New Bank Powers Concern Wall Street


The guidelines mean that large U.S. banks may have an incentive to modify even performing loans, as a way to boost fee income

Wall Street has had about a week to assess the U.S. Treasury's new plan on loan modifications. Most institutional investors—the pension managers, mutual funds, and hedge fund players who financed the housing market by buying securities tied to mortgages—have been fixated on what is now commonly called a "cram-down." That's when a bankruptcy judge has the power to usurp a bank's authority to modify mortgages. If the interest or principal on mortgages are modified, that means the investors who bought the mortgage paper in the secondary market see less income from their investments.

But there is another smaller aspect to the Treasury plan that is beginning to chill those who own securities tied to many of the mortgages sold during the real estate boom. Under the guidelines announced Mar. 4, four of the largest U.S. banks may have an incentive to modify even currently performing loans as a way to boost fee and servicing income.

Here's how the market works now: A large swath of institutional investors own bonds backed by the principal mortgages on houses, while others hold bonds backed by second liens—the loans that financed home equity loans, lines of credit, or down payments. For example, consider the case of a buyer who financed the entire purchase of a $200,000 home, including the down payment, and that house is now worth $150,000. The loan that financed the initial 10% down payment for that house (or the $10,000 the borrower later extracted as a home equity line of credit) has, by all rights, been wiped out.

A Radical Disruption of Contract Law

However, similar to empowering bankruptcy judges to break contracts governing mortgage securities, the government plan has upended the normal order of loss-taking by the stakeholders in these first- and second-lien positions. The government plan allows the bank that underwrote the home equity loan to remain intact and spread the losses to the other institution that holds the principal mortgage.

"So what?" some people might respond: The lenders all assumed risk on the investment, and now they are all getting hit for making a bad call.

But underlying the proposed changes is a radical disruption of contract law that some observers believe threatens to destabilize the markets for years to come. "I think it's a problem precedent for the government and for the abrogation of contract law," says economist and market strategist Edward Yardeni, president of Yardeni Research, an independent investment consultant. "Contracts are sacred in a capitalistic society, and if you start having the government intervene and break contracts, what do we have left? It's a real turn-off to the private sector to provide capital where it's needed, which is necessary for the long-term health of our markets and our economy. The government has managed to create chaos of our credit markets."

Four Banks Have a Powerful Say

So why dismantle the normal process under which stakeholders take losses? The answer to that may lie behind who administers, or services, those second-lien loans: Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), and JPMorgan Chase (JPM). Clearly these banks have a powerful voice in shaping new rules.

The four held $347 billion of residential revolving lines of credit, or 52% of all such loans held by Federal Deposit Insurance Corp.-insured institutions, says Laurie Goodman, a structured finance analyst at Amherst Securities, a New York firm that analyzes and trades mortgage portfolios for institutional investors. Not all those loans will be affected by the new Treasury plan. The four banks also held $441 billion worth of loans in a second-lien position.

The government's plan could allow loans in a first-lien position to be modified, leaving loans in a second-lien position untouched. As a result, Goodman worries that these institutions, which also own servicing rights on the first liens, have the opportunity to abuse their power and modify even good loans where borrowers are making payments. She says the banks have "huge incentives" to collect restructuring fees and thereby increase the value of their servicing business to the detriment of other stakeholders, among other things.

Barraged by Hedge Funds

"The time-honored priority of claims in which the second lien is written off before the first lien suffers any diminution of cash flow" is violated, Goodman wrote in a Mar. 9 report to clients. "We do not want to suggest that abuses will occur; it's just that the stage appears to have been perfectly set up for such."

As soon as her missive hit the Street, Goodman was barraged by questions from hedge funds and institutional investors who were up in arms over the Treasury's plan, she told BusinessWeek. Goodman also worries that breaking such contracts threatens the future health of the securitization market. "There's a priority and an allocation of cash flows that you've got to respect" for securitization to function at all, says Goodman, a former head of global fixed-income research at UBS (UBS), where she also ran the securitized products research group.

A Treasury Dept. official, who would speak only on condition of anonymity since he was not authorized to speak on the record, said the government is not trying to undermine contracts between investors and loan servicers. "Our program explicitly, right up on top, says you need to service to these guidelines unless there is a prohibition in the contracts. We certainly want this to be a market-based solution in terms of keeping…as many as 3 million to 4 million homeowners in their homes," he said. The Treasury recognizes that "second liens do create challenges" and is working on new rules governing the second liens, he added.

Waiting Second-Lien Guidelines

Citigroup declined to comment on the subject. The company referred to a Mar. 4 press release it issued the same day the modification plan was announced. Citi's release said it will continue to work with stakeholders to work out plans for troubled homeowners. A spokesman for San Francisco-based Wells Fargo said that the bank is "still assessing how loans held by investors fit into the Obama plan. We're hopeful investors will align with the plan."

Bank of America, through a spokesman, said that "the Administration has provided fairly clear-cut guidelines for the treatment of first liens under the Housing Stability & Affordability Program, and we understand they are working on guidelines regarding second liens. We look forward to receiving further guidance on how to proceed in this unprecedented and rapidly changing environment. Clearly, with housing values continuing to decline in many areas, a performing first lien likely will benefit both the first-lien and second-lien holders."

The bank's spokesman continued: "Without modification, a first-lien holder may foreclose on the property or accept a short sale. It is unlikely that the second-lien holder will be in a position to realize any gain from those outcomes, particularly when the balance on many first liens exceeds the property's current value. In this fuller context, the…plan does nothing to benefit the second lien beyond attempting to provide a framework that allows the first lien to perform and get paid, perhaps allowing the second-lien holder to get paid at some time in the future."

Says one large investor in mortgage-backed securities, who declined to comment on the record for fear of government retribution: "This unfettered control of restructuring loans means no one is watching the banks. You are handing them trillions with no accountability and they get a bounty for modifying."


We Almost Lost the Nasdaq
LIMITED-TIME OFFER SUBSCRIBE NOW

(enter your email)
(enter up to 5 email addresses, separated by commas)

Max 250 characters

 
blog comments powered by Disqus