A lawsuit against Bank of America claims states and banks will short bondholders $8.4 billion and damage the market by cutting home payments
The battle over the mass modifications of troubled mortgages has begun in earnest. On Dec. 1, William Frey, a private investor in mortgage-backed securities, filed a lawsuit in New York State Supreme Court alleging that the proposed modification of some 400,000 home loans originally underwritten by the defunct lender Countrywide Financial is illegal.
The lawsuit , which seeks class-action status, was filed against Bank of America (BAC), which bought Countrywide in late 2007. It argues that most of the Countrywide loans are not Countrywide's or Bank of America's to modify, but rather are owned by trusts that bought them through securitization—the process of financing home loans through the public markets by parceling them out to investors.
Frey says that BofA's modifications (BusinessWeek.com, 10/23/07) will short bondholders $8.4 billion by reducing borrower payments. While those loan adjustments may help to keep struggling borrowers in their homes today, Frey says those alterations run the risk of permanently damaging the secondary market for housing finance.
"I am an advocate for investors' contractual rights," says Frey, 50, in an interview. He has publicly argued since March that loan modifications (BusinessWeek, 11/26/08) are against contract law, and has threatened to sue banks—despite, he says, receiving pressure to back down from Washington. "Investors' voices have been muted in this debate because they speak of an inconvenient truth: Current solutions sacrifice the long-term viability of this nation's housing finance system for short-term political gain. No matter how noble the intent, it is not in the interest of the United States now, or in the future, to tell its citizens and the world at large that U.S. contract rights may be bent with the political winds."
Bank of America Response
In response, Bank of America spokeswoman Shirley Norton says: "We have not yet received a filing and, therefore, we cannot comment on specific claims. We are, however, disappointed in this attempt to halt a program intended to keep as many as 400,000 at-risk families in their homes and, together with similar programs across the industry, stabilize the nation's housing market. We are confident that together with the attorneys general we have built a program that benefits both consumers and investors, whose interests we carefully considered in developing our program."
Frey says a more reasonable, albeit unpopular, solution would be for the government—that is, taxpayers—to ante up another $500 billion to buy all of the troubled loans from mortgage-backed securities pools in order to keep the public market for financing mortgages viable. (There have been roughly $7 trillion in mortgages financed by global public markets since 2002, according to ThomsonReuters. Of course, not all of those loans are troubled.)
Securitization massively expanded home ownership in recent years by allowing investors to price the risk of less credit-worthy borrowers. But investors in some of the prime securities are angry about having to foot the bill for reworking the most risky mortgages. The chief risk manager for a mortgage investment company, who spoke on condition of anonymity, said that BofA isn't paying for the modifications out of its own pocket, but "out of the bondholders' money. That's pretty egregious."
To raise money to lend, banks and mortgage players such as Countrywide sold some of their loans via Wall Street. When loans are securitized, Wall Street bankers create trusts that buy them. When borrowers pay interest and principal on their mortgage loans, those payments go to the trusts, not to the lender that initially made the mortgage loans. To raise the money to buy or fund the loans, the trusts sell interests in a pool to investors or bondholders. These notes are securities—hence the term "securitization."
Each note entitles its owner to payment of principal, plus interest, at an agreed-upon rate until the loan is paid off. According to the suit, modifying a mortgage loan almost always means reducing or delaying payments due on a loan. Reducing or delaying those payments in turn entails a reduced or delayed flow of funds into the trusts. A reduced or delayed flow of funds into those trusts reduces the value of the certificates that those trusts sold to investors, the suit says.
Possible 400,000 revisions
The legality of that structure—and the impact of any changes on bondholders—weren't the top priorities of the attorneys general of California, Illinois, and at least five other states that last summer filed lawsuits accusing Countrywide of violating laws against predatory lending. Their complaints allege that Countrywide engaged in many deceptive sales practices, charged unlawful fees and interest rates, and made mortgage loans that Countrywide had no reasonable basis to think the borrowers could afford. All of that, the states claimed, was in violation of predatory lending laws.
