Steve Dibert, MFI-Miami Exclusive
I began working on this project last year at the peak of the modification frenzy and finished it about a month ago. I originally planned on posting it last week on the eve of the Mortgage Servicers Convention in Dallas. I decided to hold off because I didn’t want to ruin the fun of the champagne fueled Conga lines or the Mad Men style skirt chasing that usually goes on at conventions sponsored by the financial services industry.
The findings of my year-long investigation would have put everyone into a panic mode and stopped the flow of the Dom Perignon for the Conga lines and the awkward moments at the water cooler this week and replaced it with Tums and Roll-Aids. So in the spirit of not being a party pooper and in an effort to create a distraction for those employees who may have had “too much fun” I decided to wait.
What have I discovered that would create so much anxiety? Well, mortgage servicers are ripping off not only homeowners but the pension funds and hedge funds who have invested into Mortgage Backed Securities. What they’re doing is reminiscent of what was portrayed in the Martin Scorsese film, Casino, where the local mob Capos would “skim” large sums of money off the top of the casino revenues before they were counted and sent to the bosses in the mid-west.
Before we get into that, we need to hop in the Way Back Machine like Peabody and Sherman from the Bullwinkle cartoons and go back in time. Back to a time when cops were beating up hippies, Martin Luther King and Bobby Kennedy were challenging us as a nation to be better people, men were going to the moon and Jon Voight was playing a gay gigolo on the big screen.
Back then, President Lyndon Johnson had a great idea. Well, it seemed like a great idea at the time anyway, to make homeownership a birth right for every American. In those days of Prediluvian America, those who owned the loan also evaluated the risk, collected payments and would adjust payments or terms as circumstances warranted. Using this business model, lenders made money by writing loans they knew would perform and borrowers had unmediated access to decision makers at the bank that could modify the terms of the loan. This guiding principal behind this practice was transparency of all parties involved.
This sounds like a great business model and it was. It helped George Bailey survive the Great Depression in “It’s a Wonderful Life” and it helped many real life banks survive the Great Depression. However, expanding homeownership under that business model would have driven the federal budget deficit not only through the roof but to rings of Saturn. Imagine if you will today’s national debt numbers in 1967 dollars. If converted to 2010 values the numbers would be so large it would blow out a circuit on the speech synthesizer Stephen Hawking uses on his wheelchair.
Being this was the height of America’s period of ingenuity and optimism, President Johnson and his Mortgage Finance Task Force didn’t let a small problem of a sky rocketing national debt prevent them from coming up with a plan. Remember, these were the same people who built a space program from nothing and put a man on the moon within 9 years while fighting the war in Vietnam.
This group of financial wizards devised a scheme to auction off mortgages owned by the federal government and the scheme they developed would eventually turn mortgages from long-term commitments that only financial giants like governments, banks and insurance companies were willing to own, into a commodity that any investor could buy and sell. The loans are put into pools are traded like baseball cards on the commodities market. This is also when the federal government privatized Fannie Mae and created both Freddie Mac and Ginnie Mae.
The first mortgage backed security was sold in 1970 and with this business model came positive results. Lenders expanded and morphed this model to where home loans were turned into commodities where ownership and accountability diffused.
Today, the vast majority of loans are originated with the intent of selling them on the secondary market packaged together in pools called special purpose vehicles or trusts by underwriters who represent government sponsored enterprises, investment banks or commercial banks. These special purpose vehicles are then repackaged and re-disbursed to investors all over the world. Bonds are issued for the different categories of payments, including interest payments, late payments, principal payments and prepayment penalties. Different groups of investors or tranches may get paid from different categories and in a different order.
Tax and accounting rules were set up to govern these trusts or Real Estate Mortgage Investment Conduits (REMICs) and they were set up to ensure that the assets of the trust are passively managed. This means they are handled by someone else usually a servicer. This type of management is required because the trusts receive preferential tax treatment. So as long as the trust complies with these management guidelines, the trust is not required to pay tax on its income, thus increasing the profitability of the trust. Compliance also allows investors insulation from the bankruptcy of the entity that transfers the mortgages into the securitized trust. Without this protection, creditors from the originator could seize mortgage loans from the trust to satisfy debts incurred by the originator. This business model morphed into what is essentially a legally run multi-trillion dollar tax-free Ponzi scheme. This scheme is so large it makes Bernie Madoff’s empire look like a kindergarten production of the movie, Wall Street.
The only problem was the guys at Treasury, the Federal Reserve and the banks never consulted with the guys at NASA about Newton’s theories of gravity when they set this up. Who can blame them, they were bankers not rocket scientists. The bankers neglected to consider the idea that what goes up must come down. In 2007, housing which had survived 40 years of double digit interest rates, the S&L crisis, and three recessions was dealt a coup de grace by investors worldwide when they stopped buying mortgage backed securities and Newton’s theory was proven correct. The debate is still out as to what created this.
