Mortgage Banking & Consumer Credit Alert
October 2008
Author:
Laurence E. Platt
+1.202.778.9034
larry.platt@klgates.com
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No Fault Loan Modifications After EESA:
Charity Begins at Home?
Much can be and has been written about the many provisions of the Emergency Economic
Stabilization Act of 2008 (“EESA”); from a mortgage banking perspective, however,
the most important issue is the way in which the federal government as owner of
distressed residential mortgage loans and the related mortgage-backed securities will treat
defaulting borrowers.
Within days before and after the October 3rd enactment of EESA, we saw the State
Foreclosure Prevention Working Group of the National Association of Attorneys General
slam loan servicers for insufficient loss mitigation outcomes, several state attorneys general
announce a settlement in which a large loan servicer agreed to implement systematic loan
modifications, and two city sheriffs reiterate their unwillingness to complete foreclosures.
Couple these actions with states, like New Jersey, that continue to propose bills materially
diminishing the ability of loan holders and loan servicers to realize on their collateral in
response to borrower defaults, and you will see that loan servicers are stuck in the middle
of a government “holy war” to keep defaulting borrowers in their homes, without regard
to the reasons underlying the defaults.
It is hard to fight a war when you agree with the other side. Both loan holders and loan
servicers generally support the government’s strategic objective of home retention. Yet
this objective begs the question of eligibility and cost. Under what circumstances should
a borrower be eligible for a loan modification, and who should bear the cost of a loan
modification that exceeds the cost of foreclosure?
Authority to Purchase Loans and Securities
As has been well documented, the U.S. Department of Treasury (“Treasury”) has authority
under EESA to purchase up to $700 billion of “troubled assets” from qualifying “financial
institutions.” This is referred to as the Troubled Asset Relief Program (“TARP”). Residential
and commercial mortgage loans originated before March 14, 2008 and any securities based
on or related to such mortgages may constitute “troubled assets” if the Treasury determines
that their purchase “promotes financial market stability.” This means that loans eligible
for purchase are not limited by loan type, lien priority, borrower profiles, underwriting
characteristics, loan features, or occupancy status.
For example, the term “troubled assets” is not limited to hybrid ARMs or option payment
ARMs made to owner occupant, subprime or ALT-A borrowers who obtained teaser rate
loans on a stated income basis. While the major valuation problems for financial institutions
pertain to these types of loans and the related mortgage-backed securities, Treasury can
purchase any type of mortgage loan or related security if it deems such purchase to promote
financial market stability. This means, for example, that a large pool of prime, “piggy
back,” closed end, second lien loans may be purchased if the requisite finding is made.
Mortgage Banking & Consumer Credit Alert
Authority to Modify Purchased Loans Under
TARP on No Fault Basis
How will the Treasury handle troubled assets that
it holds for its own account? Will Treasury write
down the outstanding principal balance by whatever
it takes to enable the loans to be refinanced with
FHA-insured loans under the HOPE for Homeowners
Program pursuant to the HOPE for Homeowners Act
of 2008 (the “Hope Program”)? Will it merely defer
the repayment of arrearages and certain principal to
enable the borrower to resume sustainable monthly
payments with the hopes that the deferred amounts
may be collected upon the earlier of refinancing or
maturity? Will it ever direct a servicer to foreclose on
a loan where there simply is no reasonable sustainable
payment that the borrower can afford to make by virtue
of change in circumstances, such as job loss, other
indebtedness or health issues? Will aggressive loan
modifications of delinquent borrowers encourage
performing borrowers to demand similar treatment?
And how will Treasury react to state attorneys general
pressuring its loan servicers to modify beyond what
Treasury is willing to accept or to states that impose
regulatory barriers to foreclosure that are the functional
equivalent of mortgage nullification? The answers
cannot be found in EESA.
