Wednesday, December 3, 2008

Hedge Funds Scoff at Congress' Chapter 13 Mortgage Modification Threat: Funds Sue Countrywide and Jeopardize Its Huge Modification Settlement

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

A few weeks ago Congress directly warned two specific huge hedge funds, and the industry in general, not to undercut federal efforts at encouraging voluntary home mortgage modifications. These two hedge funds, Greenwich Financial Services and Braddock Financial Corporation, were apparently "instructing the servicers of their mortgages to defy this national program and to insist on further socially and economically damaging foreclosures."

This strong warning came specifically in the form of a very explicit statement by the chairman of the House Financial Services Committee and five of his pertinent subcommittee chairs (and in letters addressed personally to the presidents of
Greenwich Financial and of Braddock Financial Corporation, and to the Managed Funds Association ("The Global Voice of the Alternative Investment Industry").) These influential members of Congress, albeit all Democrats, clearly threatened to "invoke the protection of the bankruptcy laws on single family residences" if these two particular hedge funds and the industry in general does not "reverse this policy."

But then this Monday (12/1/08), Greenwich Financial, whose president, William Frey, has been an outspoken critic of mortgage modifications, threw down its own gauntlet, in the form of a lawsuit filed in New York State Supreme Court in Manhattan, against Countrywide Financial Corp., now owned by Bank of America. This proposed class-action lawsuit seeks to require that Countrywide pays to the 374 securitization trusts involved the FULL VALUE of all the mortgage loans that Countrywide had sold to them, reflecting a total debt of about $80 billion. In October Countrywide had settled predatory lending charges by fifteen state attorneys general by agreeing to reduce mortgages by $8.4 billion through mandatory mortgage modifications. (See my 10/7/08 Bulletin on this settlement, called What You and Your Clients Need to Know About Yesterday's $8 Billion Countrywide/Bank of America Settlement).

The persistent Gordian Knot preventing solution of the mortgage meltdown has been the ownership of a large portion of mortgages not by single creditors but by multiple parties through the infamous mortgage backed securities.

At the outset, the mortgages backed by these securities include a disproportionate share of the troubled loans. As stated last month by James Lockhart, the head of the Federal Housing Finance Agency, in his own plea to the holders of these securities:
The performance of private label mortgage backed securities that were sliced and diced and sold to investors is just the opposite of Fannie Mae’s and Freddie Mac’s [which "only represent 20% of serious delinquencies".] Private label securities represent less than 20% of the mortgages but 60% of the serious delinquencies. As the regulator of the housing GSEs [Fannie Mae and Freddie Mac] that own over a quarter of a trillion dollars of private label securities, I ask the private label MBS [mortgage backed securities] servicers and investors to rapidly adopt this program as the industry standard. Not only will this streamlined program assist borrowers, but broad acceptance and effective implementation could stabilize communities and property values.
And for a variety of reasons, in part because of the multiple owners involved, convincing the holders of these private lable MBS's--often hedge funds and brokerage firms--to agree to mortgage modifications has been very difficult. This has greatly stymied the various much-ballyhooed federal mortgage modification initiatives of the last few months. With the major exception of the aggressive modification efforts by the FDIC at institutions that it has taken over--including IndyMac in July and Downey Federal Savings last month--the various governmental programs have all been voluntary on the part of the mortgage holders. Appeals to the common good, such as in the ones quoted above by the FHFA's Lockhart, or even Congressional threats have thus far not proved very effective.

The one major MANDATORY mortgage modification program has been the one agreed upon by Countrywide/Bank of America in the largest ever predatory lending settlement in history. It was scheduled to go into effect December 1, 2008. So Greenwich Financial's decision to target this program, or at least to try to draw a bright line in favor of investors' rights here, is fascinating. In some respects this week's lawsuit by Greenwich Financial against Countrywide could be seen as merely a strong ($8 billion!) message that it wasn't part of the settlement with the state attorneys general and so it refuses to share in the losses agreed to by Countrywide and its owner, Bank of America. As Greenwich's Frey said in written testimony in response to the Congressional ire referred to at the beginning of this Bulletin (oddly, he was not compelled to testify in person in spite of being invited to in the above letter from the Congresspersons): “These [residential MBE] investors are not only investment banks, college endowment funds, and sovereign wealth funds, but ordinary Americans in significant numbers.” And as he said in reference to Greenwich's lawsuit, "[Countrywide's] intention is to modify them, and they don't have the right to do that." Greenwich is merely seeking a declaratory judgment that it, and the other involved investors for whom it is seeking class action status, will not have to take any losses related to this massive settlement.

But Countrywide's response is that "[l]oan modifications have been occurring for decades without objections or challenges, so we are especially troubled at the timing of this complaint. . . . . We are confident any attempt to stop this program will be legally unsupportable.” In other words, we are being (forced to be) flexible--shouldn't the investors be as well?

The bottom line is that as policy makers seek ways to pressure and entice lenders to modify mortgages, the investors in the creative instruments backing up these mortgages are understandably asserting their contract rights, and now resorting to litigation. Given the phenomenal sums involved, this is not at all surprising. But if the investors and their agents refuse to be flexible about accepting reductions in value, while others in the financial chain are sharing in the pain, this reveals the continued intractability of the problem, and the severe limitations of voluntary solutions. And litigation delay is systemically dangerous because every passing month without efficient and workable solutions to the home mortgage meltdown causes ever broader economic fallout. Thus as the Congressional warning stated, these actions by the hedge funds are greatly undercutting the arguments of those "in the financial community" that mortgage modification through bankruptcy "would be damaging" and "would not be necessary to achieve the economically desirable result of reduced foreclosures." Given the bellicose behavior of Greenwich Financial and the general turf-protecting behavior of its industry, we shall see during this delicate transition to and beginning of a new Congress and new Administration whether the threatened "much tougher legislation," in the form of bankruptcy mortgage modifications or otherwise, will be forthcoming.

POSTSCRIPT: One of the most sadly entertaining items I have read in months came across my screen in researching for this story, testimony in 2003 by an attorney for Orrick, Herrington, and Sutcliffe, LLP, a "global law firm" with 21 offices on three continents, at a House subcommittee hearing on "Preventing Abusive Lending While Preserving Access to Credit," in which he argued against "[w]ell intended, but overly restrictive, regulation" in the securitization arena. In light of the events of the past few months, the following portions of his testimony will make you both laugh and cry:
Securitization reflects innovation in the financial markets at its best.

Virtually all ... MBS [mortgage backed securities] are rated by independent rating agencies whose analyses is watched closely by investors as a guide to the credit quality of the securities. In almost all cases, rating agencies monitor the performance of the securities on an ongoing basis.
Securitization reallocates risk at many levels. By shifting the credit risk of the securitized assets (for a price) to ... MBS [mortgage backed securities] investors, financial institutions can reduce their own risk. As the risk level of an individual institution declines, so does systemic risk, or the risk faced by the financial system overall.
Good to see that "systemic risk" and "the risk faced by the financial system" has been reallocated so seamlessly.

by Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

Please note that this writer is not licensed to practice law in Oregon. This means that he is not legally permitted to give any legal advice or provide and legal services. This Bulletin and the entire contents of this website is written only for attorneys. and is not intended for the public. If any non-attorney is reading this, you must consult an attorney about ANYTHING you read here. Nothing in this website is intended to be nor should be read as being legal advice to anyone.

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