Wall Street conspiracy theorists like claim that it was a planned bust out by the mega-wealthy. They claim the investment houses did sort of like what Tony and the boys did when someone owed them money on The Sopranos. They went in and ravaged through everything of value and maxed out the guy’s credit with no intent of paying it back. The only difference, they claim, was that the banking bust out was legal because it was done by “respectable society”. They claim that Bear Stearns and other investment houses pre-sold these securities and needed to fill them as quickly as possible which is why you had so many exotic mortgages such as Option-ARMs, No-Doc and NINJA programs.
Once investors stopped buying mortgage backed securities, this created a domino effect across credit markets and eventually reached the homeowner. People stopped buying homes and property values plummeted faster than contestants on a Japanese game show. Overleveraged homeowners now owed more on their mortgages than their house was worth.
The rise of the MBS industry has created a new generation of loan servicers. Up until the meltdown, loan servicers were like an Asian wife. They were dutiful and passive in public, but yet behind closed doors yielded great power.
The sole purpose of these servicers was to collect and process payments on mortgage loans. While some specialize in subprime loans, some servicers specialize in loans that are already in default (so-called special servicers). There are companies that contain entire families of servicers: prime and subprime, default and performing. Some of these servicers are affiliated with the originating company. Nearly half of all subprime loans are serviced by either the originator or an affiliate of the originator. However even when the servicer is affiliated with the originator, it no longer has exclusive control over the loan or an undivided interest in the loan’s performance. Servicers are usually collecting the payments on loans someone else owns and then pay the Trustees on a quarterly basis and this relationship is governed by the Pooling and Servicing Agreement or PSA. The PSA is essentially the agreement between the servicer and the trust which details the responsibility of both parties.
Servicers receive their revenue two ways. First, they receive the majority of their revenue from acting as an automated pass-through accounting entity whose mechanical actions are performed offshore or by a computer system. Second, servicers generally profit from servicing fees based on a fixed percentage of the total unpaid principal balance of the loan pool and interest income on homeowners’ payments held by the servicer until the service has to make payments to the investor. They then deduct any pay outs at an inflated rate for taxes and insurance or any affiliated business arrangements from the payments to the investor.
After the meltdown, mortgage servicers were no longer willing to play a passive role in public and moved from the proverbial bedroom to the boardroom faster than when O-Ren Ishii cut off Boss Tanaka’s head with her samurai sword in the movie, Kill Bill.
Like O-Ren Ishii, the servicers were smart and they quickly figured out that if they acted quickly they could profit from the financial chaos around them. Servicers were flooded with requests for modifications from upside down homeowners. They quickly seized on the idea that they could exploit their ability to skim off the top of the payments to investors by exaggerating their cost estimates and by increasing the outstanding balances of the loans in the trust. There was one problem with that idea; most homeowners in late 2007 early 2008 were not yet behind on their payments.
What servicers began doing next is shocking! They began to tell homeowners they would not negotiate a modification unless they were 90 days behind on their payments. Publicly the excuse was because they needed to rescue as many homeowners as possible before moving on to stable homeowners. This wasn’t entirely true. Let’s be honest, this was a blatant lie. What they weren’t saying is how much their profit margins increased by encouraging people to go into default. The longer someone stays in default the more profit they made by misleading both the trustee and the homeowner. This gave the servicers incentive to push homeowners into delinquency and keep them there indefinitely with or without a pending modification.
When the homeowner would submit the application for the modification, the lender would drag out the approval process by repeatedly claiming they lost the paperwork. Again, this all goes back to their profit margin on loans in default and the outstanding balances of the pool. This is why when HAMP was announced in 2009, servicers were included into the program. HAMP was intended to encourage servicers to modify loans but the cash incentives offered by the federal government were not large enough to entice the servicer to abandon the profitable business model of skimming off the top.
Another misleading statement made by servicers is that they need approval from the trustee to approve a modification. This is another lie. Due to the passive management requirement of the trust under REMIC guidelines, investors have little control and seldom influence the servicer’s actions when it comes to modifying a homeowner’s loan and thus have full discretion to negotiate a modification of a loan for the homeowner. Most PSA also impose no meaningful restrictions against servicers who negotiate modifications and actually authorize modifications. In most cases, the PSA immunizes the servicer from litigation from investors when they do modifications.
Servicers also use the excuse that REMIC guidelines penalize them from doing loan modifications. This is also not factual accurate. REMIC rules offer an “escape” clause. REMIC rules state that a loan can be modified when it is in default or a default is reasonably foreseeable.
So now my friends, you now know what would have turned off the flow of Champagne for the Conga lines and put a stop to the reckless sexual abandonments at the conference last week. The Lending Industry’s dirty secret and the trail of public betrayal that they hid from homeowners and investors.
The shocking thing about this whole scheme is its not independent companies doing it. It’s the major banks. Wells Fargo, JP Morgan-Chase, Bank of America, HSBC, they all do it. That’s right. These banks who received corporate welfare checks in the billions of dollars are now pocketing money from some sweet old grandmother’s pension fund. So while grandma is forced to eat cold oatmeal because she can’t afford to heat it up, banking executives from Citibank and JP Morgan-Chase go in front of congress and claim they had nothing to do with it.