Cleaning Up the Subprime Aftermath

JPMorgan Chase trumpeted some impressive news on Jan. 14, 2011. It had earned a record $17.4 billion in quarterly profits in fiscal year 2010, a 47 percent jump from the previous quarter. Three days later, the bank quietly released a less flattering statement. Its mortgage-servicing division, the third largest in the country, had overcharged some 4,000 active-duty troops on their mortgages and improperly foreclosed on 14 of them, violating a law called the Servicemembers Civil Relief Act. This story broke because of embarrassing litigation. A Marine F-18 fighter pilot, Capt. Jonathan Rowles, who had been faithfully paying his mortgage, was marked delinquent. He and his wife hired a lawyer and spent two years fighting to get JPMorgan Chase to relent.

The foreclosure mess is the sequel to the subprime calamity. During the housing bubble, investment bankers sought to move as many mortgages as they could, sound or otherwise. No-documentation loans packaged by Wall Street were blessed by the ratings agencies and sold to investors who would go on to lose a ton of money. The aftermath is just as messy. A business model that lost trillions during the crash is now pursuing profit by further bilking the victims. But servicers are also finding that basic paperwork trails were not properly created during the boom. So as they try to expedite foreclosures, they play fast and loose with the law.

Three elements are needed to reform this broken system. The first is an in-depth investigation of the mortgage-servicing industry's abuses. The second is the creation of a proper system for the servicing of debt with enforceable consumer protections. The last is a more effective plan to limit foreclosures and get a floor under housing prices, using better and more comprehensive loan modifications.

Iowa Attorney General Tom Miller has been leading his fellow state attorneys general in investigating servicer fraud and working on a potential settlement that would combine procedural reforms with a onetime fine for past abuses. The proceeds could underwrite loan modifications. The plan, a bit jerry-built, has the support of the Obama administration but is being mightily resisted by the banking industry.

What went so wrong with mortgage servicing? Picture two entirely dissimilar businesses, a call center and a surgery clinic. A call center can be run like a high-volume factory. Workers function by reading scripts, without a lot of skill or training. But in the surgery clinic, each patient will be different, and the surgeon will often have to rely on extensive expertise in making judgments. This is not a business that can be run on the cheap.

Mortgage servicing has elements of both business lines. The call-center equivalent is taking in mortgage payments and passing them along to investors. It's paint-by-the-numbers. The more customized business line, analogous to a surgery clinic, kicks in when mortgages go bad. An effective loan modification takes time, extensive communication, and detailed knowledge of the customer.

The servicers have stuck to the first kind of high-volume business model, which worked fine to pump out new mortgages during a housing bubble -- but now they have to carry out the second line of business in the crash. The temptation for servicers is to make up the difference by gouging customers and pushing more fees when times are rough. A 2007 earnings report by Countrywide Mortgage (which later went broke) put this bluntly, noting that "increased operating expenses in times like this tend to be fully offset by increases in ancillary income in our servicing operation, greater fee income from items like late charges, and importantly from in-sourced vendor functions." Translation: They'll make a windfall out of junk fees and foreclosures in a downturn that will balance out the bad housing market. The business line is only profitable when consumers and investors are being gouged.

In addition to the fixed fee they get for processing each individual mortgage, servicers make money from default fees such as late charges. Servicers also collect fees when mortgages go into foreclosure. But a good loan modification reduces principal, avoids foreclosure, and produces no windfall fees -- exactly what servicers aren't incentivized to do.

Consider one common scam that often shows up in foreclosure litigation. We all know about abusive credit-card fees. You overdraw your account slightly or are a day late on a credit-card payment, and a $3 cup of coffee becomes a $33 cup of coffee. It's painful but not the end of the world. In many mortgage-servicing fraud cases, however, a late fee is added to the loan balance. Though the next payment comes in on time, part of it is applied to the fee first, so there isn't enough to cover the monthly payment. This makes that payment late, creating a cascade of more fees, more arrears, and pushing the homeowner closer to delinquency. By the time the homeowner is aware of this, a servicer is threatening to foreclose unless a huge payment or refinancing happens.

This abuse is called "pyramiding late fees"; it is only one of many new ways servicers extract money from investors and home-owners. A related abuse is so-called dual tracking, where consumers work in good faith with lenders to negotiate a modification while other employees of the servicer relentlessly pursue a foreclosure. As Capt. Rowles found out when JPMorgan Chase told him his loan was delinquent, it can take years and costly legal expenses to set things right.

The system is designed to prevent people from accessing information. We don't really know how pervasive such practices as pyramiding and overcharging are, how difficult it is for consumers to get errors corrected, or the extent to which services fail to hold valid notes and liens that legally allow them to foreclose. So the first step for reform is an in-depth investigation into how seriously servicers have exploited these conflicts and how it has affected both borrowers and lenders. This process is proceeding piecemeal though litigation and action by state attorneys general -- but not comprehensively.

A full investigation would produce a public record of practices, based on the examination of records and testimony by witnesses. Once the scope and the particulars of abuses are clear, we need to establish responsibilities and rules for servicers to follow.

A rough draft of decent rules is contained in a proposed general settlement drafted by the state attorneys general. The settlement would require that proper procedures be followed. For example, monthly payments must be applied to interest and principal first. Each monthly statement must be a comprehensive record of all money supposedly owed, by category. Dual tracking is flatly prohibited -- -servicers may not initiate foreclosure proceedings while a borrower is working in good faith on a loan modification. There must be a single point of contact between the servicer and the borrower. Documentation of liens and notes is required. There are also detailed procedures required for loan modifications.

