Statement provided to the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, U.S. House of Representatives, Newnan, Georgia
Statement provided to the Subcommittees on Financial Institutions and Consumer Credit and Oversight and Investigations, Committee on Financial Services, U.S. House of Representatives, Washington, D.C.
Testimony before the Subcommittee on Financial Institutions and Consumer Protection, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.
Investor Repurchase Requests
The cost associated with foreclosure documentation problems, including robo-signing, are not the only potential liabilities facing financial institutions in the wake of the mortgage and housing crisis. As losses in MBS have been escalating, investors in MBS and purchasers of unsecuritized whole loans are more frequently exploring, and in some cases asserting, contractual and securities law claims against the parties that originated the loans, sold the loans, underwrote securities offerings, or had other roles in the process. The essence of these claims is that mortgages in the securitization pools, or sold as unsecuritized whole loans, did not conform to representations and warranties made about their quality–specifically that the loan applications contained misrepresentations or the underwriting was not in conformance with stated standards.
The potential liability associated with contract claims in securitizations is usually called put back risk because many of the relevant agreements permit the buyer of the mortgages to put them back to the seller at par. Buyers can demand that the seller or another party that makes representations repurchase the mortgages if defects are found in the underlying loan documentation or in the underwriting that conflict with the sale agreements. Although the representations and warranties in the various agreements vary considerably, they frequently require that the defect materially and adversely affect the value of the loan before put back rights can be exercised. At the time of the put back, the mortgage loan may have become seriously delinquent or entered into default. Because underperforming mortgages are typically valued substantially less than par, the put back transfers any potential loss from the buyer back to the original seller or mortgage securitizer.
Given the poor performance of the mortgage assets, investors, including the Government Sponsored Enterprises (GSEs), have sought to pursue put back claims through various legal avenues, including requesting that mortgage servicers provide underlying mortgage files and the requisite documents. A GSE will generally buy a loan out of an MBS pool when the loan becomes 120 days delinquent. The GSE will then conduct a review of the delinquent loan file, and if it finds that the loan did not comply with its underwriting standards, it will request that the loan be repurchased by the originator/seller or that the GSE be made whole on any credit losses incurred.
During the third quarter of 2010, Fannie Mae collected $1.6 billion in unpaid principal balance (UPB) from originators, and currently has $7.7 billion UPB in outstanding repurchase requests, $2.8 billion of which has been outstanding for more than 120 days. Freddie Mac has $5.6 billion UPB in outstanding repurchase requests, $1.8 billion of which has been outstanding for more than 120 days. As of the third quarter of 2010, the four largest banks held $9.7 billion in repurchase reserves, most of which is intended for GSE put backs.
There are also pending claims by some investors alleging that underwriters and sponsors of securitizations failed to comply with the federal securities laws covering the offering documents and registration statements. These suits specifically reference descriptions of the risks to investors, the quality of assets in the securitization, the order in which investors would be paid, or other factors. Most of these lawsuits are in the early stages, and it is difficult to ascertain the probability that investors will be able to shift a substantial portion of the losses on defaulted mortgages back to the parties that sold the loans or underwrote the offerings.
While the full extent of put back exposure is for this reason hard to specify with precision, the risk has been known for some time and has been an ongoing focus of supervisory oversight at some institutions. However, in light of recent increased investor activity, the Federal Reserve has been conducting a detailed evaluation of put back risk to financial institutions. We are asking institutions that originated large numbers of mortgages or sponsored significant MBS to assess and provide for these risks as part of their overall capital planning process.
Supervisory Responses
The revelation of documentation flaws in foreclosure processes raise two kinds of questions for supervisors: First, what actions are appropriate and sufficient to respond to problems identified at specific regulated banking organizations? Second, what does the failure of supervisory examinations to uncover these flaws counsel for future supervisory practice?
With respect to the question of actions aimed at specific institutions, the Federal Reserve and the other federal banking agencies have significant supervisory and enforcement tools that can be used to address certain types of deficiencies in the foreclosure and mortgage transfer process. For example, numerous enforcement tools are available to address safety and soundness issues such as inadequate controls and processes, weaknesses in risk-management and quality control, and certain types of compliance weaknesses in foreclosure operations. These tools include supervisory enforcement actions that require an institution to correct deficient operations in a prescribed period of time and Civil Money Penalties (CMPs) for egregious actions. The agencies may also lower examination ratings, which can result in limiting the permissible activities and affiliations of financial firms and trigger other supervisory reviews and limitations, and restrict the ability of institutions to expand. The agencies also have the authority to assess CMPs on individuals who are responsible for violations, to issue cease and desist orders on responsible individuals, or, if the statutory criteria are met, to remove them from banking. In addition, we may make referrals to law enforcement agencies, or require institutions to file Suspicious Activity Reports, as appropriate.
