Banking Law

Sheila Bair continues to say anything...ANYTHING...to satisfy her consumer advocacy fetish. Her latest exercise in self-pleasuring came last Friday, in a speech in San Jose (I guess she knew the way). She was hell-bent on continuing to give legal advice to servicers of collateralized subprime mortgage debt obligations as to how to best serve the interests of various classes of bond holders without getting themselves sued by an unhappy class...or two...or more... of disgruntled investors. She's obviously irked that too many servicers simply refuse to take her advice to modify loans across the board for at least five years (preferably, for the balance of the initial 30 year loan term) at existing teaser rates.

Some servicers have told us that they are afraid to systematically modify loans for fear that investors will sue them. But the smarter question that loan servicers ought to be asking is whether there's a bigger risk of a lawsuit if they don't do modifications. Given today's market conditions, foreclosure will likely cost investors a lot more money than the lower returns they would get from modified loans.

Actually, the "smarter question" is what the heck does this have to do with Bair's job as head of the FDIC?  Of course, that horse ran out of the barn long ago. No matter how many times I see her on a cable news show, taking this issue up with a loan servicing executive or knowledgeable banker who tells her that she simply doesn't get it, she keeps singing this same tune. She always asserts that loan modifications are always better for the bondholders "as a group" (different classes of bondholders be damned) and loan servicers are bloody morons if they disagree with her contention that they have little-to-no risk of being sued if they do as she advises. Sheila's of the school that if a statement is asserted often enough, it becomes incontrovertible fact. And yet, certain damned fools keep resisting her air-tight legal advice as to the complete lack of legal exposure that servicers have for modifying loans as she wants them to be modified, post haste.

It appears that she's become so frustrated that she's now willing to promote a "solution" (as unnecessary as she thinks it must be) in which Congress enacts a law that gives loan servicers blanket immunity from civil lawsuits by those bondholders who might have a facially valid claim that "doing it Sheila's way" is a breach of the servicers' obligations to bondholders.

If need be, Congress could step in to protect loan servicers from investor lawsuits by clarifying that systematic loan modifications are consistent with, if not required by, their fiduciary obligations to investors. My hope is that investors wake up to what's going on and push hard for loan modifications, not fight them.

That would be an interesting piece of litigation to both write and litigate over the coming years. Make no mistake: if Congress passes such a law, it will be litigated and that litigation will likely take years to play out. A recent Housing Wire post explains the problem succinctly.

At issue here is the differing objectives between where a bondholder sits. Junior bondholders want to see the freezes put into effect, protecting at least some of their cashflow; more senior bondholders tend to see the rate freeze program as detrimental at worst, and risky at best, to their overall position, said one source that spoke with HW.

This is just the kind of boneheaded interference with private contractual rights that someone who's spent her entire career as only a professional bureaucrat, politico, or college professor would advocate. I suppose that she expects that injured classes of bondholders, especially those holding the tranches with the highest ratings (the "first-out crowd"), will sit on their fat behinds and just take it like slugs.

I wonder if any such bonds were purchased by (and if so, still held by) state and local public employee retirement systems? It would be especially ironic if clown princes like Ohio Attorney General Mark Dann, Eliot Mess Light Andrew Cuomo of New York, or the Lone Star State's own man-on-the-make, Greg Abbott, were to sue servicers and successfully allege that the law was either unconstitutional or a compensatory taking under the Fifth Amendment and demand compensation.

Whoever the plaintiffs might be, and no matter what clever arguments are mustered to support such legislation, perhaps the more gun-shy servicers will desire that the bill also provide that the US Treasury will pick up their lawyers' tabs. What are the odds of that happening? Since Ms. Bair believes that it's within her duties to advance the interests of the FDIC by pushing this position, perhaps it's also in the interests of the FDIC to put its money where Ms. Bair's mouth is. The FDIC can indemnify the loan servicers. How about it? Get your legal beagles on the case, pronto, Sheila.

Not that anyone currently expects that subprime mortgage securities will ever make a major comeback on Wall Street, but it would be nice if someone other than the befuddled Ms. Bair, who will be long gone when the next shoe drops, consider what might be the long term consequences to mortgage securities of all stripes (not just subprime) if the U.S. Congress starts rewriting legal documents that govern the relationships between the private parties to the securities. If I could accurately predict such matters, I'd be rich, instead of of a lawyer. Nevertheless, I suspect that such a process might have the same effect on mortgage securities that FIRREA and its aftermath had on those wonderful "negative capital notes" that the old FSLIC issued to fill the hole of insolvent thrifts back in the 1980s, and on the "yield maintenance agreements" and regulatory forbearances it and the FHLBB agreed to that were cut back or "yanked" by new regulators. In other words, what's the appropriate "risk premium" that an investor ought to request to adequately compensate it for the risk of the advent of a future Sheila Bair?

I'm not a fan of government bailouts, but I'm much less of a fan of half-baked legislative interference in private contractual rights and in the structure of financial products. I'm almost to the point where I agree with Alan Greenspan's warning that if Congress believes that it simply must "do something," then it should spend money to directly assist people in need, but it should not mess with the structure of the market or of the products of the market, because Congress almost always screws that up with a host of unintended consequences.

Then again, no matter what "solution" Congress comes up with to ease the pain of the markets working through this painful correction process that is upon us, I suspect that it will screw it up.