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The Coming Regulatory Attack on Banks and Mortgage Servicers

The Obama administration has voiced concern over the growth in the shadow inventory of houses, which grew 25 percent in 2010 according to a recent Standard and Poor's report. Apparently the backlog of homes that is slowing down recovery isn't big enough. At least, that would appear to be the administration's perspective based on the recently revealed plans to penalize the banks as much as $20 billion for errors in mortgage servicing uncovered in last year's robo-gate scandal.

Reports have surfaced that federal regulators, in association with state attorneys general, are developing an agreement where banks would modify $20 billion worth of underwater mortgages by writing down the principal balance of the loan and taking the losses themselves as penance for mistakenly foreclosing on a few homes and losing the paper work on a number of others.

The Wall Street Journal accurately calls this "housing market masochism" because a punishment like this would be sure to halt mortgage lending, expand the shadow inventory by slowing the foreclosure process, and ensure the housing recovery process takes at least an extra year or three. Shouldn't the punishment avoid hurting the homeowners it is seeking justice for?

Securitized mortgages do not contractually require servicers to bear principal losses. Penalizing servicers anyway by forcing them to modify mortgages would substantially impact the future reliability of contracts and could stop all mortgage lending in its tracks right now until certainty in rule of law was reestablished. At the very least mortgage servicing fees would increase in the future, to account for the increased risk of federal penalties, and J.P. Morgan warned in a note last week that some banks may exit the business all together, reducing future securitization and increasing the cost of mortgage credit for borrowers.

This outcome of forced modifications should certainly give regulators pause. So too should the substantial moral hazard problems associated with lowering mortgage balances because housing prices have fallen. The plan, which has not been officially announced, reportedly would focus on the 14 largest servicers who have made foreclosure processing mistakes, though reports suggest that modifications would be at the discretion of the servicers, a complexity that could open up a large can of legal worms.

Who gets a modification? How would banks decide? There is $744 billion in negative equity in the American housing market according to CoreLogic, and $20 billion would do little to address that broad problem. And beyond the complexities of determining who in this pool would get a forced modification, imagine if just a fraction of those underwater on their homes decided to forego payments in hopes of getting further government concessions to force banks into modifying loans.

Even Fannie Mae and Freddie Mac, essentially run by the Treasury Department, have been slow to embrace principle write downs because of the fear that more homeowners would stop paying their mortgage to get in on the action.

More legal problems could arise from investors who contractually don't want mortgages they own modified. Though at least regulators have anticipated that investors in mortgage-backed securities should not be forced to take a loss here, and reports suggest the restitution plan would require the banks to eat the losses stemming from from writing down mortgages that are larger than the homes they are associated with.

The good news for the banks is that the regulators need to agree on a proposal before they can be forced into one, and that has not come easily. The American Banker has suggested that the Federal Deposit Insurance Corp wants "a program that would streamline modifications in return for a clearer path to foreclosure if the borrower redefaults." Meanwhile, the Consumer Financial Protection Bureau (CFPB) and Housing and Urban Development Department (HUD) want a strong principal reduction program, while the Comptroller's office "wants to instead focus on fixing safety and soundness problems."

The differences in how to penalize the banks stem from mixed reasons why a fine should be levied in the first place. Some in the administration want to unclog the pipeline of loans awaiting modification. And they have long wanted to push banks to write-down mortgage principal on a wide scale basis to eliminate the high level of negative equity in today's housing stock.

Mortgage "cramdown" legislation-where a judge can break a loan agreement to forcibly lower principal balances to the current value of the home-was a popular idea in early 2009, but did not pass Congress given the threat it posed to rule of law and long-term trust in contracts.

Then the administration turned to HAMP-the Home Affordable Modification Program-to modify up to four million mortgages by spending $75 billion giving banks cash in exchange for modify mortgage payments, reducing interest, and keeping homeowners in their homes. The program is on the chopping block now because it has only accepted 500,000 borrowers into the program, paid out only $1 billion of funds, and has in several cases made borrowers worse off than before.

This should provide a warning to policymakers that mortgage modifications really are not the panacea that many believe them to be. Recently released information about HAMP indicates that 75 percent of those who started modifications eventually fell back into delinquency, certainly a contributor to expansion of the shadow inventory to over three years of supply at the end of 2010.

The reasons for this are because foreclosures are not primarily due to high interest payments that could be reset at today's rates, but rather homeowners being stuck in homes beyond their means and not having enough income to make even the lowered payments in a modification. Extending modifications to these individuals simply slows down the foreclosure process; forcing the modifications for those that could afford the change would inspire waves of strategic defaults.

This is not to say banks should not bear the consequences for their mistakes. The question is whether forcing modifications is the equitable way to provide restitution for those who were wrongly foreclosed on and whether $20 billion is an appropriate penalty for sloppy mortgage servicing bookkeeping.

There is likely a deeper motive at work in this process, likely including the desire of some regulators to punish the banks for their overall role in the financial crisis. Elizabeth Warren, the not-so-tacit director of the recently created CFPB, has repeatedly argued for reparations from the banks that she sees as the villains who created the whole mess in the first place. This reflects her ideology more than it does an adequate review of financial history though, even from the liberal perspective of The Financial Crisis Inquiry Report.

State attorneys general are also seeking a political win, since they made a huge show out of joining forces to review the foreclosure scandals that emerged in the later half of 2010. A large settlement from the banks would certainly pay dividends in their next election. These state officials argue that banks have hurt struggling homeowners by not having the appropriate staff and technology to provide timely assistance to borrowers.

The Comptroller's office, however has reported that the number of borrowers improperly dealt with has been "small." And the Federal Reserve has joined them in a review of foreclosure procedures to separately suggest the appropriate penalties-which would likely be in the millions, not billions, according to a report from the Journal.

The banks will argue that any pound of flesh reflect proven damage done. For those borrowers wrongly foreclosed upon, restitution should be made. And for those borrowers unable to get timely help with their mortgage payments, systems can be fixed.

But according to a note from J.P. Morgan, the proposed settlement of $20 billion would likely only double the current modifications in HAMP to a total of just over one million mortgages, still well short of the administration's goal, leaving millions without modifications anyway and not fully addressing the housing problem. The consequences of the $20 billion punishment would not be small however.

Anthony Randazzo is Director of Economic Research


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