As a threshold matter, the ability of Treasury to dictate
the treatment of delinquent borrowers depends on
whether it owns either the whole loans or merely the
related mortgage-backed securities. If the former,
Treasury can do whatever it wants to, subject to the
conflicting guiding principles set forth in EESA. If the
latter, it acquires the securities subject to the existence
of a loan servicing agreement between the loan servicer
and the trustee on behalf of all of the securities holders;
Treasury’s contractual authority to direct the actions
of the servicer is limited. It cannot direct the servicer
to take actions that are inconsistent with the servicer’s
obligations under the applicable servicing agreement
if there are other securities holders.
EESA seems to direct Treasury to minimize foreclosures
in connection with the whole loans and the securities
that it purchases. The language of the statute, however,
lacks clarity and will leave servicers scratching their
heads to determine how they should proceed. Section
109(a) of EESA obligates Treasury to “implement a
plan that seeks to maximize assistance for homeowners
and use the authority of the Secretary to encourage the
servicers of the underlying mortgages, considering
net present value to the taxpayer, to take advantage
of the HOPE for Homeowners Program … or other
available programs to minimize foreclosures.”
In Section 110(b) of EESA, Congress took the
opportunity to provide parallel provisions for mortgage
loans and mortgage-backed securities that are owned or
controlled by the Federal Housing Finance Agency in
its capacity as conservator of Fannie Mae and Freddie
Mac, the Federal Deposit Insurance Corporation
(“FDIC”) and the Federal Reserve Board (“FRB”),
which are collectively defined in EESA to be “Federal
Property Managers.” (References in this Alert to
Treasury, consequently, generally apply equally to
Federal Property Managers.) This makes sense because
the federal government wants to take a uniform
approach to the extent possible to loan modifications
and very well may use Fannie Mae and Freddie Mac as
indirect vehicles to purchase troubled assets outside of
the $700 billion Congressional authorization.
What does this language mean? Is the required
consideration of “net present value” intended to be a
floor beyond which Treasury and its servicers should
not go in offering loan modifications in lieu of pursuing
foreclosures? In this regard, the analysis is not much
different than what servicers generally are doing
now—offering modifications if the cost to modify does
not exceed the cost to foreclose and sell the related
REO. Perhaps the phrase “maximize assistance” tilts
in favor of permanent changes to loan terms rather than
temporary forbearance, but it is not clear.
Moreover, certain conflicting considerations are
required under Section 103 of EESA to be taken into
account by Treasury in exercising its new statutory
authorities. These conflicts presumably are the result
of Congressional compromises that were required
to secure bipartisan support. For example, the
required consideration of “protecting the interests
of taxpayers by maximizing overall returns and
minimizing the impact on the national debt” would
seem to limit Treasury’s ability to incur modification
costs for defaulting borrowers in excess of the cost of
foreclosure. Requiring Treasury to take into account
“the need to help families keep their homes and to
stabilize communities,” however, would seem to
obligate Treasury to do whatever it takes to avoid
foreclosures. The unfettered pursuit of this objective
might render meaningless the phrase “considering net
present value to the taxpayer.” So is Treasury as a note
October 2008 | 2
Mortgage Banking & Consumer Credit Alert
holder obligated by EESA to write down a principal’s
loan amount in order to qualify the loan for an FHAinsured refinancing under the HOPE for Homeowners
Program even if the size of the write down would
exceed the cost to foreclose?
The use of the word “consider” is what underscores
this ambiguity. The ordinary meaning of the term does
not mandate any action other than to think about the
issue. Congress could have bound Treasury to reject
loan modifications exceeding the cost of foreclosure.
It did not use such declarative language, however. It
is anticipated that Treasury will inform its servicers
whether “consider” creates an outright ceiling on the
cost of a permissible loan modification.
Compare this approach to the August 8, 2008
announcement by the FDIC regarding the “Loan
Modification Program for Distressed IndyMac
Mortgage Loans.” As conservator for the IndyMac
Federal Savings Bank, FSB (“IndyMac Federal”),
the FDIC announced a program to modify troubled
mortgages on a systematic basis to achieve “affordable
and sustainable mortgage payments by borrowers
and increase the value of distressed mortgages by
rehabilitating them into performing loans.” While
the program is limited to first lien, owner occupant
residential mortgage loans, it is not limited to
subprime or ALT-A borrowers. Any such borrower
whose loan is owned by IndyMac Federal and who is
seriously delinquent potentially is eligible for a loan
modification, even if the delinquency results from postclosing changes in the borrower’s repayment capacity.
