Author Archives: David Reiss

FDIC Lawsuit against Bank Directors

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The FDIC has filed a lawsuit (hat tip LaCroix by way of April Charney) against the officers and directors of a small bank in New Mexico alleging negligence, gross negligence and breaches of fiduciary duties.  The FDIC alleges that the

Defendants, as officers and directors of Charter Bank of Santa Fe, New Mexico (“Charter Bank” or “the Bank”), committed $50 million – 72 percent of the Bank’s core capital of $69 million – to open and operate a highly risky and speculative subprime lending operation in Denver, Colorado in late 2006, when they knew or should have known that there was no secondary market for subprime loans. The Bank funded loans that no reasonable financial institution would have made at any time, much less in 2007 and 2008 when the risks of such lending were well recognized. The Defendants negligently permitted and presided over, and failed to suspend, limit or stop the production of a portfolio of approximately $50 million in risky, subprime residential loans intended for sale into a secondary market that at the time was recognized to be increasingly unstable, unpredictable, and illiquid due to concerns about the credit quality of subprime loans. (1)

While the allegations, if true, would prove that the bank engaged in predatory lending, the complaint is revealing about the behavior of the bank’s regulators too:

Federal regulators repeatedly warned the Director Defendants that the Bank was over-leveraged and needed to raise more capital. The Director Defendants responded that they could operate the Bank with less capital and more borrowed money because they had placed most of their loans in the real estate acquisition, development, and construction loan business. The Director Defendants asserted that, because these loans were shorter in duration, the Bank had less risk – an analysis that failed to anticipate any real downside risk in the real estate development business. (6)

One wonders if the regulators should have done more than “repeatedly warn”  these defendants in the run up to its failure.

The complaint also has some revealing allegations about how far lenders went to skirt the Home Ownership and Equity Protection Act’s regulation of high cost loans by limiting “loans to interest rates of no more than 11.5 to 12 percent. Given the minimum FICO score and maximum debt-to-income ratios for SLG loans based solely on stated income, these artificially capped interest rates were simply insufficient to cover the very high risk of default.” (10)  Clearly, incentives ran amok at this closely held bank.

 

Strategies to Improve the Housing Market

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Boston Consulting prepared this Strategies to Improve the Housing Market report on behalf of The Pew Charitable Trusts.  The report focuses “on practical solutions that can readily be implemented by industry, agencies, and regulators working within existing mandates, or by nongovernmental organizations.”  (6)  I highlight three proposals in their report that I find particularly interesting.

1.  Promulgate Consistent Set of Loan Servicing Standards

Mortgage servicing is governed by a number of loan servicing standards—including standards under the DOJ settlement, OCC consent orders, FHFA Servicing Alignment Initiative, CFPB, as well as those of individual states—which vary in scope and individual provisions. A consistent set of loan servicing standards across the servicing life cycle can both ensure a basic standard of service for all homeowners and reduce the operational complexity of complying with multiple, varying standards for servicers.  (8)

This seems to be key to dealing with the misaligned incentives and anticommons problems that have become so apparent during the Subprime Bust.

2.  Streamline The Foreclosure Process in Key States

The long foreclosure process, particularly in judicial states, creates negative impacts on both lenders and communities, particularly when borrowers are “free riding.” While preserving the primacy of states and localities in foreclosure law, experts highlighted the desirability of working with them to develop a “model” foreclosure process based on best practices, to be adopted by states and localities on a voluntary basis. We recommend that an NGO takes the lead on developing such a model, based on best practices across jurisdictions, brings in key states and other relevant stakeholders to build consensus, and advocates for change with state policy makers and legislatures.  (9)

This issue is more complicated than the report (and most other commentators) concedes.  The claim that borrowers are “free riding” is not exactly true.  Lengthy foreclosure periods existed before the mortgages were entered into and were presumably priced into the cost of mortgages.  Indeed, the FHFA is trying to reprice mortgages in jurisdictions with the longest periods.  There are clearly policy choices at issue in the design of a foreclosure process.  For homeowners and lenders alike, the difference between the lengthy judicial process and the relatively rapid non-judicial process is only the most stark example of how process (in this case, length of process) affects substantive rights (that is, post-default occupancy periods).