Although the examinations are not yet fully completed, based on what we have already learned, the Federal Reserve expects to use many or all of these tools through the course of our review of foreclosure and other mortgage matters. In particular, the Federal Reserve has already emphasized to the industry and to institutions we supervise the importance of addressing identified weaknesses in risk-management, quality control, audit, and compliance practices. The problems that are evident to date raise significant reputation and legal risk for the major mortgage servicers. These weaknesses require immediate remedial action. They will also affect the rating assigned by Federal Reserve supervisors to management of bank holding companies, even where the servicing activity was in a banking subsidiary of a holding company. In addition, the federal banking agencies expect that employees are adequately trained and have sufficient resources to appropriately review the facts and circumstances of files when preparing documents, and that legal processes are fully and properly followed. Banking organizations also must ensure quality control for third-party service providers, including legal services.
With respect to future supervisory practice more generally, two points for increased emphasis are already apparent. First, this episode has underscored the importance of our using the new authority given the Federal Reserve in the Dodd-Frank Wall Street Reform and Consumer Protection Act to send our examiners into non-bank affiliates of large bank holding companies, including those in large institutions that have become bank holding companies only in the last couple of years.
Second, our experience suggests that the utility of examining and validating internal control processes within firms may extend beyond improvements to the specific processes subject to the exam. We have found that problems in foreclosure practices do not seem as pervasive in institutions in which we had previously examined other internal control processes, found shortcomings, and insisted on corrective action. While we would not draw strong conclusions from such a limited experience, it seems possible that a firm may improve its general approach to control processes once it has been required to remedy problems in discrete areas. If this relationship is borne out, it could be a significant advance in supervisory practice, insofar as resource constraints will always limit the number of supervisory examinations.
Possible Need for Structural Solutions
Beyond remedial or punitive measures directed at specific firms and future-oriented changes in supervisory practice, structural solutions may be needed to address the range of problems associated with mortgage servicing. Similarly, the foreclosure documentation problems are another reminder of the degree to which foreclosure has been preferred to mortgage modification, notwithstanding various efforts to change this imbalance. Here again, a more structural solution may be needed
The explosive growth of securitization as a vehicle for financing mortgages was accompanied by the emergence of a sizeable mortgage servicing industry–that is, a group of firms servicing mortgages that they did not own or, in many cases, that they had not originated. While there have surely been economies associated with this industry, there have also been chronic problems. It has been increasingly apparent that the inadequacy of servicer resources to deal with mortgage modifications–an area that was a point of supervisory emphasis–was actually a reflection of a larger inability to deal with the challenges entailed in servicing mortgages in many jurisdictions and dealing with a complicated investor base. For example, foreclosure procedures are specifically the province of real property law governed by the states, and can vary not only by state, but also within states and sometimes even within counties. With or without regulatory changes, it is quite probable that servicer fees to securitization trusts will increase to reflect the costs associated with the complexities of the contemporary mortgage model.
The impetus for change in the mortgage servicing industry is likely only to increase as the advantages of servicing rights for regulatory capital purposes become limited after the new Basel III requirements are implemented.1 It is possible that servicing issues can be satisfactorily addressed through the actions of the various primary regulators. However, in light of the range of problems already encountered, and the prospect of further changes in the industry–including the possible migration of more servicing activity to non-banking organizations–it seems reasonable at least to consider whether a national set of standards for mortgage servicers may be warranted.
The case for concerted, coordinated action is much clearer with respect to the slow-moving pace of mortgage modifications. Regardless of the findings that emerge from the examinations underway, and remedial actions required to correct past mistakes, this episode has again drawn attention to what can only be described as a perverse set of incentives for homeowners with underwater mortgages. Homeowners who try to obtain a modification of the terms of their mortgages are all too frequently subject to delay and disappointment, while those who simply stop paying their mortgages have found that they can often stay in their homes rent free for a time before the foreclosure process moves ahead. Moreover, many homeowners believe, reportedly on the basis of communications from servicers, that the only way they can qualify for modifications is by stopping their mortgage payments and thus becoming delinquent.
