The National Mortgage Settlement: Does the Punishment Fit the Crime?

This educational and thoughtful post on the large settlement the Obama administration recently accepted from the largest mortgage originators comes courtesy of a financial industry insider who must remain anonymous due to employer restrictions. However I am happy to be able to post it on his behalf, and I hope our readers enjoy it as much as I did.  

Under the terms of the landmark National Mortgage Settlement, (NMS) the 5 largest mortgage originators (GMAC, Bank of America, Citi, JP Morgan Chase and Wells Fargo) reached a $25 billion agreement with the US Attorney General, representing the Obama administration's latest response to the mortgage crisis. The settlement follows a finding that these mortgage companies routinely signed foreclosure-related documents outside the presence of a notary public and without really knowing whether the facts they contained were correct (robo-signing) in violation of existing laws.

The agreement will settle all state and federal investigations related to the practice. Meanwhile, the cash will be used to provide benefits to distressed borrowers whose loans are owned by the settling banks as well as to many of the borrowers whose loans they service via direct payments from the states and the federal government. It is the largest multi-state settlement since the Tobacco Settlement in 1998.

Though the funds will be used to provide relief to distressed borrowers, the root cause of the settlement was the bank's mortgage servicing businesses, not their origination arms. Despite this, under the terms of the settlement, the large banks will be forced to modify the terms of loans that they never originated. While there might of been instances of robo-signing, an illegal practice, the punishment for that is an expansion of their long-term liabilities by having to take on new loans they didn't originate through the forced refinancing mechanisms put in place under NMS.

However, during the run up to the crisis, there were other companies who were taking a slightly more exotic approach. In the early to mid-2000's tens of thousands of mortgages were originated by smaller securitized mortgage companies backed by private investors who, after originating the loan portfolio, would package it, tranche it and sell it as investment-grade paper all over the world.  These collateralized debt obligations (CDOs) would come to be known as the dreaded subprime mortgage bonds. Once sold, investors in these instruments would cash in and move on to loan, securitize and sell all over again. 

What these smaller, private investor pools were not equipped for was the actual servicing of the loans. They also proved poor at providing the conduits by which mortgage payments would be bundled and paid out to bond owners via semi-annual interest payments. The 5 largest mortgage originators in the nation jumped at the opportunity to use their size and scale to meet this need, becoming the 5 largest mortgage servicers in the process. They accomplished they by deploying their armies of customer service representatives in new subsidiaries whose sole purpose was payment collection and mortgage servicing. 

While they received service fees for this practice, the primary motivation was the opportunity to be first in line to refinance these serviced loans in the future as the buyers matured financially and their loan moved closer to term in future interest rate environments. Part of what made this so attractive was the low risk to the banks if the homeowners defaulted as they were, in most cases, only servicing those loans. 

However, the banks ultimately resorted to illegal signing tactics once foreclosures started to pile up, and NMS has exposed these failings of their lucrative side business. Of course as a result it has also become a way for the Feds to provide relief to those homeowners with loans not owned by Fannie or Freddie. It seems that, though these banks weren't the root cause of the crisis, the Obama administration identified them as the only potential deep-pockets path to a big settlement, and hooked on to robo-signing issue as the way to accomplish this.  

Assuming this is true, they (the banks) will pass along billions of future cash flows to the federal and state governments to relieve distressed homeowners in the hopes that, lowering payments and forgiving principal balances, homeowners will have additional monthly cash flows to spend and help re-energize the economy. However, the forgiveness or elimination of debt comes from the destruction of equity and the resulting projected future cash flow. In short, this agreement amounts to reflation with destruction of corporate equity to forgive the debts of the middle class. This almost begs the question, why isn't this getting more publicity? One guess is that banks, whatever their role in the crisis was, will get little sympathy for claiming innocence.

Mortgage servicing, a practice which was intended to be a low risk cash generator for banks has instead turned out to be a Trojan horse bringing thousands of new, and potentially unqualified, loans onto their balance sheets. The regulations the government has promulgated over the past few years have sought to reduce the risk within the industry. However, in a severe case of mixed signals, the administration's pursuit of justice via settlement punishes banks for what were intended to be risk-averse behaviors with what could be very damaging long-term results. Other than the robo-signing fiasco, these banks largely played by the rules. In the run up to the crisis, they were generally issuing fairly traditional 30 year mortgages with fixed rates to what were, at the time, qualified buyers. As the crisis hit, they took their lumps as foreclosures accelerated and wrote down their losses as they came.