On Oct. 6 the attorneys general and Countrywide agreed to settle those allegations. As part of the agreement, Countrywide was required to modify at least 50,000 home loans by Mar. 31, 2009, and potentially alter an additional 350,000 thereafter, according to the suit. If BofA plans to modify about 400,000 loans with the average loan about $200,000, then Frey's attorney, David J. Grais of Grais & Ellsworth in New York, figures it will cost them about $80 billion to repurchase the loans and make good on the contracts.
While he's so far the only member of the proposed class against the Charlotte (N.C.)-based BofA, Frey says he's on a crusade on behalf of all large investors who bought Triple A-rated mortgage bonds, and not just those who bought bonds backed by Countrywide mortgages. The suit alleges that modifications favor bondholders who bought the riskiest pieces. Normally those investors should suffer losses first, but that's not what's happening in the current wave of workouts, according to the suit.
While Frey says he can't quantify the number of members in the proposed class, he and his attorney say there are potentially thousands of investors who could sign on because there are hundreds of securitizations, each of which issued dozens of certificates. Frey's attorneys say they have already received inquiries from dozens of interested investors, including pension funds, public- and private-sector retirement managers, hedge funds, and mortgage real estate investment trusts. Few, however, are willing to speak up because the issue is so politically charged.
A win/win result?
The largest subprime-mortgage servicing company, Ocwen, could be in the crosshairs of such lawsuits if its workouts are found to break securitization contracts. Nevertheless, Paul Koches, general counsel for Ocwen, contends that modifications are in the best interest of the borrowers and the market. Moreover, he says servicers are contractually bound to pursue modifications that benefit all parties.
In an e-mail, Koches claims that "modifications designed to yield greater cash flow to investors…compared to net liquidation proceeds from a foreclosure are not only legally permitted, they are arguably required of the servicer. In a market environment where loss severities on foreclosures exceed 50%, loan modifications are not only a useful tool in protecting investors, but they also keep homeowners in their homes—truly a win/win result."
Koches adds that as a loan servicer, he's obligated to "act in the best interest of the investor." That standard, he says, should be interpreted as applying to all investors in a securitization in the aggregate—irrespective of the specific impact on any particular class of investors.
Frey has been publicly outspoken about the contract violations of mortgage modifications since March. And he's been accused by high-ranking members of Congress of getting in the way of efforts to remedy the nation's foreclosure crisis. After complaining publicly that he would sue any servicer who proceeded with modifications, Frey received an invitation to address Congress in public testimony. He received a sharply worded letter dated Oct. 24 and signed by six members of Congress, including Barney Frank (D-Mass.), Maxine Waters (D-Calif.), and Luis V. Gutierrez (D.-Ill.). The letter said: "We very much hope you will be able to tell us very soon that you have reversed your position of trying to obstruct" a bailout bill.
Would All Premiums Rise?
Frank ultimately withdrew the invitation, and Frey elected to go ahead with the suit, despite what he regards as intimidating tactics. He says he's talked confidentially with many investors who are worried they'll be forced out of business if they complain. Because he only accepts private money to invest, Frey says he's got less to lose. (He won't disclose his assets.)
The broader risk of loan modifications, Frey and others say, is that homeowners may wind up paying higher interest rates on home loans in the future. They compare the home-loan situation with that of credit cards, whose contracts can be altered: A bankruptcy judge can forgive principal and then lower rates for those overly indebted. One of the biggest reasons interest rates on mortgages are so low is that so far there's been no way to alter the mortgage contract once it has been securitized.
"The public policy problem going forward is, if Congress can legislate or a judge can break the contract, then I as an investor will demand a much higher premium," says the mortgage-company risk officer. "I can't model and price something that is 'oh gee, we're going to change the rules.' It's a big problem."
Editor's Note: The original version of this story said the lawsuit was filed in federal, not state, court.
Business Exchange related topics:Mortgage LendersBank of AmericaSecurities LendingHousing Market