When the $25 billion national mortgage settlement was struck in early 2012, regulators bragged that the top five mortgage servicers would be held responsible for their conduct, particularly the "robo-signing" of foreclosure documents.
But it turns out that mortgage bondholders paid for nearly one-quarter of the $20 billion in relief provided in the settlement, or $5 billion at a minimum. (The banks paid $5 billion in cash penalties.) These investors have long complained to regulators that the settlement was poorly structured because large bank servicers got credit for principal reductions and loan modifications they did not pay for themselves.
"Investor loans were responsible for an enormous amount of credited relief," says Laurie Goodman, the director of the Housing Finance Policy Center at the Urban Institute. "This was very, very clearly more than was originally thought would be provided through investor loans."
The settlement was structured to give banks more incentives to write down principal on loans they owned themselves, with fewer incentives for modifying loans held in securitized trusts. For example, servicers received a dollar of credit for every dollar of principal writedowns on mortgages they owned themselves but 45 cents' credit for every dollar in reductions on investor loans.
But those incentives apparently were not strong enough for Bank of America (BAC) and JPMorgan Chase (JPM). In a report last week, Goodman wrote that the two banks took advantage of the opportunity to reduce their own losses. Investors paid for $3.7 billion of the relief credited under the settlement to Bank of America and $1.2 billion to JPMorgan Chase.
By contrast, Citigroup (NYSE:C), Wells Fargo (WFC) and Ally Financial's former Residential Capital unit used a negligible amount of investor loans to earn their credits, providing virtually all of the principal reductions to loans held in their own portfolios.
"Bank of America and JP Morgan Chase were able to gain some settlement credit without taking the loss themselves," Goodman wrote.
In all, B of A earned 39% of its credits on the backs of investors and JPMorgan Chase earned 29%, Goodman found.
B of A and JPMorgan did not respond immediately to requests to comment. Joseph Smith, the monitor for the settlement, was unavailable for comment, his office said, but in a statement he confirmed that only 76% "of total credited relief under the National Mortgage Settlement was related to loans owned by servicers rather than serviced for other investors" — meaning investors ate the other 24%.
It can be argued that principal reductions and loan modifications are also in the best interest of investors because the loans become more affordable and resume performing, and the losses tend to be less than those taken when a borrower goes into foreclosure.
But investors say they ended up paying for the servicers' misdeeds, which is essentially unfair.
"It's a travesty that we knew was coming," says Vincent Fiorillo, a global sales manager at DoubleLine Capital and the president of the board of the Association of Mortgage Investors, a trade group of bondholders.
Fiorillo has long doubted Department of Housing and Urban Development Secretary Shaun Donovan's assurance that there would be a 15% cap on the total number of investor-owned loans that banks could modify under the agreement. The final settlement did not include any cap.
HUD did not respond immediately to a request to comment.
Goodman suggested that future settlements "need to be careful and explicit" about the terms under which investor loans may be used in meeting servicers' obligations. She also suggested a bigger challenge will come from settlements involving nonbank servicers that own no loans themselves outright and instead are agreeing to what the industry refers to as "soft dollar obligations," in the form of principal reductions and loan modifications that ultimately are paid by investors, not servicers.
Regulators continue to approve such settlements
In December, Ocwen Financial (OCN) agreed to pay more than $2 billion to the Consumer Financial Protection Bureau for a laundry list of misdeeds, including mishandling foreclosures, failing to honor loan modifications agreed to by previous servicers and charging borrowers excessive and hidden fees.
Ocwen agreed to pay $127.3 million to the CFPB, while $2 billion is to be paid by investors in the form of principal relief given to distressed borrowers over three years.