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Feb. 10 (Bloomberg) -- The government’s deal with banks over their foreclosure practices after 16 months of investigations is cheap for the loan servicers while costly for bond investors including pension funds, according to Pacific Investment Management Co.’s Scott Simon.
In what the U.S. called the largest federal-state civil settlement in the nation’s history, five banks including Bank of America Corp. and JPMorgan Chase & Co. committed $20 billion in various forms of mortgage relief plus payments of $5 billion to state and federal governments yesterday.
“This was a relatively cheap resolution for the banks,” said Simon, the mortgage head at Pimco, which runs the world’s largest bond fund. “A lot of the principal reductions would have happened on their loans anyway, and they’re using other people’s money to pay for a ton of this. Pension funds, 401(k)s and mutual funds are going to pick up a lot of the load.”
Asset managers are frustrated with the deal because, in addition to the debt the banks own, it gives credit to the lenders for changes to loans they hold no interest in and oversee for investors. That “treats people’s 401(k)s and pensions,” which hold mortgage securities, “like perpetrators as opposed to victims,” Simon said.
The deal comes after all 50 states announced a probe into foreclosures in 2010 following disclosures of faulty documents used to seize homes, costing bondholders as liquidations of bad debt were delayed.
“Think about this, you tell your kid, ‘You did something bad, I’m going to fine you $10, but if you can steal $22 from your mom, you can pay me with that,’” Simon said yesterday in a telephone interview from Newport Beach, California.
Government officials say the costs will be “funded primarily by the banks, not third-party investors,” according to a statement posted yesterday on a website created for the settlement. The five banks will get different amounts of credit for various types of borrower aid, with loans in government- backed mortgage bonds exempted.
The $250 billion Pimco Total Return Fund last month was 50 percent invested in mortgage debt, typically government-backed securities, according to its disclosures. It also owns home-loan bonds in private funds for institutional clients.
Simon has said for more than two years that Pimco supports the greater use of principal cuts on debt that exceeds homes’ values. It isn’t clear how often reductions for individual borrowers sparked by yesterday’s deal will be large enough to help, he said.
Laurie Goodman, the Amherst Securities Group LP analyst who has advocated mortgage forgiveness in testimony to Congress, joined him in criticizing the agreement yesterday.
“There is no one who has been more vocal in support of principal reduction than I have been,” she said in a telephone interview. “There is a difference between principal reductions and giving banks credit for spending other people’s money.”
Investors have criticized servicers for allegedly basing decisions on loan modifications on their ownership of second- lien home-equity debt, which foreclosures can wipe out. Another allegation is that banks have hindered efforts to force repurchases of faulty mortgages and didn’t have enough staff for troubled loans.
Such complaints were included in a letter sent to Bank of America in 2010 by a lawyer for a group including Pimco that later struck a proposed $8.5 billion settlement with the lender, which needs court approval.
Working Out Loans
Yesterday’s deal does “encourage servicers to do what they are supposed to do” and try to work out loans, Simon said. It will also help the housing market and provide aid to homeowners and foreclosed-upon borrowers, with limited releases of legal liabilities for banks, he said.
In return, banks won’t need to completely write down their home-equity debt before reducing mortgages, a “big deal for them” that “makes it incredibly difficult for the private market to develop,” Simon said. After the worst housing slump since the 1930s, the government is helping to finance about 90 percent of new loans, according to newsletter Inside Mortgage Finance.
“Property rights and contract law once again take a beating,” Simon said. “It ultimately means the private market will take longer to develop and credit will be less available. You’ll need bigger down payments and higher rates. That’s the problem you won’t see for a while. Investors won’t get tricked again.”
U.S. Housing Secretary Shaun Donovan told reporters yesterday that “a relatively small share, in the range of 15 percent, of the principal reduction” resulting from the settlement will come from investor-owned loans.
“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.”
While officials said servicers will only rework mortgages when it is in bondholders’ best interest, banks are now “doubly” incentivized, by the deal and their second-lien holdings, to skew such calculations, Goodman said.
Insufficient penalties imposed on banks for breaking rules may fail to prevent that from happening again, Simon said.
“There’s a moral hazard element here,” he said. “This settlement makes that potentially more likely to occur, not less.”
--With assistance from David McLaughlin in New York and Lorraine Woellert in Washington. Editors: John Parry, Dennis Fitzgerald.
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