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. 


  1. Anonymous7/6/12 12:40

    Fascinating take. But your analysis leads me to a different conclusion. These banks grabbed a hot potato--and the loss lands with the last one holding it. That these banks kept issuing traditionally (i.e. not sub-prime) mortgages shows that they knew the loans they were servicing were risky. If you agree to play a role in a risky deal, you had best conduct yourself in a manner beyond reproach. The privately funded loan-makers were taking the money and running while selling CDOs. That there was a risk the banks, as loan-servicers with deep pockets, would be left holding the bag was an obvious risk.

    One quote that stands out: "[T]he forgiveness or elimination of debt comes from the destruction of equity and the resulting projected future cash flow."

    That is true in theory, but when those future payments are not forthcoming (because without restructuring the borrower cannot make them), the destroyed wealth is purely fictional. That is certainly the case with at least some mortgages. Sadly, it is probably also the case with some of Europe's sovereign wealth.

    I am also struck by the statement: "Other than the robo-signing fiasco, these banks largely played by the rules."

    Yes, except for the laws they broke, they did not break any laws. This is a novel argument in mitigation that deserves wider application. Imagine a bank robber pleading for sympathy because he didn't rob anything else, or a kidnapper seeking a reduced sentence because after all, he only ever committed kidnapping.

  2. Thanks for stopping by, and thanks for the comment.

    I will make a quick response, though I am of course not speaking for our anonymous author...

    I think everything you say is right (unfortunately including the bit about the destroyed wealth. Another way to look at it is that the banks will be paying for the settlement not out of those failed mortgages you noted, but other sources, making it an even bigger systemic issue).

    However, I think you might put too much store in the mitigation analogies. While in the examples you gave, you are using lack of other crimes as mitigating factors to the crimes comitted, in the article, the author gave the relative lightness of the crimes as mitigating factors to the disproportionate punishment, a much different animal.

    Addressing your examples, there are established and well-known penalties for bank robbery and kidnapping which would by nature rule out using the lack of other crimes committed as mitigating factors.

    However, in this case, the banks who are able to bear the burden of the administration's intentions are being called on to pay a penalty disproportionate to their role in the mortgage fiasco as well as disproportionate to the ills they could have expected even in a meltdown scenario.

    By rights, it would be the originators who should bear the burden of making people whole who were put into inappropriate products. However, since many of those companies disappeared, the Feds looked for a way for the deep pockets to bear the burden.

    Under this perspective, robo-signing, while illegal and inarguably something that should be punished, was merely a hook for getting banks to pay for the bigger issue.

    That is what I believe the author was concerned about. Maybe some of our readers are not, basically due to the 'grabbing the hot potato' take on things (though one could argue that, as Fannie and Freddie now own many of the 'bad' loans, maybe they are the hot potato entity...however that quickly gets one mired in a quasi-governmental area of grayness more perilous than a steel spider web).

    Either way, it was an interesting approach for the government to take, and one which will have an impact on behavior in the future, for better or worse.

    Thanks for the comment,

    1. Anonymous8/6/12 11:00

      Well, the punishment is not related to the crime. But I disagree that it is overly harsh.

      Their crime may seem like a technicality to you, but in my view affixing a false notary seal is morally equivalent to perjury. They could certainly face much harsher penalties than this settlement. The banks are getting off lightly because they are sorely needed in the economy; they are simply too big to punish with criminal sanctions, such as revocation of the entity's charter and its dissolution.

    2. Thanks for this response, you make an excellent point, and one which I agree with - at least in part. I hope I didn't make it seem like I felt the banks should have gone unpunished.

      This might surprise you, but I would be in favor of a punishment that did fit the crime. If the banks committed perjury, then the government should have proven it and punished them for that, even if it were a more severe penalty than what happened here (again, I am speaking for myself here, and not the author - I get the sense he might disagree and focus more on the harshness, but I can't say for sure).

      I should back this up by explaining my position on banks. I am neither pro- nor against banks, at least in the way most people these days would take those designations. If things played out the way I thought they should have a few years back, some of these banks wouldn't even exist...I thought creative destruction should have been allowed to run its course, and that things shouldn't have stopped with Bear.

      In other words, I am no bank apologist. I am not anti-bank either, and I understand the critical role they play in a system I am very in favor of. Maybe call me a capitalism purist...

      Now that you know where I stand on the banks, I do believe that punishing them for something they didn't do creates a situation where the main historic reasons behind criminal law, retribution and deterrence, go unaddressed.

      Now, one might be able to argue that this settlement is a deterrent, but for what? Being the biggest institutions standing after a crisis?

      Give me the perjury charge any day of the week...at least the banks would have been punished for what they did. Here it is clear to me that they weren't.


  3. Only the Secretary of state is the appointing officer of any notary. Without knowing him or without his permission, no one can be appointed as a notary. According to Notary commission requirements, applicants must be 18 years old, applicants must be a resident of that state or can be a permanent alien resident of U.S, applicants must not disqualified from voting, applicants must pass the required state exam

  4. You have no guarantee that you will have sufficient funds to pay off the mortgage at the end of the repayment period, as the pension fund could perform below expectations.

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