Mortgage Meltdown

Catching Up

Well, it's good to be back writing this blog again.  Sorry to my readers for the long, unexplained absence.  I just returned from an almost month-long trial in Baltimore, Maryland (I am based in Reinhart's Milwaukee office).  A lot has happened in the interim, so let's get to it.  What follows is quick summary of some of the legal developments/stories from the mortgage meltdown:

(1)  Countrywide boss Anthony Mozilo was served with a "Wells notice" by the SEC.  As first reported by the Wall Street Journal and the L.A. Times, Countrywide's former CEO and other executives have been provided notice from the SEC that it intends to file formal civil charges for securities fraud and insider trading.  A Wells Notice is the name for this formal notification, and it provides the lawyers for Mozilo and the other executives to submit argument and evidence to try and persuade the Commission not to file the charges. Reuters June 2 story on the subject is here.  Although SEC may bring civil charges, criminal charges are also a possibility.

(2)  Subprime securities class action dismissal motions decided.  Several motions to dismiss were denied, as in the Moneygram, Inc. case involving allegations that the company failed to disclose risks of its own investments in mortgage backed securities (opinion here).  Similarly, a Florida District Court permitted claims to proceed against BankAtlantic Bankcorp., a Florida-based bank.  The court held that the amended complaint had cured prior deficiencies in pleading a strong inference of scienter (here).  Conversely, the case against Washington Mutual was dismissed with leave to amend (see here), and a securities fraud complaint against mortgage insurer Radian Group was dismissed with prejudice (here).  For more detail on these dismissals, go over to the D&O Diary blog which has consistent, in-depth analysis of the opinions and a running tally of the subprime securities motion to dismiss decisions.

(3)  Legislation Passed.  On May 20, President Obama signed two bills, the Helping Families Save Their Homes Act and the Fraud Enforcement and Recovery Act of 2009.  The first expands the mortgage foreclosure mitigation efforts, increased FDIC deposit insurance to $250,000 through 2013, and increases the borrowing authority for both the FDIC and the credit union deposit insurance counter-part.  The bankruptcy cramdown provision, which would have allowed bankruptcy judges to modify mortgages, was defeated and did not make it into the law.  The Fraud Enforcement and Recovery Act is intended to provide more resources and penalties for financial fraud, by extending the prohibition against making false statements in a mortgage application to employees and agents of a mortgage lending business; expanding the concept of monetary proceeds under federal anti-money laundering statutes to include gross receipts, a response to the Supreme Court’s June 2008 Santos decision; and expanding False Claims Act liability by, in part, overruling the Supreme Court's interpretation of the mental state required to prove a claim under the Act in Allison Engine Co. v. U.S. ex rel. Sanders, 128 S. Ct. 2123 (2008). 

(4)  More bank failures.  Throughout the first half of this year banks have failed at an accelerated rate, with the largest failure this year (the 34th) being Florida's BankUnited FSB, with $12.8 billion in assets.  The BankUnited closure was also notable because several private-equity firms, rather than another bank, purchased the deposits from the Office of Thrift Supervision and will operate the new BankUnited.  All of these bank closures have also substantially depleted the FDIC deposit insurance fund, so the FDIC approved a special assessment on banks to replenish the fund (the details are found here.)

(5)  Cleveland's Nuisance Suit Dismissed.  City of Cleveland's nuisance lawsuit against various investment banks and mortgage lenders was dismissed.  The district judge considering the case concluded that the nuisance claim was (1) barred by the economic loss doctrine, which prevents recovery in tort for purely economic damages (i.e. no personal injury or property damage); (2) preempted by Ohio law governing municipal regulations; (3) barred because a nuisance claim cannot be founded on subprime lending, which was lawful activity and heavily regulated; and (4) barred because the alleged damages were to remote.  The opinion is here. 

(6)  General Motors filed for bankruptcy protection this week at about the same time that another auto industry stalwart, Chrysler, was emerging from bankruptcy.  The United States government will own about 60% of the new GM.

New SEC Chair Weighs In On Ratings Agencies

The credit rating agencies that provided securities packaging subprime mortgages with investment grade ratings have been in the cross-hairs of regulators and plaintiffs since the mortgage meltdown first began in the spring and summer of 2007.  Yet very little has been done to change the way that they are regulated.

So last week new SEC Chairwoman Mary Schapiro hosted a round table on what more should be done.  Many see the fundamental problem with the current structure is that the rating agencies are generally paid by the issuer or underwriting of the security they are asked to rate.  This "issuer-paid model" accounts for 98% of all bond ratings.  There is an inherent conflict of interest in this model, where issuers will shop around for the highest rating.

