Bankruptcy

Foreclosure Fraud Settlement: The Empire Strikes Back (or Why Are Republicans So Obsessed with Backdoor Cramdown?)

By Adam Levitin

It's not surprising to see the banks and their supporters on the Hill pushing back on the proposed Foreclosure Fraud settlement term sheet. (See here and here and here).  There seem to be three major lines coming out of the banks:

 (1) It's "backdoor cramdown," and the agencies shouldn't be pursuing a policy rejected by Congress.  

Thus, House Republicans wrote to Treasury Secretary Geithner that "The settlement agreement not only legislates new standards and practices for the servicing industry, it also resuscitates programs and policies [namely bankruptcy cramdown] that have not worked or that Congress has explicitly rejected."  These House Republicans want to know:  "What specific legal authority grants federal and state regulators and agencies the power to require mortgage principal reductions when the House and Senate have voted down such proposals?"  .  Similarly a coterie of bank-friendly pundits chimed in calling this sub rosa cramdown.  

(2) CFPB has no business being involved given that it doesn't have a director.  

This has to be read between the lines as a thinly veiled Elizabeth Warren witch hunt.  At least one commentator was upfront about that in the American Banker.   

(3) The settlement could negatively affect the safety and soundness of the banks.  

Let me address all of these points.  There's a lot of willful confusion about this term sheet and what it is.  

This is the term sheet for a settlement.  A settlement is a contract--it is a voluntary agreement between two parties to settle litigation.  If a party doesn't like the terms offered, it is free to reject the offer and litigate.  Put differently, the banks have to decide if they would prefer to buy peace with the AGs or litigate.  That's the banks' choice.  And that means that claims that this is sub rosa regulation are ridiculous.   

Government agencies have always advanced policy agendas through settlements, as well as rule-making, but when they choose to move via settlement, it always means that there's a possibility of litigation.  In this sense, the proposed term sheet couldn't be more different than bankruptcy cramdown.  Bankruptcy cramdown would make mortgage modification involuntary.  If the homeowner filed for bankruptcy and qualified, the bank would have no choice about a loan modification.  Here, the banks have a choice.  

There's nothing, absolutely nothing, in the term sheet requiring principal write-downs.  So how on earth is this cramdown?  The term sheet would require banks to include principal reductions as part of a modification "waterfall", but even so, the modification would have to be (1) NPV positive, as determined by the servicer according to its own proprietary NPV formula and inputs, and (2) would not have principal reductions as the first part of the waterfall.  

Requiring servicers maximize NPV is just making explicit what is stated in most PSAs--that the servicer will manage the loan as if for its own account.  That means maximizing NPV.  Any corporation that isn't maximizing the NPV of its assets is committing waste.  Business judgment rule means that there's a lot of leeway in determining what maximizes the value of a firm's assets, but the principle is inherent.  

If anything, we should be pushing much harder for principal reductions.  At this point, it seems that every financial-related market has cleared except for housing.  At this point if a buyer and seller can agree on a sale for $150,000 the transaction isn't going to happen because the bank won't take $150,000 on a $200,000 mortgage, even if the bank will only get $100,000 in foreclosure.  By my estimates, banks denied around 200,000 short sales last year.  The real impact was much greater, however, because realtors are refusing to handle short sales.  Realtors only get paid if the sale closes, and they rightly see no point in putting in the effort to do a sale only to have it collapse because the bank refuses to sign off.  Widespread denial of short-sales is chilling the entire short sale market.  

So how is this market going to clear?  It will clear via foreclosure sales, but that is the slowest, worst way we can do it, and robosigning and chain of title problems only make it a slower and less effective market clearing mechanism.  Congress unfortunately took a pass on bankruptcy cramdown as a method for clearing the market, so that really only leaves voluntary principal reduction mods.  (And remember, if the banks agree to buy peace with a settlement, any mods that occur thereunder would be voluntary).  If Congressional Republicans and pundits have a better idea, I'm all ears.  But I really can't believe that foreclosure sales are the best way for the market to clear.  No one thinks that they are an efficient market mechanism. 