The FDIC says that it only will make modification
offers to borrowers “where doing so will achieve an
improved value for IndyMac Federal or for investors
in securitized or whole loans.” It does not guarantee a
modification for all borrowers.
The FDIC protocol calls for modifications to produce a
38% debt-to-income (“DTI”) ratio of principal, interest,
taxes and insurance, using a combination of interest
rate reductions, extended amortization, and principal
forbearance, based on a permanent interest rate at the
then current Freddie Mac survey rate for conforming
mortgages. The FDIC reserves the right to reduce the
rate for five years in order to achieve the 38% DTI.
Interestingly, with respect to loans it holds for its own
account, the FDIC as conservator for IndyMac Federal
does not obligate itself to consider the net present
value of alternative loss mitigation strategies. Instead,
the protocol simply calls for modifications based on
the DTI ratio. The only explicit mention of seeking
to maximize the net present value of the mortgage is
where additional interest rate reductions are needed to
hit the 38% mark.
There are three important points to highlight regarding
the way that Treasury acts under EESA and the FDIC
acts as conservator for IndyMac Federal in deciding
whether to modify loans and, if so, who pays for it.
First, depending on how one interprets the provisions
of EESA, neither Treasury nor FDIC explicitly requires
a “net present value” analysis for loans that each holds,
although Treasury at least has to think about it. Second,
neither plan limits the availability of modifications
to defective loan originations that are designed to
make a borrower whole for a loan he or she never
should have obtained either at all or on certain terms.
Rather, each makes sustainable affordability the goal
for delinquent borrowers without regard to how or why
the borrower is in a delinquent status. Third, the cost
of the modifications is borne by the loan holder, which
indirectly may mean the taxpayers. Of course, there are
differences, but FDIC promulgated its program before
Congress enacted EESA and armed Federal Property
Managers with virtually the same authority granted to
Treasury.
Authority To Modify Pooled Loans Under TARP
on No Fault Basis
Contrast this approach with the treatment of loans
where Treasury and FDIC do not own the whole loans
but instead own either the related mortgage-backed
securities or the contractually based loan servicing
rights. In this case, Congress recognized the inherent
limitations in the rights of Treasury when it directed
Treasury to “encourage” servicers to minimize
foreclosures. To the extent Treasury as a securities
holder has any approval rights under the investment
contract (i.e., the servicing agreement), EESA instructs
Treasury to consent, where appropriate, to reasonable
requests for loss mitigation measures, including term
extensions, rate reductions, principal write down,
increases in the proportion of loans within a trust or
other structure allowed to be modified, or removal
of other limitations on modifications. The FDIC also
acknowledges in its program that any modifications
will be “provided consistent with agreements governing
servicing for loans serviced by IndyMac Federal
for others.”
October 2008 | 3
Mortgage Banking & Consumer Credit Alert
The statutory right of Treasury to encourage servicers
to minimize foreclosures on pooled mortgages is
not intended to supersede the contractual rights of
other investors holding mortgage-backed securities
on the same pooled mortgages. Section 119(b)(2)
makes clear that any exercise of the authority of the
Treasury pursuant to EESA shall not impair the claims
or defenses that otherwise would apply with respect to
persons other than the Secretary. Thus, if an investor
wanted to make a contract claim against a servicer for
following the encouragement of Treasury in conflict
with the servicing contract, EESA does not nullify the
right to assert such a claim. While the “savings clause”
of Section 119 does not apply by its terms to Federal
Property Managers, Section 110(d) explicitly addresses
the subject of conflicting interests by providing that
“The requirements of this Section shall not supersede
any other duty or requirement imposed on the Federal
Property Managers under otherwise applicable law.”
But Congress did try to protect servicers from investor
claims, at least as it relates to Treasury. It did so by
taking a “half page” out of the HOPE for Homeowners
Act of 2008 to protect servicers against the risk of
lawsuits by MBS holders of mortgage-backed securities
if they modify loans backing securities held by
Treasury. The earlier housing act added a new Section
129A to the Truth in Lending Act called “Fiduciary
Duty of Servicers of Pooled Residential Mortgages.”