Although the SEC has adopted some new regulations to address this conflict of interest problem (for example prohibiting any employee involved in rating a issue to also be involved in the fee negotiations), Ms. Schapiro acknowledged there was more to do.  Many of the proposals at the meeting focused on solving this conflict of interest dilemma.  Some participants suggested all firms should be required to switch to an investor based model, or have the rating fees paid out of a portion of the bonds' interest payments.  Others went further, suggesting that a new regulatory body, similar to the Public Accounting Oversight Board (PCAOB), should oversee rating agencies.

Ms. Schapiro suggested that the structure the SEC set in place when it settled a 2003 enforcement action with ten of the largest investment banks could be applied to rating agencies as well.  The settlement, which resolved claims that the investment banks provided slanted research in companies in which they had a financial interest, required the banks to distribute independent research along with the firm's own research in certain circumstances.

Legislators are apparently getting involved as well.  According to a Wall Street Journal article (here), Senator Schumer is considering introducing a bill that would require rating agencies to separate any consulting business from the ratings business.  Another Senator, Jack Reed, would outsource the regulation to the class-action bar.  He supports passing legislation that would make it easier for investors to bring class action securities lawsuits against the rating agencies (rating agencies have traditionally had success asserting a first amendment privilege, claiming that, like a newspaper, they simply provide information to the public).

Putting the legislative proposals aside, I think that the PCAOB-like oversight structure may be worth pursuing, particularly if nothing is done about changing the issuer-paid model.  Moreover, the issuer-paid model does seem to support capital formation by allowing the most bonds to get ratings, so we may not want to do away with it entirely.

Coverage of the roundtable is available here, here and here.

Mortgage Modification By Bankruptcy Passes House

On March 5, the House of Representatives passed a bill that permits bankruptcy judges to modify mortgages on primary residences (referred to as a "cramdown" provision) in personal bankruptcy cases.  Last week the House delayed a vote on the legislation due to some unexpected opposition from moderate House Democrats.  Republicans, as well as those in the financial services industry, generally oppose the measure.

As a concession to get approval of some House members, provisions were added to the bill to narrow the circumstances in which a mortgage can be modified.  For example, the new bill requires the judge to consider whether the homeowner has previously received a "qualified loan modification," such as when the lender has offered to modify the loan such that monthly payments on the loan are less than 31% of his monthly income.  Under such circumstances, the person filing bankruptcy could not get a mortgage modification through the bankruptcy.  This provision seems to dovetail with the Obama mortage modification plan (here), which seeks to encourage lenders to modify more mortgages.

In addition, the amended bill would require judges to first look to extending the length of the loan or decreasing the loan interest rate before actually lowering the principle amount of the loan.

The legislation faces sterner opposition in the Senate.  Interestingly, Reuters has interviewed several federal judges and looked at the history of bankruptcy judges use of similar tools in the 1980s.  The judges quoted in the article claim that fears of the widespread use of the cramdown provision, and therefore the feared consequences of bankruptcy modification tool, are overblown (here).

Whatever the consequences of the bill if it gets passed by the Senate, it is clear that new mortgage modification legislation and regulation will present lenders and mortgage servicers with new legal challenges.

Additional coverage of the bill is available here, here and here.

Citigroup Supports Bill Allowing Mortgage Modification In Bankruptcy

Last week, Citigroup broke ranks with the banking industry and publicly supported a bill being introduced by Senator Richard Durbin of Illinois which would allow bankruptcy judges to modify mortgages in the context of individuals' Chapter 13 bankruptcy cases (often referred to as a "cramdown").  Citigroup's CEO indicated it would support a bill allowing bankruptcy judges cramdown authority if the law was restricted to already existing mortgages, if it required borrowers to provide 10 days notice to their lender prior to filing bankruptcy, giving the lender an opportunity to offer a loan work-out; and if the law prevented the bankruptcy judge from rescinding mortgages that contained only minor violations of TILA.

The rest of the Mortgage Banking industry continues to oppose the legislation (here).  They were able to keep a similar provision out of the EESA legislation passed last Fall.

I think this is an interesting development and a possible reflection of the explicit or implicit influence the federal government is having or will have on private business as a result of its unprecedented direct investment in the financial sector.  Citi has been the largest beneficiary of direct Government investment, save for perhaps AIG.  As this blog noted previously (here), the Government has purchased $45 billion in preferred stock from Citi as well as providing a "backstop" on losses related to a $306 billion pool of mortgage-backed securities held on Citi's balance sheet.

