Monday, October 28, 2013

Can't the law just fix underwater mortgages?

California has been particularly hard hit by the foreclosure crisis. Many homes are underwater, meaning homeowners owe more on their home mortgage than the home is worth.

Image courtesy shankbone

Say a homeowner took out $500,000 at the height of the market to buy a house, but that house is now only worth $250,000 after the housing crisis. Homeowners are stuck--they cannot afford to pay their mortgage, but they cannot sell their homes to repay the mortgage, either.

It is in the bank's interest as well as the homeowner's to keep the homeowner in her home and making affordable loan payments. Ideally, the bank would reduce the amount the homeowner owes on the mortgage to match the home's diminished value. But for various reasons, it is hard to make principal reduction happen. One of these reasons is that banks are not always free to do what they want with the mortgages they created (or in Bankish, the mortgages that they "originated").

Wait, what? Banks don't call the shots on the mortgages they originated? Here's why. Banks often "pool" mortgages and sell them to financial institutions (either government--think Fannie Mae and Freddie Mac--or investment banks), who in turn sell them to groups of investors. The banks can take the money they make selling off mortgages towards making new loans. Great idea, right? The risks of individual mortgages are evened out, and banks have the money to keep on churning out fresh loans.

But there are consequences of this pooling system. Banks that sell off mortgages have to follow certain conditions laid out in "pooling and servicing" agreements. These pooling and servicing agreements are notoriously sloppy. When they were drafted, nobody expected things to go wrong. If you're in the mood to gouge your eyes out, you can read through one of the disastrous things here. Though pooling and servicing agreements often take away the banks' rights to modify the mortgages they sell, the example agreement I've chosen actually appears to grant banks authority to modify--but kind of tough to tell what exactly the bank is allowed to do under the agreement's murky language: "In order to minimize losses on defaulted mortgage assets, the servicer may. . . be permitted to modify mortgage assets that are in default or as to which a payment default appears imminent."

If you're feeling brave, you can look to see if your own mortgage has a pooling and servicing agreement using these instructions from the Ohio Supreme Court. Start here and put in your lender's name, look for the date your mortgage was made, click on the prospectus, then do a control + F for "modify" to see what the contract says about your bank/servicer's authority to modify. This process of finding your pooling and servicing agreement is one part art, one part science, and one part guesstimation, so please don't despair--it's not you, it really is just unnecessarily complicated and confusing.

In pooling and servicing agreements, investors often freeze the original loan contract in place. As a result, the banks don't have the authority to modify the home loans. All that the bank can do under the contract is continue to collect mortgage payments and send them along to the investors who own the pool of mortgages.

Again, everybody here is stuck: the homeowner is stuck in her home, the bank is stuck charging a homeowner according to the original plan, and both are locked in to an agreement by an depersonalized group of investors who have no relationship to either homeowner or bank.

Enter law. The law can fix things, right? Well, people are trying a lot of different legal strategies to deal with underwater mortgages.

State and federal governments tried to address part of the underwater home loan situation using litigation. In 2012, the Department of Justice, the District of Columbia, and 49 states' attorneys general (all except Oklahoma) sued the five major mortgage lenders: Bank of America, Wells Fargo, JP Morgan Chase, Ally/GMAC, and Citi. They brought the suit in the DC Circuit in March, and by April all five of the banks agreed to settle. The complaint specifically did not address the mortgage securitization issues we talked about above, like pooling and servicing agreements, but focused mostly on the banks' deceptive and unfair business practices in customer service (being uncommunicative, transferring homeowners to many different points of contact, foreclosing on a house while a homeowner was applying for a modification, etc.).

Local governments are talking about using another controversial strategy: seizing underwater home loans using eminent domain. About two dozen local governments are considering these strategies, in California (San Bernardino County, the City of Sacramento, the City of Richmond) and across the country (Chicago, IL, North Las Vegas, NV, Detroit, MI, Suffolk County, NY, Newark and Irvington, NJ). San Francisco-based venture capital for-profit firm Mortgage Resolution Partners has been pitching the idea to local governments across the country.

The way eminent domain would work with underwater mortgages is roughly as follows: governments would seize the mortgages and pay the investors (generally pension funds and money market accounts) fair market value for them. Local governments would then sell the mortgages to a new investor, which would generate the money to pay fair market value for other underwater mortgages. Sound familiar? It's similar to the process banks use to service mortgages, just with a local government stepping in to press the "re-set" button.

Would a "re-set" be fair to the people who depend on those pension funds and money market accounts (like those who depend on the California Public Employee Retirement System)? Would those funds have any chance of getting the money they expected, anyway?

We don't know yet. And we may have to wait to get the answer.

The question has not yet been properly brought before a court. Judge Charles Breyer of the District Court for the Northern District of California recently dismissed a complaint that Wells Fargo filed against the City of Richmond--because nothing has happened yet, the claim was not yet ripe for adjudication.

NOTE: There are many folks out there with more expertise on this complex subject than I have. Please, as always, feel free to forward your corrections to thelawinlife@gmail.com.

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