The title is misleading because the provisions of
the new section do not seek to impose a fiduciary
or any other duty on loan servicers. Rather, the new
provisions seek to provide a federal statutory rule of
construction of a clause in an “investment contract”
between two private parties—the loan servicer and an
investor. Although the term is not defined, we assume
that an “investment contract” is intended to mean a
loan servicing agreement.
provisions obligating the servicer “to act in the best
interests of such investors and parties,” but they do so
in fundamentally different ways. A servicer under the
HOPE Program is deemed to have acted in the best
interests of the investors if it agrees to or implements
a modification or workout plan that meets certain
enumerated criteria. It references a modification or
refinancing under the HOPE Program as an illustrative
example of a plan that would be eligible for this
interpretation. A servicer would qualify for this federal
statutory rule of construction of a private contract if:
(i) the modified mortgage is in default or default is
reasonably foreseeable; (ii) the mortgagor is occupying
the property securing the mortgage; and (iii) the
anticipated recovery under the plan “exceeds, on a
net present value basis, the anticipated recovery on
the principal outstanding obligation of the mortgage
through foreclosure.”
Under EESA, however, a servicer is not explicitly
required to consider the “net present value” of the
anticipated recovery in determining whether it has
met its contractual responsibility to act in the best
interests of all investors. Rather, the duty is deemed
satisfied merely if the servicer agrees to or implements
a modification or workout plan pursuant to which the
servicer “takes reasonable loss mitigation actions,
including partial payments.” This obviously is a much
looser standard.
Specifically, if an investment contract imposes a duty
on the servicer “to maximize the net present value of
the pooled mortgage” to an investor, the phrase is to
be interpreted to mean that the duty is owed “to all
investors and parties having a direct or indirect interest
in such investment, not to any individual party or
group of parties.” Note, again, the provision assumes
that a duty exists in the applicable contract; it does not
impose any such duty. Section 19(b)(2) of EESA uses
substantially similar language.
In both cases, the federal interpretation applies only if
the investment contract in question does not establish
a different standard. In other words, a servicer does
not qualify for the benefit of the federal statutory rule
of construction if the applicable servicing agreement
imposes its own standards and foreclosure would
be a less costly loss mitigation alternative for the
loan holder. And neither insulates servicers against
lawsuits by investors; they merely provide a federal
interpretation of the private contract clauses that might
be in dispute if an investor were to bring such a suit. At
the same time, even if the language is not as helpful or
as clear as it could be, servicers for Treasury likely will
take comfort from the fact that the federal government
will be “covering their backs” for aggressive loan
modifications of pooled mortgages; one wonders how
many investors would want to be in a lawsuit where
the defense is that the servicer followed the direction
of the federal government.
In addition, both EESA and the HOPE for Homeowners
Act of 2008 seek to interpret private contractual
Congress would rather that Treasury avoid such
potential conflicts with other securities holders in the
October 2008 | 4
Mortgage Banking & Consumer Credit Alert
first place. EESA authorizes Treasury to coordinate
with the FDIC, the FRB, the Federal Housing Finance
Agency, HUD and other federal government entities that
hold troubled assets to attempt to identify opportunities
for the acquisition of classes of troubled assets that
will improve the ability of Treasury to improve the
loan modification and restructuring process. In other
words, the best execution for Treasury is to buy up the
outstanding securities relating to any mortgage pool to
maximize its ability to modify mortgage loans.
Eligibility for FHA Refinance Under HOPE
Program
As noted above, Congress directed Treasury and
Federal Property Managers to maximize assistance
to enable the troubled loans under their control to
be refinanced with FHA-insured loans under the
HOPE Program. While EESA may not establish strict
eligibility requirements to purchase or modify such
loans, their eligibility for FHA-insured refinancing
under the HOPE Program is sharply limited. The HOPE
Program is limited to borrowers who reside in their
property securing the loan being refinanced and who
have made a minimum of six full monthly payments
during the life of the existing senior mortgage. Eligible
borrowers must certify that they did not knowingly
or willfully provide material false information to
obtain the existing mortgage being refinanced under
the HOPE Program.