3.  Rationalize First and Subordinate Lienholder Rights

In the context of continuing demand for home equity loans (second or subordinate liens), there is a need to clarify the rights of first and second lienholders to avoid a repeat of current frictions in the future and to restore investor confidence that first lienholders will have enforceable priority in the event of default. Any new framework put forward should achieve two key objectives:

>  protecting first-lien priority

>  standardizing treatment of seconds in loss mitigation efforts.

Conflicts between first and second lienholders have been a source of controversy and friction since the crisis began. It is unlikely that private investors will want to commit substantial new investment dollars to private securitizations until this issue is resolved. The industry, perhaps through the auspices of one of its trade association, should take the lead on further developing these options, in the first instance, with involvement from the FHFA, Treasury, and FDIC.  (11, emphasis deleted)

This is a very important issue.  I have been struck since the early days of the crisis how non-lawyers in particular (economists are particular offenders!) assume away the legal rights of seconds in their proposals to address the foreclosure epidemic.  Unsurprisingly, the seconds (knowing what happens to those who “ass-u-me”) have successfully asserted their legal rights to protect their financial interests.  Any solution to the problem of misaligned incentives between first and seconds must take the legal rights of these profit-maximizing entities into account.

Empirical Evidence of Predatory Steering in the Mortgage Market

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Agarwal and Evanoff have released a draft of Loan Product Steering in Mortgage Markets.  They sought to determine whether there was empirical support for the frequent anecdotes of credit steering in the literature about predatory lending.  They find such support. They find evidence

consistent with institutions steering customers to affiliated lenders that provide more-expensive loan products. Specifically, we find that steered loans have an annual percentage rate (APR) 40–60 basis points higher than that of non-steered loans after controlling for various borrower and loan characteristics. Given the average APR for the sample of loans is 6.5%, a rate 40–60 basis points differential is economically significant. We also find that the steered customers perform better on their mortgages—consistent with them being lower-risk, better-qualified borrowers than those normally associated with their eventual loan products. Specifically, we find that the probability of steered loans being delinquent is 1.4–2.0 percentage points lower than that of non-steered loans. Again, given an average delinquency rate of 5%, this differential is also an economically significant result.  (22, footnote omitted)

While I am not in a position to evaluate their empirical findings, I question the following:  “We also find that steered loans are often placed in private securitized pools—much more so than being held in portfolio or sold to the housing GSEs. This is consistent with the steering taking place in an attempt to satisfy the demands of investors looking for highly rated mortgage-back securities.” (22)  This assertion does not appear to take into the robust literature about the market for lemons which would suggest that originators would try to keep the lower risk mortgages for their own portfolios.  It also does not appear to account for how securitizers actually structure MBS in order to achieve a high rating (using techniques such as overcollateralization, subordination and insurance to do so).  In other words, securitizers do not need low risk mortgages to make low risk MBS if they can otherwise provide credit enhancements as part of the structure of the MBS.

The authors state that their results are “the first explicit evidence of systematic mortgage lending abuse during the run-up in the housing markets.” (1)  They also demonstrate the difficulty in regulating away predatory behavior from the mortgage markets as profit-seeking holding companies appear to have developed techniques to achieve net profits even while one subsidiary took actions that appeared to be inconsistent with its own quest for profits.  This should give regulators at the CFPB something to think about.

 

Federal Reserve Report on the 30 Year Fixed Rate Mortgage

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Fuster and Vickery have posted Securitization and the Fixed-Rate Mortgage, a FRB of NY Staff Report.  This paper brings some empirical research to the debate over the proper fate of the 30 year mortgage.  Commentators are sharply divided over whether the government must be intimately involved in the operations of the residential mortgage markets in order to keep the 30 year FRM available in the United States.   (Whether that is a worthy goal is another question entirely.)