I suspect that this may have bought some ability to influence decisions at the company.  Others in the financial press have speculated that Citi's support for the bill is not the result of Government influence, but rather because it is in Citi's own self-interest.  Because its losses on billions of mortgage-related assets are capped under the second bailout, Businessweek speculates (here) that the bill would drive down the price of mortgage-back assets further, hurting Citi's competition (who does not have the benefit of the Government's backstop).  NYT article, containing similar reference, here.

Citi's more innocuous party line is set forth in a letter from its CEO, Vikrit Pandit, to lawmakers.  He writes that the law "will serve as an additional tool" to help homeowners at risk of foreclosure. "Given today's exception economic environment, we support its swift passage."

EESA Provision Invoked By Tenant Seeking To Prevent Eviction In Mortgage Foreclosure Action By Fannie Mae

The first litigation related to the Emergency Economic Stabilization Act (EESA) that I have seen was reported in the Hartford Courant, and the context is a bit of a surprise.  It involves a residential tenant named Evelyn Colon who filed an action in housing court seeking to prevent her eviction from her apartment building which is the subject of a mortgage foreclosure proceeding (here).

Fannie Mae holds the mortgage on the apartment building owned Colon's landlord.  Colon argues that when Fannie Mae was nationalized on September 7, the mortgages it holds became "troubled assets" subject to the provision in Section 109(b) of the EESA (full text here).  Section 109(b) states the Treasury, in coordination with other federal agencies, including the Federal Housing Financing Agency, should attempt to "permit bona fide tenants who are current on their rent to remain in their homes under the terms of their lease."  Because the Federal Housing Financing Agency is the conservator for Fannie Mae and Freddie Mac, Colon argues that the EESA requires those entities to take every effort to permit tenants to stay in their residences during foreclosure proceedings.  Here is the full text of Section 109(b): 

"The Secretary shall coordinate with the [FDIC, the Fed], the Federal Housing Financing Agency, the Secretary of Housing and Urban Development, 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 the Secretary to improve the loan modification and restructuring process and, where permissible, to permit bona fide tenants who are current on their rent to remain in their homes under the terms of their lease."

It will be interesting how the federal government responds to this litigation, and what guidance it will do to keep tenants and homeowners in their residences that my be subject to foreclosures of mortgages held by Fannie Mae and Freddie Mac.  The problem of tenants being caught up in mortgage foreclosures against their landlords was also highlighted earlier this month when the Cook County Sheriff (Chicago) suspended all evictions because he did not think that many tenants were receiving adequate notice.

Could An Accounting Rule Be At The Center Of The Financial Crisis?

Oh, the trouble caused by fair value, or "mark-to-market" accounting.  First, it was at the center of the Enron accounting scandal (here), when that company used this accounting rule to manipulate its earnings on energy derivatives contracts (unrealized gains on these contracts constituted one-half of the company's profits in 2000).  Now it seems that mark-to-market accounting under FASB 157 may be a key contributor to the wave of bank failures and the current turmoil in the financial markets.

In the debate over the Emergency Economic Stabilization Act, some of the alternative proposals involved suspending the application of FASB 157 (FASB opposed the proposals, here).  Many believe that the fair value accounting, also known as "mark-to-market," required by FASB 157 for illiquid mortgage-backed assets has caused banks and other financial institutions to carry these assets on their balance sheets at far below their intrinsic value. This is one reason that supporters of the EESA believed that the government could actually make money by purchasing the distressed assets and re-selling them at a profit once the market improves.

Banks may have been writing down these assets too far because the fair value of the assets must be tied to the market value of the assets.  But because these days most mortgage-backed assets are being sold in distressed, forced sales at "fire sale" prices, the market may not reflect their true value.  Nonetheless, companies were applying FASB 157 to require these fire sale prices to largely establish the value of similar assets on their balance sheets.  The effect of FASB 157 was aptly described in an article on CNBC's website (here):

The rule is “well-intentioned,” says Joshua Ronan, professor of accounting at NYU’s Stern School of Business, but has created the market equivalent of a "negative feedback loop" or transactional gridlock.

“If the market is temporarily depressed for a number of reasons, then you are compelled to value these assets at what you can sell them for. But any number of these assets—CDOs—are very illiquid, thus trading is thin,” explains Ronan.“As a result, you have to resort to models, and in this environment people will be very cautious and mark them down."