This means that borrowers who obtained their original
mortgages on a stated income basis and materially
lied about their income are not eligible for an FHA
refinancing under the HOPE Program. The fact that a
mortgage broker or a loan officer may have encouraged
the borrower to lie does not relieve the borrower of
responsibility for his or her prior actions. If it is true
that stated income loans, which some refer to as “liar
loans,” make up a material portion of the loans to be
purchased by Treasury under TARP, either as whole
loans or as pooled loans, it does not appear that EESA’s
statutory goal of maximizing modifications to qualify
for FHA-insured refinancings can be realized.
Protection of Tenant Rights
In addition, this additional authority is intended to
facilitate permitting bona fide tenants who are current
on their rent to remain in their homes under the
terms of the lease, which is reminiscent of the tenant
protections provided last year in H.R. 3915. In the case
of a mortgage on a residential rental property, the plan
requires protecting any governmental subsidies and
protections and the taking into account of the need for
operating funds to maintain decent and safe conditions
at the property.
What does this really mean? If Treasury purchases
an investor loan, it seems determined to ensure that a
bona fide tenant does not get adversely impacted by a
default by the owner of the property? But how far is
Treasury determined to go to protect tenants? Do they
get a perpetual occupancy right as long as they pay
their rent? Interestingly, the FDIC’s announced loan
modification program is limited to owner occupant
mortgagors so bona fide tenants occupying homes
securing investor loans are not entitled to any articulated
special protections, although FDIC presumably would
be subject to Congressional direction as a Federal
Property Manager.
Blame-Based Modifications
Nowhere in EESA will you find accusations of blame
for the mortgages that now are considered troubled
assets. The articulated statutory considerations are
based on the need to provide financial stability,
protect communities and preserve home retention.
It doesn’t matter if the borrowers knowingly lied
about their income or were induced by fraud to obtain
unsustainable mortgage loans. It doesn’t matter if the
loans were sustainable at the time of origination but
subsequent events in the borrowers’ circumstances
caused or materially contributed to the borrower’s
default. These are no fault modifications, and the
government will eat the cost. Of course, only so much
money has been allocated to Treasury to purchase and
modify loans on a no fault basis.
The state attorneys general, on the other hand, are
relying on their role as the states’ chief law enforcement
officers to force loan modifications. In the absence of
any legislative authority, the state attorneys general
need to predicate their demands on allegations of
wrongdoing, even if the servicers were not themselves
involved in the origination of the loan. Without the
fear of a lawsuit, the state attorneys general have no
statutory basis to force loan modifications.
Early in the process state attorneys general asserted that
unaffordable interest rate resets were the cause of the
delinquency crisis. By making loans that lenders knew
or should have known the borrowers could not afford
at reset, the lenders engaged in unfair and deceptive
practices, the claim goes. Interestingly, though,
October 2008 | 5
Mortgage Banking & Consumer Credit Alert
both the second and the third reports from the State
Foreclosure Prevention Working Group acknowledged
the significant number of delinquencies that occurred
prior to any reset.
Unwilling to attribute such delinquencies and defaults
to post-closing changes in the borrower’s economic
circumstances, declines in property values, or the
general unavailability of residential mortgage credit,
the state attorneys general again blamed the originating
lenders. As the third report (“Report”) notes, “This
continuing trend of a significant portion of ARM
loans being delinquent well in advance of the
initial reset date confirms earlier assessments that
unsound loan products, weak underwriting and
mortgage origination fraud have been the primary
causes of the crisis in subprime mortgage lending.”
In fact, the Report acknowledged that a “relatively
small proportion” of delinquent, subprime and ALT-A
loans could be “attributed directly to payment shock
associated with an initial rate reset.” If external
factors or borrower fraud had any impact on these
delinquencies, one could not discern any recognition
of that fact from the Report.
