Thursday’s $25 billion foreclosure settlement received praise from some consumer groups, but the reaction was not all positive. One detail of the deal that has raised questions and concerns is reports that the five major U.S. banks will get credit for principal reduction of mortgages they do not own. While the fine print of the plan has yet to be released, mortgage investors fear they will be forced to write down the value of their holdings.
So how would the big banks get credit for using other people’s money to pay for principal write-downs? The answer lies in the evolution of the way mortgages are financed. In the old days, when a home buyer wanted to buy a home, he took out a loan from his local bank. The savings and loan business model involved collecting deposits from the community and then loaning that money back out, at higher rates, to home buyers and other borrowers.
This model, however, left banks open to certain risks like regional economic downturns or rising interest rates. (The savings and loan crisis of the 1980s was an example of what can happen to this business model in an environment of rising interest rates.) So in the 1990s more and more lenders began to “securitize” mortgages; that is, they would sell the cash flows from their mortgages — the monthly principal and interest payments — to investors, while continuing to “service” those payments in exchange for fees.
Yes, these are the mortgage-backed securities that we’ve heard so much about for the past few years — but their affect on the recent foreclosure settlement is a new wrinkle. The problem is that the five major banks involved in the settlement service many mortgages, but it is unclear how many of these loans the banks actually own. Any kind of large scale principal write-down would have to include some cooperation with the investors that own the mortgages. But these investors were not responsible for the misdeeds that precipitated the settlement, so it seems unfair — and may not be legal — to force them to take losses when they weren’t the ones committing fraud.
The government has only released a very broad outline to this deal, so it is still unknown what exactly will be asked of mortgage investors. According to Bloomberg News, Housing and Urban Development Secretary Shaun Donovan said that less than fifteen percent of the write-downs will come from investors, and that this deal will not impinge on the rights of investors:
“Nothing in it requires any trustee or servicer to reduce principal where it’s not allowed legally by the underlying documents,” Donovan said. “The misunderstanding somehow that investors will be paying the banks’ share is just false.”
But it remains unclear what legal framework will be used to get investors to write down the value of these mortgages. According to Merritt Fox, a securities law professor at Columbia University, the securitization agreements made over the past several years make it hard to modify loans and, “from a legal point of view I don’t see how any deal the attorneys general and the federal government enter into with the banks could alter that.”
Absent further details, investors in mortgage-backed securities are worried. Vincent Fiorillo, a senior portfolio manager at Double Line Capital, a firm that invests in mortgages, says that investors are open to principal write-downs in certain situations. However, he says investors were not involved in the foreclosure settlement negotiations between banks, the federal government and state attorneys general: “We are not responsible for the problem and since we were not at the table, why should we be expected to pay for this as well?”
Denizens of Main Street may not have much sympathy for well-compensated portfolio managers. But remember, many regular Joes are exposed to all kinds of financial instruments through pension funds and other investments. It is quite possible that you are the lender who owns a little part of your next-door neighbor’s mortgage, and vice versa.
As a result, if investors are forced to contribute to this principal reduction plan, the foreclosure settlement could represent yet another bailout – a transfer of wealth from the public at large to the big banks.