The bad mortgages that got the current financial crisis started have
produced a terrifying wave of home foreclosures. Unless the foreclosure
surge eases, even the most extravagant federal stimulus spending won’t
spur an economic recovery.
The Obama Administration is expected within the next few weeks to
announce an initiative of $50 billion or more to help strapped
homeowners. But with 1 million residences having fallen into foreclosure
since 2006, and an additional 5.9 million expected over the next four
years, the Obama plan—whatever its details—can’t possibly do the job by
itself. Lenders and investors will have to acknowledge huge losses and
figure out how to keep recession-wracked borrowers making at least some
monthly payments.
So far the industry hasn’t shown that kind of foresight. One reason
foreclosures are so rampant is that banks and their advocates in
Washington have delayed, diluted, and obstructed attempts to address the
problem. Industry lobbyists are still at it today, working overtime to
whittle down legislation backed by President Obama that would give
bankruptcy courts the authority to shrink mortgage debt. Lobbyists say
they will fight to restrict the types of loans the bankruptcy proposal
covers and new powers granted to judges.
The industry strategy all along has been to buy time and thwart
regulation, financial-services lobbyists tell /BusinessWeek/ . “We were
like the Dutch boy with his finger in the dike,” says one business
advocate who, like several colleagues, insists on anonymity, fearing
career damage. Some admit that, in retrospect, their clients, which
include Bank of America (BAC Citigroup and JPMorgan Chase,
would have been better off had they agreed two years ago to address
foreclosures systematically rather than pin their hopes on an unlikely
housing rebound.
In public, financial institutions insist they’ve done their best to
prevent foreclosures. Most argue that giving bankruptcy courts increased
clout, known as cramdown authority, would reward irresponsible borrowers
and result in higher borrowing costs. “What we’re trying to do now is
target the bill to make it as narrow as possible,” says Scott Talbott, a
lobbyist for the Financial Services Roundtable. On the defensive, the
industry nevertheless benefits from one strain of popular opinion that
home buyers who took on risky mortgages—even if the industry pushed
those loans—don’t deserve to be rescued.
AN INDUSTRY IN DENIAL
However the skirmish ends, the industry’s contention that it has done as
much as possible to limit foreclosures seems hollow. Some statistics it
cites appear to be exaggerated. Even pro-industry figures such as Steven
C. Preston, a Republican businessman who headed the Housing & Urban
Development Dept. late in the Bush Administration, concede that many
lenders have dragged their heels. “The industry still has not stepped up
to the volume of the problem,” Preston says. One program, Hope for
Homeowners—which Bush officials and banks promised last fall would shield 400,000 families from foreclosure—has so far produced only 25 refinanced loans.
Meanwhile, an already glutted market sinks beneath the weight of more
foreclosed homes. Borrowers whose equity has evaporated have nothing to
tap into if the recession costs them their jobs. Some lawmakers and
regulators are calling for a foreclosure moratorium. “People are falling
through the cracks,” Preston says. “That’s bad for communities, bad for
the individuals losing their homes, and bad for investors.”
In early 2007, as overextended borrowers began to default on
too-good-to-be-true subprime mortgages, housing experts sounded an alarm heard throughout Washington. Christopher Dodd (D-Conn.), chairman of the Senate Banking Committee, wanted to push a bill requiring banks to
modify loans whose enticingly low “teaser” interest rates soon give way
to tougher terms. But he knew that with Republicans strongly opposed, he
lacked the muscle, according to Senate aides. So Dodd did what
politicians often do. He convened a talkfest: the Homeownership
Preservation Summit.
A who’s who of banking executives gathered on Apr. 18, 2007, behind
closed doors in an ornate hearing room in the marble-faced Dirksen
Senate Office Building. Dodd told them they needed to get out in front
of the foreclosure fiasco by adjusting loan terms so borrowers would
continue to make some payments, rather than stopping altogether.
Foreclosure proceedings typically cost banks about 50% of a property’s
value. That’s assuming the home can be resold—not a certainty when empty
houses multiply in a neighborhood. “What are you doing?” Dodd asked the
executives. “What do you need me to do to help you modify loans?”
Some from the industry denied a foreclosure problem existed, including
Sandor E. Samuels, at the time chief legal officer of subprime giant
Countrywide Financial. They vowed to continue selling loans with
enticing introductory rates as well as those requiring minimal evidence
of borrowers’ income. “We are going to keep making these loans until the
last second they are legal,” Samuels later told a fellow participant.
On May 2, 2007, Dodd’s office issued a “Statement of Principles”
stemming from the summit. It outlined seven vaguely worded industry
aspirations, such as making “early contact” with strapped borrowers and
offering modifications that could include lowering loan balances. The
principles had no effect, some summit participants now concede.
Much of Dodd’s attention shifted to his campaign for the Democratic
Presidential nomination. Senate Banking Committee spokeswoman Kate
Szostak says Dodd aggressively pursued the foreclosure issue, but “both
the industry and the Bush Administration refused to heed his warnings.”
The lawmaker accepted $5.9 million in contributions from the
financial-services industry in 2007 and 2008.
Asked about his role at the summit, Samuels confirmed in an e-mail that
he “did speak—formally and informally—about the performance” of subprime
loans. But he declined to elaborate. He now works as a top in-house
lawyer for Bank of America, which acquired Countrywide in July 2008.