(2) Improper Involvement of CFPB.

This is not CFPB's term sheet.  It's the AGs' term sheet.  CFPB doesn't have a term sheet.  Why?  Because CFPB doesn't exist yet.  There isn't anyone with a CFPB email address yet. There's a CFPB transition team at Treasury, but there's no CFPB, and CFPB can't do much, it seems, before it has a director.  There's simply no CFPB yet and that means there's no authority for CFPB to produce a term sheet.  That's not to say that CFPB transition staff aren't involved in settlement discussions, and the transition staff have been an important voice at the table, but this term sheet is an AG product.  I don't see what legal grounds there are to possibly get worked up about who is in the room discussing the settlement terms when all legal authority remains with appointees.  The Republicans might not be pleased with who's at the table, but they've got no legal grounds for complaining.   

Congressional Republican's obsession with the CFPB and Elizabeth Warren (do they have some sort of negative crush on her?) sells the AGs short.  The AGs are plenty fired up about servicing fraud and servicers' failure to engage in serious loan modification efforts.  And this isn't their first rodeo.  The AGs remember tangling with Ocwen, Fairbanks (now Select Portfolio Servicing) and EMC (later Bear Stearns and now JPMorgan Chase) back in 2003 for predatory servicing.  Their steamed that they're having to clean up the same mess twice.  

The term sheet does mention the CFPB an awful lot, but it's in the context of enforcement.  Basically the AGs are proposing a deal with the banks and part of what they're proposing is that the CFPB will enforce the deal.  The AGs could just have easily nominated the FTC or, lehavdil, Punxsuatawney Phil the Groundhog, or even Charlie Sheen to handle the enforcement.  That doesn't mean that the nominated entity has to do any enforcement, although in the CFPB case (or FTC case) one would hope so.  

So why are the AGs nominating CFPB to do the enforcement?  For starters, they don't have the resources to do it. State AG budgets are strapped like all state agencies. And the CFPB is the only federal regulator the AGs trust. They don't trust the OCC to do anything other than cheer the banks on, and they're not real big on the Fed or FDIC. So they are nominating the CFPB.  But that doesn't make this a CFPB term sheet or CFPB settlement. It's a AG proposal. (And note that it isn't an OCC, Fed, FDIC, or Treasury proposal.)  

(3) Safety and Soundness (or it's just terrible that the banks' will have to pay smaller dividends and smaller bonuses) 

 The safety and soundness point is just laughable. The whole argument for creating CFPB was that safety and soundness means bank profitability.  An unprofitable bank isn't safe or sound. Predatory lending is highly profitable.  It isn't done just for shits and giggles.  Bank regulators won't crack down on abusive bank behavior because they don't want to hurt bank profitability.  That's why bank regulators shouldn't be in the consumer protection business; there needs to be a separate consumer protection regulator.  

In any case, the banks are out of TARP and are paying dividends or about to do so. Paying a dividend that renders a firm insolvent or insufficiently capitalized is a fraudulent transfer and violates state dividend statutes. If the banks are healthy enough to pay dividends, they're healthy enough to bear the consequences of their actions. They can't have the benefits of conservatorship without its burdens. As usual, however, this is the state of the world that a large part of our financial services industry believes is its entitlement.  

We're also hearing the "sanctity of contracts" line reemerging. Spare me. The interest rate is just as an important part of a contract as the repayment of principal. Banks have had no problem changing interest rates and suddenly their holier than thou when it comes to principle. Contracts are just that. They're not sacred and their not suicide pacts. They should be honored and enforced except when doing so is societally stupid, and that's long been the nature of contract law (defenses like duress, unconscionability, fraud, minority, etc. all fit into this meta-category of the societally stupid exception.). Do we want to be a society of Jephthahs? 

Finally, apologies about the title. One has to find humor in this stuff somehow.  

Full post as published by Credit Slips on March 09, 2011 (boomark / email).