This proposal is a promising start. But critics point out that it could let servicers and affiliated banks off the hook too easily. Some abuses were so extreme and fraudulent that they invite criminal prosecution, which should not be precluded by an across-the-board settlement before a comprehensive investigation. A figure of $20 billion has been leaked by the attorneys general as a possible fine, to be spent on loan modifications, but that may not be enough money. Far more costly write-offs are needed. And the deal proposed by the attorneys general is not self-enforcing.

The Office of the Comptroller of the Currency, widely acknowledged to be the most pro-industry of the bank-regulatory agencies, will share some enforcement authority, especially with the future of the new consumer bureau in doubt. The OCC became famous as an anti-consumer agent in 2003 when it went on a campaign to overturn Georgia's anti-predatory lending laws, specifically a bill called the Georgia Fair Lending Act. The office used federal "preemption" to override state laws, noting industry complaints that Georgia's consumer protections were hampering the streamlined chain of securitization. In a speech to the Federalist Society right before he acted to pre-empt Georgia law, Comptroller John D. Hawke Jr., who headed the OCC, stated: "The private-investor secondary mortgage market in those states has been hard hit, particularly for subprime mortgages, because of actions taken by the rating agencies in reaction to those states' predatory lending laws."

Rather than creating rules up front, Hawke said he would seek out and stop abusive practices after the fact. As the crisis deepened last fall, Mother Jones reporter Andy Kroll asked officials how many complaints they investigated over the past decade. The OCC couldn't think of any.

The enforcement of any settlement -- or better yet, of tough regulations -- needs to fall to the Consumer Financial Protection Bureau and be backed up by the state attorneys general, agencies better aligned with protecting the interests of consumers. But the new consumer bureau does not open for business until July, and without a permanent leader, it can't take over many of the necessary responsibilities.

Whatever the problems of the settlement crafted by the attorneys general, the current counteroffer by the banks is even worse. The leaked settlement offer by the banks is nothing but a promise to do what they should have been doing all along. But whatever trust the largest banks may have had has been destroyed in the post-crash era, and any plan that has weak or nonexistent enforcement and penalties should be considered dead on arrival for progressives.

President Barack Obama's administration seems to be struggling with the question of whether foreclosures are a good thing or bad thing for the economy. The industry and some policy-makers contend that the housing sector has so many foreclosures to get through that the quicker we get through them, the better. If borrowers got mortgages that they didn't deserve and couldn't afford, the quicker these mortgages are dispensed with, the faster recovery will come. In this view, as long as the foreclosures are spaced out enough to keep pressure off the banks, letting foreclosures happen ultimately gets us back to a better economy.

But this thinking is perverse. Foreclosures have huge social costs and put pressures on an already weak market. They put disinflationary pressures on an economy that is resorting to unorthodox monetary policy to keep prices steady. Foreclosures reduce the value of neighboring properties, causing uncertainty and retrenchment by neighbors.

As properties remain abandoned, blight and crime enter. The costs of a foreclosure to a municipality, which one study estimates is around $20,000 per event if the property is abandoned, put pressure on already weak local budgets. At that rate, two foreclosures is close to a teacher's salary. The decision not to seek a comprehensive solution to the foreclosure crisis will likely be remembered by history as being as disastrous as Treasury Secretary Andrew Mellon's infamous call to "purge the rottenness out of the system" through mass liquidation during the Great Depression.

The modifications that are most likely to work are ones with a serious reduction of principal owed. A recent study from the Federal Reserve Bank of Chicago has shown that modifications with a serious principal write-down are far more likely to work than ones that only reduce interest rates. Since servicers are paid first and as a percent of the balance, they take a loss to their business if they do a good write-down and gain income if they do a bad modification (since interest-rate cuts often come with increased principal amounts).

Studies also show that mortgages held on banks' books where there are no servicers are far more likely to have a modification. Remember that a foreclosure is also a principal-reduction event, with current losses estimated to be as high as 70 percent. So the choice isn't between a principal reduction and nothing but between a principal reduction that keeps the present owner from being displaced and one that results in a vacant, foreclosed house sold at a massive discount.

Rules for modifications can also deal with the conflicts of interest when the servicer is also a lender to the household. In the case of a second mortgage, the servicer's position would have to be completely eliminated before a good loan modification can go through. Making servicers responsible for the entire loan, not just their part of it, can change their incentives.

Another part of the solution is to allow the modification of mortgages in bankruptcy. Under current law, judges aren't able to modify a primary mortgage under bankruptcy as they do with other forms of debt. Bankruptcy is a central part of the safety net for middle-class families in the United States. It provides a way for people who have become overwhelmed by debts to discharge them, conditional on certain rules. It is a tool that can be adjusted to deal with new problems as they arise, and it is appropriate to change the code to deal with this new problem.

Adam Levitin of Georgetown Law School has proposed a "Chapter M" bankruptcy provision, a modified, partial bankruptcy to enable distressed homeowners to reduce the cost of their mortgage debts without suffering general bankruptcy. This approach would move foreclosure actions from state court to federal bankruptcy court. Successful petitions could be offered via a standardized, prepackaged bankruptcy plan. The plan might include a "clawback" mechanism to address potential future housing-price appreciation. If the homeowner were to default again, the foreclosure process could be sped up. Going through the process could give the lender a clean title, which would help solve the documentation problems now pervading the industry.

The failure of the loan-servicing business model, from the robo-signing of bogus foreclosure documents, to junk fees, to blocked modifications, are not just assaulting consumers a second time but threatening the integrity of property records. This fiasco is also making the payment system for the largest lending market in the largest economy in the history of the world untrustworthy. The normal market forces that would bring this back into a healthy state have broken down. The government has a responsibility to expose bad practices, streamline regulations, and stop foreclosures from wrecking the economy. What needs to be done is clear. The only question is whether the political will exists.

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