Opinion

Alison Frankel

Rest easy, MBS investors: You’re protected in mortgage settlement

By Alison Frankel
February 14, 2012

Asking investors in mortgage-backed securities to trust the banks that issued them is like asking Charlie Brown to trust Lucy van Pelt. MBS noteholders are so convinced they’ve been duped by the folks that packaged and sold shoddy mortgage loans that it’s little wonder the banks’ $25 billion settlement with federal and state regulators has been greeted with a tsunami of skepticism. Sure, MBS investors understand that the settlement doesn’t preclude them or regulators from suing over deficient securitizations. But their fear, in the absence of the actual settlement documents, is that the loan modifications the deal calls for will reduce the revenue stream to MBS trusts.

It’s an understandable fear. The five banks that agreed to the settlement — Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, and Ally Financial — carry some troubled mortgage loans on their own books. Others were bundled into MBS trusts, in which the banks transfer ownership of the mortgages and remain as servicers. MBS noteholders are supposed to receive a stream of income from the principal and interest payments on the underlying mortgage loans. So if a bank agrees to reduce the unpaid principal a homeowner owes on a mortgage that’s been securitized, less money flows to the trust and into MBS investors’ hands.

Investors have complained that banks will modify securitized loans, shifting the $25 billion price tag to MBS noteholders. PIMCO’s Scott Simon told Bloomberg News that because the settlement gives banks credit for reducing principal in loans held by MBS trusts, investors like those in his bond fund “are going to pick up a lot of the load.” The American Association of Mortgage Investors called the settlement “flawed and opaque,” and asserted that the deal penalizes responsible investors. Time wondered if the settlement is “A Stealth Bank Bailout.”

It’s not, based on what I’ve been told about the nitty gritty of the settlement terms. Most pooling and servicing contracts between MBS issuers and investors have explicit provisions prohibiting issuers from modifying loans without investors’ consent. Bondholders have assumed that banks would attempt to override those provisions. But I’ve been told that the $25 billion settlement agreement will include a specific provision that investors’ contractual rights under pooling and servicing agreements (PSAs) remain in place. And if banks attempt to breach those agreements to satisfy obligations under the deal with state and federal regulators, there’s no indemnity for them in the settlement.

There’s also a built-in disincentive to attempt to earn credit for modifying securitized loans, as opposed to bank-held mortgages: Banks only receive a partial credit for writing down principal on loans they service but don’t own. So if they write off $100,000 of unpaid principal on a mortgage in their own portfolio, they receive a $100,000 credit toward the billions they’ve pledged to modify; on a securitized loan they will get only a $40,000 or $45,000 credit.

Moreover, the settlement is expected to include provisions that restrict loan modifications to situations in which the write-down increases the so-called net present value of the mortgage to investors. If, for instance, a homeowner is on the verge of default in an area of the country where the housing market is depressed, a principal reduction that permits the homeowner to continue making mortgage payments and avoid foreclosure could be the best way to minimize investor losses. If, on the other hand, a loan modification would merely delay an inevitable foreclosure in a region where the house could be resold quickly, that’s a better alternative. My understanding is that the settlement will require banks to analyze the impact on net present value of securitized loans before they’re permitted to be modified. It may even require banks to obtain the consent of MBS investors before modifying a loan held in an MBS trust.

The settlement architects anticipated that the PSA contract protection and built-in disincentives make it more cost-effective for banks to find candidates for principal reduction among their own mortgage holdings, rather than in securitized pools. Other critics of the $25 billion settlement have complained that it will inspire homeowners to stop paying their mortgages. That may be so, but if homeowners take that risk, their chances of obtaining a loan modification should be a lot better if they hold a bank-owned mortgage.

There may still be wholesale modification of MBS-trust owned mortgages, but those would likely be through investor-negotiated settlements such as the proposed $8.5 billion Bank of America deal with Countrywide MBS investors. That deal, which has been challenged by some investors, calls for BofA to write down unpaid principal in underlying loans under terms that protect investors. (Write-downs, for instance, have to be net-present-value positive.) My understanding is that if JPMorgan, for instance, decides to negotiate a global MBS settlement with investors — not an entirely far-fetched idea, since the investor group that pushed BofA into a settlement has sent demand letters to JPMorgan MBS trustees as well — it can receive credit toward the $25 billion settlement from any loan modifications made through that deal. That’s all very hypothetical, however.

The easiest way to stop all the guesswork about the $25 billion settlement would be to publish the agreement. I understand that getting signoff from five banks, 49 state AGs, and a slate of federal agencies isn’t easy. But neither is correcting misimpressions created by the information-vacuum.

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