Although there were some proposals to amend EESA to require the suspension FASB 157 for some period of time, ultimately the EESA only included a provision, Section 133 of the Act, that required the SEC and FASB to study the role of FASB 157 in the mortgage meltdown.  Under the terms of Section 133, the study will focus on the effects of FASB 157 on a financial institution's balance sheet; the impacts of such accounting on bank failures in 2008; the impact of such standards on the quality of financial information available to investors; the process used by the Financial Accounting Standards Board in developing accounting standards; the advisability and feasibility of modifications to such standards; and alternative accounting standards to those provided in FASB 157.  The entire text of the EESA is available here.  The SEC announced the initial steps for the study yesterday (here).

In the meantime, the SEC and FASB have provided additional guidance in the application of the mark-to-market rules in the current illiquid market for mortgage backed assets hoping to lessen the "negative feedback loop" and allow companies to reduce write-downs on assets where there has been a distressed sale of same or similar assets in the market.  The SEC tells companies that:

• Management's internal assumptions on the present value of future cash flows of an asset can be used to value an asset when market for the asset does not exist.
• "Broker quotes may be an input when measuring fair value, but are not necessarily determinative if an active market does not exist for the security."  Thus, when a bank goes to sell an asset and receives a low-ball bid from a broker, under this new guidance the bank does not have to mark-down the asset as a result of this lone bid.
• Companies can disregard forced-sale or distressed sales of similar assets in fair valuing mortgage backed assets: "The results of disorderly transactions are not determinative when measuring fair value. The concept of a fair value measurement assumes an orderly transaction between market participants. An orderly transaction is one that involves market participants that are willing to transact and allows for adequate exposure to the market. Distressed or forced liquidation sales are not orderly transactions, and thus the fact that a transaction is distressed or forced should be considered when weighing the available evidence. Determining whether a particular transaction is forced or disorderly requires judgment."
• Moreover, even orderly transactions in an "inactive market" do not automatically set the price of the same or similar assets. 

The Mortgage Bankers Association issued a press release applauding the new guidance from the SEC and FASB, particularly the endorsement of the use of discounted cash flow to fair value assets where there is no active market.  The press release states that “FAS 157 was never test driven in a market where the only transactions occurring are distressed sales. In such an environment, FAS 157 was only exacerbating the market illiquidity. This announcement should have an immediate impact allowing companies to reflect the true value of their mortgage assets and increasing capital and liquidity in today's stalled credit markets.”

Although it may take some time -- it certainly was not reflected in the stock market activity yesterday -- I think that the new guidance will have the effect envisioned by the MBA.  Unfortunately this action was not taken earlier.  I think the SEC's study conducted pursuant to EESA will find that the way companies were applying FASB 157 did play a significant role in our recent troubles.

Too Late To Stem Current Crises, House Passes Mortgage Reform Bill.

Last Thursday (November 15th) the U.S. House of Representatives passed a mortgage industry reform bill aimed to prevent a recurrence of the mortgage meltdown and current crisis in the housing market. The bill, H.R. 3915, would require the nationwide licensing of mortgage brokers and loan officers, establishing nationwide borrowing standards, and ban certain "predatory" lending practices, such as certain incentives that encouraged brokers to steer borrowers into unsuitable loans. The most controversial part of the bill permits borrowers to sue the originating lender that issued the mortgage -- even if the mortgage was later sold as part of the securitization process -- if the lender did not exercise due diligence in checking that the loans were made fairly and the borrower has "a reasonable ability to repay the loan." Not surprisingly, banking and mortgage industry groups, who believe it will lead to a flood of litigation, oppose this provision, and one Republican called it a "trial lawyer's dream."

Of course, this bill will do nothing to stem the current problems in the credit markets and the wave of foreclosures in the subprime lending sector that are at the root of the problem. Moreover, the legislation appears to be a possible overreaction. Lending to subprime borrowers has already dried up and is virtually non-existent. The provisions creating new statutory rights to sue lenders may have the unintended consequence of severely limiting future mortgages and home ownership by lower income borrowers.

Although the bill in the House had bipartisan support, it is unclear whether the Senate will pass the same bill or a different version, and whether President Bush will sign it. Stay tuned to mortgage meltdown for updates on the progress of this legislation.

The Clinton Plan

In yet another sign that the subprime meltdown has hit the big-time, presidential candidate Hilary Clinton announced here that if elected she will pass The Foreclosure Rescue Fraud Act.  The Act will impose criminal penalties on fraudulent "foreclosure consultants."  Her announcement comes shortly after she introduced the Home Ownership Protection and Foreclosure prevention bill (See here) designed to prevent abusive lending practices and on the heels of recent indications that Congress and President Bush might reach agreement on proposals to expand Freddie Mac and Fannie Mae to assist distressed homeowners (here).