There is a glaring problem with proposals to dismantle Fannie Mae and Freddie Mac and “bring private capital back” to the mortgage market: Investors got mugged once and are not likely to walk down the same alley again.
From 2002 to 2006, Wall Street banks overtook Fannie and Freddie and issued the majority of mortgage-backed securities. The market for “private-label” mortgage-backed securities, the securities issued by Wall Street banks, collapsed in 2007 and remains comatose. In 2013, Fannie and Freddie issued 99 percent of new mortgage-backed securities.
The unchallenged assumption in Washington is that the overhaul of the housing finance system should drastically reduce the role of government and revive the private-label mortgage-backed securities market. Investors are not likely to buy new mortgage-backed securities from Wall Street banks if the new securities are like the old ones.
Wall Street banks bought mortgages and sold securities to investors backed by the mortgages. “Securitized” mortgages are technically owned by a “trustee” who hires a “servicer” to collect monthly payments and otherwise deal with the homeowner. The system worked fine when homeowners made payments on time and in full or had enough equity to sell their home to avoid foreclosure.
When the bubble burst, investors read the fine print in their mortgage-backed securities. Investors learned that trustees and servicers had little incentive to act in investors’ best interests.
Servicers were often subsidiaries of banks that held a second mortgage on the same home. There is a flagrant conflict of interest for the servicer of a first mortgage to hold a second mortgage on the same home.
In foreclosure, holders of first mortgages get paid in full before holders of second mortgages get paid anything. If the first mortgage is for more than the home is worth, the second is really unsecured debt. When the servicer holds the second, however, they can use “loss mitigation actions” to protect their own interest at the expense of investors. Instead of foreclosing, the servicer can reduce the principal on the first, reduce the second not at all, and just appropriate investors’ collateral.
In other circumstances it is in investors’ interest to modify distressed mortgages and the servicer’s interest to foreclose. It takes much more work to negotiate a sensible modification of a distressed mortgage than to foreclose, but servicers are paid better to foreclose. Last year, six former Bank of America employees filed sworn statements in a class-action lawsuit by homeowners against the bank. The employees allege that the bank denied mortgage modifications to qualified homeowners, falsely claimed not to have received necessary paperwork, falsified electronic records, ignored properly completed applications, and then made homeowners start all over because the paperwork was no longer current. The bank gave bonuses, the former employees said under oath, for pushing homeowners who qualified for modifications into foreclosure instead. According to the former employees, the bank pushed for foreclosure instead of modification for the sake of a modest additional profit. Bank of America hotly denies the allegations.
Servicers sent business--from homeowner’s insurance to the maintenance on foreclosed home—to their affiliates at unconscionable prices, which servicers charged to defenseless homeowners and investors. Servicers pocketed illegal fees from homeowners, sometimes tipping homeowners into foreclosure, also to the great detriment of investors.
Investors’ legal remedies for the long train of abuses and usurpations by servicers are frustratingly inadequate. The servicer’s contract is not with investors, but with the trustee. The investors’ contract is with the trustee, and the contract requires little of the trustee.
Trustees paid little attention to the work of servicers, despite the obvious harm to investors from servicers’ conduct, and did next to nothing to hold servicers accountable.
Trustees, not investors, had the legal right to demand that Wall Street banks buy back mortgages that were not what the banks promised investors. More than a third of the mortgages that backed many securities were bad loans, which resulted in enormous losses to investors.
The bank that issued the securities hired the trustee, usually another bank, which hired the servicer, which was usually a subsidiary of the bank that hired the trustee. It was a cozy arrangement for everyone but investors.
Legislation now before the Senate includes provisions to strengthen servicer accountability, encourage sensible loan modifications, and reform servicer compensation, and an informal coalition of housing advocates spearheaded by the National Consumer Law Center urge more protections for homeowners and investors, such as requirement of smooth, efficient transfers of mortgages from one servicer to another.
But the obvious conflicts of interest must end. Servicers should not hold second mortgages on the same homes for which they service first mortgages. Trustees and servicers should have a fiduciary duty to put the interests of investors ahead of their own. Trustees must have an enforceable duty to supervise the work of servicers diligently, and hold servicers accountable. Trustees must have an enforceable duty to require banks to buy back mortgages that were not what banks promised investors.
Investors will not bring “private capital” to the mortgage finance system unless they know that they won’t get mugged again.
Miller represented North Carolina's 13th Congressional District from 2003 to 2013. As a member of the Financial Services Committee, he introduced legislation to reform mortgage securitization and servicing. He is now a senior fellow at the Center for American Progress and a lawyer with Grais & Ellsworth, which represents plaintiff-investors in mortgage-backed securities litigation.