The state attorneys general also noted that twenty
percent of the subprime and ALT-A loans that servicers
modified in the last twelve months were again
delinquent. Further turning a blind eye to the impact
of post-closing changes in circumstances, the Report
attributes this recidivist behavior to a “widespread
lack of sustainability in modifications made to date.”
Interestingly, the Report notes but does not try to
explain the material increase in the delinquency rate
for prime loans.
Without blaming originators for borrower defaults
there is no real basis to demand that loan servicers and
loan holders eat the costs of modifications. The state
attorneys general are not persuaded by the argument
that loan holders have to maximize the interests of
the investors in evaluating alternative loss mitigation
strategies. Nor do they care that the borrowers
themselves may have caused or contributed to their
default status by lying to obtain the mortgage loans.
From their vantage point, if a loan never should have
been made in the first place or, if so, only on materially
better terms for the borrower, they argue that loans
should be modified on a systematic basis to provide
sustainable repayment terms, even if the related
costs would exceed those of a foreclosure and sale of
the REO.
In other words, the obligation to modify a defective
origination is like a covenant running with the land
and becomes the responsibility of whoever owns or
services the loan—a type of assignee liability that is
not necessarily neatly grounded in the law. There are,
however, two material limitations to the persuasive
abilities of the state attorneys general. First, if the cause
of the borrower’s default is post-closing changes in
circumstances or borrower fraud, there is no “hook”
to catch an unwilling servicer who elects to follow
its contractual responsibilities to the investors rather
than the “requests” of the state attorneys general. Loan
holders are not known for their willingness to sacrifice
their investment for the greater public good. If there is
no fault or blame, holders will expect reimbursement
for losses that they would incur if they were to agree
to sustainable modifications exceeding the cost of
foreclosure. Second, no state attorney general can
force FHA to insure a refinancing of a loan as to which
the borrower materially lied about income, even if
third parties encouraged the borrower to lie; HUD’s
regulations now make such a borrower ineligible for
an FHA-insured loan under the HOPE Program.
Conclusion
And that’s the public policy conundrum. On the one
hand, there is not enough money for the government
to buy all of the loans that require loan modifications
to provide long-term sustainability, particularly if the
loans are not eligible to be refinanced through the
FHA HOPE Program. On the other hand, innocent
servicers and loan holders cannot be forced to bear
the extra cost of loan modifications resulting from
declining property values, job losses and the general
unavailability of residential mortgage credit if those
losses exceed the foreclosure value of the home. In this
circumstance, servicers may prefer to keep borrowers
in their home, but their contractual responsibilities
require them to foreclose. The public berating of loan
servicers and loan holders for not making charitable
gifts to delinquent homeowners in the form of generous
loan modifications is not productive.
So the “holy war” will continue to seek to maximize
home retention, but the question ultimately will turn
from who is to blame to who will bear the cost? Will it
be the taxpayers or the private loan holders? It is often
said that “charity begins at home;” less clear is whether
charity begins with the home.
October 2008 | 6
Mortgage Banking & Consumer Credit Alert
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+1.202.778.9257
+1.202.778.9039
+1.202.778.9081
+1.202.778.9207
+1.202.778.9856
+1.202.778.9445
+1.202.778.9046
stacey.riggin@klgates.com +1.202.778.9202
Director of Licensing
Washington, D.C.
Stacey L. Riggin
Regulatory Compliance Analysts
Washington, D.C.
Dameian L. Buncum
Teresa Diaz
Jennifer Early
Robin L. Gieseke
Allison Hamad
Joann Kim
Brenda R. Kittrell
Dana L. Lopez
Patricia E. Mesa
Jeffrey Prost
dameian.buncum@klgates.com teresa.diaz@klgates.com jennifer.early@klgates.com robin.gieseke@klgates.com allison.hamad@klgates.com
joann.kim@klgates.com brenda.kittrell@klgates.com dana.lopez@klgates.com patty.mesa@klgates.com
jeffrey.prost@klgates.com +1.202.778.9093
+1.202.778.9852
+1.202.778.9291
+1.202.778.9481
+1.202.778.9894
+1.202.778.9421
+1.202.778.9049
+1.202.778.9383
+1.202.778.9199
+1.202.778.9364
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