Quite apart from the impact upon families who lose their homes, the dominance of foreclosures over modifications raises macroeconomic concerns. The number of foreclosures initiated on residential properties has soared from about 1 million in 2006, the year that house prices peaked, to 2.8 million last year. Over the first three quarters of this year, we have seen a further 2 million foreclosure filings, and an additional 2.3 million homes were in foreclosure at the end of September. All told, we expect about 2.5 million foreclosure filings this year and next year and about 2.4 million more in 2012. While our outlook is for filings to decline in coming years, they will remain high by historical standards. Currently, more than 4.5 million mortgage loans are 90 days or more past due or in foreclosure. These numbers compare to just 520,000 permanent loan modifications executed under the Treasury Department’s Home Affordable Modification Program (HAMP) and an additional 1.6 million proprietary loan modifications by servicers participating in the HOPE NOW Alliance program.2
The Federal Reserve believes that in most cases the best way to assist struggling borrowers is a mortgage modification allowing them to retain their home with an affordable mortgage payment. In a housing market where values have declined so much, following a period in which all actors relied upon rising house prices to sustain mortgage practices, foreclosures simply do not make sense as a preferred response. Foreclosures are costly to all parties and more broadly to our economy. Lenders and investors incur financial losses arising from the litigation expenses associated with the foreclosure process and the loss on the defaulted mortgage when the foreclosed property sells at a liquidation price that is substantially less than the loan balance. Local governments must contend with lower property tax revenue and the ramifications of neglected properties that may threaten public safety. Additionally, neighbors and neighborhoods suffer potential spillover effects from foreclosure sales because foreclosures may reduce the attractiveness of the neighborhood or may signal to potential buyers a forthcoming decline in neighborhood quality. In the end, an overhang of homes awaiting foreclosure is unhealthy for the housing market and can delay a recovery in housing markets and the broader economy.
Several possible explanations have been suggested for the prominence of foreclosures: the lack of servicer capacity to execute modifications, purported financial incentives for servicers to foreclose rather than modify, what until recently appeared to be easier execution of foreclosures relative to modifications, limits on the authority of securitization trustees, and conflicts between primary and secondary lien holders. Whatever the merits and relative weights of these various explanations, the social costs of this situation are huge. It just cannot be the case that foreclosure is preferable to modification for a significant proportion of mortgages where the deadweight costs of foreclosure, including a distressed sale discount, are so high. While some banks and other industry participants have stepped forward to increase the rate of modifications relative to foreclosures, many have not done enough. We need renewed attention in many quarters of government and the financial industry, and among investors in mortgage-backed securities, to the lagging incidence of modifications.
Rate Lock Advisory – Monday Mar. 2nd
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Monday’s bond market has opened up sharply following significant losses in stocks. The stock markets are showing early losses due to more concerns about banks and the Fed’s need to stabilize the financial system. The Dow is currently down 180 points while the Nasdaq has lost 38 points. The bond market is currently up 27/32, which will likely improve this morning’s mortgage rates by approximately .375 of a discount point.
There were two pieces of economic data released this morning and both showed stronger than expected results. The first was January’s Personal Income and Outlays data that showed personal income rose 0.4% while spending rose 0.6%. Both readings were higher than forecasts, but the income reading was well off expectations. Analysts were calling for a decline in income of 0.2%. This means that consumers had much more income to spend than thought and apparently spent more of it than they had expected. This is considered negative news for bo nds and mortgage rates.
The Institute for Supply Management (ISM) reported late this morning that their manufacturing index for February rose slightly to 35.8. Forecasts had called for a decline in the index, meaning that manufacturer sentiment was higher in the month than thought. This is also bad news for bonds because a strengthening manufacturing sector would indicate and increase in economic activity.
Despite this morning’s data, bonds have drawn interest from investors over more concerns about AIG and other financial institutions. Those concerns have pushed the Dow to its lowest level in approximately 12 years. As investors sell stocks they are moving funds into the safety of bonds. The result is a nice rally in bonds that may continue for a couple of days.
Tomorrow’s only relevant data is the Fed Beige Book during afternoon trading. This report details economic activity throughout the country by region. The Fed relies heavily on t his data during their FOMC meetings, so look for a potential reaction during afternoon trading tomorrow. It probably will not cause a major sell off in the stock or bond markets, but could cause enough movement in bond prices to possibly improve or worsen mortgage rates slightly if it reveals any significant surprises.
If I were considering financing/refinancing a home, I would…. Lock if my closing was taking place within 7 days… Float if my closing was taking place between 8 and 20 days… Float if my closing was taking place between 21 and 60 days… Float if my closing was taking place over 60 days from now… This is only my opinion of what I would do if I were financing a home. It is only an opinion and cannot be guaranteed to be in the best interest of all/any other borrowers.
