create involves the problem of conflicting interests among investors who own the first mortgage on a property and holders of the second liens. First liens of any kind take priority and are supposed to be paid off before secondary obligations are. But many of the companies servicing loans today own second liens on the same properties whose first mortgages are held by investors in securitizations.

By removing any liability associated with modifying the first mortgage, the banks that own the second liens can expose investors to losses or reduced income while keeping their own interests in the second lien intact.

There is a lot of money riding on this conflict. Of the roughly $12 trillion mortgage market, $1 trillion is in second liens. The bulk of those liens — 70 percent — are held by banks, analysts say. And while the top four servicers administered 55 percent of first liens in the fourth quarter of 2008, they also held $440 billion in second liens.

“In corporate bankruptcies, banks are enforcing their positions as senior lien holders,” Mr. Priore said. “Yet they want mortgage investors who hold first liens to take a back seat to their subordinate interests.”

In addition to these downsides, it is not even clear that a safe harbor for servicers would encourage prudent loan modifications. Mortgage pool documents don’t restrict such changes. Typically, lawyers say, these agreements allow servicers to change the terms of a mortgage loan if it is in default or in imminent danger of defaulting.

Because servicers’ actions are dictated by the best interests of the investors in the mortgage pools, loan modifications that minimize the kinds of losses typically seen in foreclosure should be an easy sell. That may be why investor suits against servicers have been so rare.

James B. Lockhart III, director of the Federal Housing Finance Agency, said that while he has not taken a position on the bill or its safe-harbor provision, servicers can and should do far more in the way of loan modifications.

“There are definitely unintended consequences” to the legislation, Mr. Lockhart said. “We would hope that the servicers use the flexibility they already have in the pooling and servicing agreements and make the modifications they can. That is the No. 1 thing.”