Peter Wallison at the American Enterprise Institute has argued that the existence of 30 year FRMs in the jumbo market demonstrates that the government does not need to play an active role in the mortgage markets to ensure the availability of that mortgage product.  David Min, formerly of the Center for American Progress, has argued that the government must continue to play an active role in order to keep that product in the market.  My own position has been in the middle — the government can reduce its dominant role in the mortgage markets while retaining a role during financial crises.

Fuster and Vickery test whether securitization, by allowing interest rate and prepayment risk “to be pooled and diversified, increases the supply of FRMs relative to ARMs.”  (1)  They find that “lenders are averse to retaining exposure to the risks  associated with FRMs in portfolio. Securitization increases lenders’ willingness to originate FRMs by transferring these risks to a diverse international pool of MBS investors.” (2)  Unsurprisingly, they also find that “when private MBS markets are liquid and well functioning, as in the period before the onset of the financial crisis in mid-2007, private and government-backed securitization perform similarly in terms of supporting FRM supply. However, public credit guarantees may make securitization less susceptible to market disruptions, thereby improving the stability of FRM supply.” (2)  Fuster and Vickery suggest that the current GSE- centered mortgage finance system may not be necessary for FRMs to remain widely available at competitive rates, but only as long as private securitization markets are liquid.”  (30)

Fuster and Vickery do not mean to say that they have produced the last word on this topic, but their findings are intuitive to me.  This debate is central to any plan for the future of the American housing finance system, so more empirical work in this area is most welcome.

GAO Report on Challenges for Financial Regulatory Reform

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The GAO has issued a report, Financial Regulatory Reform:  Regulators Have Faced Challenges Finalizing Key Reforms and Unaddressed Areas Pose Potential Risks.  The report notes that

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A variety of challenges have affected regulators’ progress in executing rulemaking requirements intended to implement the act’s reforms. Regulators to whom we spoke indicated that the primary challenges affecting the pace of implementing the act’s reforms include the number and complexity of the rulemakings required and the time spent coordinating with regulators and others. In addition, some regulators identified additional challenges, including extensive industry involvement through comment letters and litigation resulting from rulemakings, concurrently starting up a new regulatory body and assuming oversight responsibilities, and resource constraints.  (23)

These challenges are only compounded by the recent court decision that throws CFPB rulemaking into a pit of uncertaintly.  While the decision addresses the legality of NLRB recess appointments, it clearly implicates the appointment of Richard Cordray as the Director of the CFPB.  This has serious consequences for Bureau rulemaking which cannot be occur without a Bureau Director being in place.  (See Dodd-Frank section 1022(b)(1), codified at 12 U.S.C. section 5512(b)(1))

Foreclosure = Debt Collection

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The Sixth Circuit ruled in Glazer v. Chase Home Finance LLC, __ F.3d ___ (Case No. 10-3416, Jan. 14, 2013) that “that mortgage foreclosure is debt collection under” the Fair Debt Collection Practices Act. (2) As Glazer indicates, courts have been split on this issue, but the trend seems to be in accord with Glazer.

Of particular note to lawyers:  “Lawyers who meet the general definition of a “debt collector” must comply with the FDCPA when engaged in mortgage foreclosure. And a lawyer can satisfy that definition if his principal business purpose is mortgage foreclosure or if he “regularly” performs this function.” (16)

Center on Budget and Policy Priorities Report on Rental Assistance

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The Center has issued a thought-provoking report, Renters’ Tax Credit Would Promote Equity and Advance Balanced Housing Policy.  The summary states that

Over the past several decades, the nation’s housing policy has focused predominantly on increasing homeownership.  Most federal housing expenditures now benefit families with relatively little need for assistance.  About 75 percent of federal housing expenditures support homeownership, when both direct spending and tax subsidies are counted.  The bulk of homeownership expenditures go to the top fifth of households by income, who typically could afford to purchase a home without subsidies.  Overall, more than half of federal spending on housing benefits households with incomes above $100,000.

The report makes the obvious but politically delicate point that federal housing policy should assist low-income households as opposed to upper income households.  The report proposes a well thought out renter’s tax credit that could complement existing programs like the Low Income Housing Tax Credit.

Whether a renter’s tax credit (budgeted at $5 billion in the report) is politically feasible at this time is another question entirely.