A major reason financial institutions and investors are so determined to
avoid modifying loan terms more aggressively has to do with accounting
nuances, say industry lobbyists. If, for example, a bank lowered the
balance of a certain mortgage, there would be a strong argument that it
would have to reduce the value on its balance sheet of all similar
mortgages in the same geographic area to reflect the danger that the
region had hit an economic slump. Under this stringent approach,
financial industry mortgage-related losses could far surpass even the
grim $1.1 trillion estimated by Goldman Sachs in January. A desire to postpone this devastating situation helps explain lenders’ intransigence, says Rick Sharga, vice-president of marketing at RealtyTrac, an Irvine (Calif.) firm that analyzes foreclosure patterns.
By mid-2007, Bush Administration officials were deeply worried about the
financial industry’s unwillingness to confront the growing catastrophe.
Even banking lobbyists say they realized that their clients had lapsed
into denial. The K Street representatives agreed that Treasury Secretary
Henry Paulson needed to step in, says Erick R. Gustafson, then the chief
lobbyist for the Mortgage Bankers Assn. “It was like an intervention,”
he says. “We had to get Treasury involved to get the banks to give us
information.”
That summer, Paulson, a former CEO of Goldman Sachs, summoned industry
executives to the Cash Room, one of Treasury’s most elegant venues.
There, beneath replica gaslight chandeliers, Neel T. Kashkari, a junior
Goldman banker whom Paulson had brought to Treasury, urged industry
leaders to move swiftly to keep more consumers from losing their homes.
Bankers know how to adjust interest rates, extend loan durations, and,
if necessary, lower principal, said Kashkari, who has temporarily
remained in his post. A couple of months later, Paulson summoned the
executives again, this time to his conference room. “We told them we
need to get over the goal line,” recalls a former top Treasury official.
“Cajoling is a euphemism for what we did. We pounded them.”
One product of the Treasury conclaves was the Hope Now Alliance, a
government-endorsed private sector organization announced by Paulson on
Oct. 10, 2007. Lenders promised to cooperate with nonprofit credit
counselors who would help borrowers prevent defaults. Faith Schwartz, a
former subprime mortgage executive, was put in charge.
WINDOW DRESSING?
The alliance got off to a shaky start. An early press release contended
that there had been more foreclosures nationally than the Mortgage
Bankers Assn. was conceding at the time. “We looked like the Keystone
Kops,” says an industry lobbyist. Soon it became apparent that the
program was primarily a public-relations effort, the lobbyist says.
“Hope Now is really just a vehicle for collecting and marketing
information to the Treasury, people on the Hill, and the news media.”
In a press release last Dec. 22, Hope Now said it had prevented 2.2
million foreclosures in 2008 by arranging for borrowers to catch up on
delinquent payments and, in some cases, easing terms. But the data don’t
reveal how many borrowers are falling back into default because many
modifications don’t, in fact, reduce monthly payments. The alliance
doesn’t receive this information from banks, says Schwartz.
There’s reason for skepticism. Federal banking regulators reported in
December 2008 that fully 53% of consumers receiving loan modifications
were again delinquent on their mortgages after six months. Alan M.
White, a law professor at Valparaiso University, says the redefault
rates are high because modifications often lead to higher rather than
lower payments. An analysis White did of a sample of 21,219 largely
subprime mortgages modified in November 2008 found that only 35% of the
cases resulted in lower payments. In 18%, payments stayed the same; in
the remaining 47%, they rose. The reason for this strange result:
Lenders and loan servicers are tacking on missed payments, taxes, and
big fees to borrowers’ monthly bills.
Consider the case of Ocbaselassie Kelete, a 41-year-old immigrant from
Eritrea who called Hope Now last fall. Kelete, a naturalized U.S.
citizen, bought a $540,000 townhouse in Hayward, Calif., in November
2006 with no down payment and 100% financing from First Franklin
Financial, a subprime unit of Merrill Lynch. At the time, he and his
wife earned $108,000 a year from his two jobs, with a pharmacy and an
office-cleaning service, and hers as a janitor. Kelete says First
Franklin and his realtor convinced him that he could afford a pair of
mortgages, one with a 7.5% initial rate that would rise after three
years, and a second with a fixed 12% rate. His monthly payment would
total $3,600.
TALKING POINTS
By the time McConnell talked to the JPMorgan and BofA representatives
the next day, however, “they had gone on full defense mode and started
to complain about how lousy a deal Citi had struck,” says the person
familiar with the exchanges. Bank opposition, Durbin says, “was very
shortsighted in light of the mess they have created in our economy.”
In the following weeks, banking lobbyists launched a renewed attack on
the cramdown legislation, enlisting as an ally Republican Representative
Lamar Smith of Texas, among others. Apart from Citi, “the industry
remains united in that bankruptcy cramdown would destabilize the market”
by creating widespread uncertainty about the value of numerous troubled
mortgages, says Steve O’Connor, senior vice-president for government
relations at the Mortgage Bankers Assn. His group is distributing
talking points to key congressional aides laying out reasons why
“Congress should defeat bankruptcy reform legislation.” These include
the argument that if lenders can’t be confident that loan terms will
survive, they will raise rates and reject riskier borrowers. Industry
lobbyists are organizing home state bankers to pressure moderate
Democrats they hope will be receptive to limiting the kinds of loans
eligible for cramdown. One target: Senator Evan Bayh of Indiana.
Stefanie and James Smith of Santa Clarita, Calif., fear they may need
the help of a bankruptcy court if they are to keep the subdivision home
they bought for $579,000 in November 2005. Stefanie, 37, a university
human resources coordinator, and James, 40, a federal law enforcement
agent, borrowed the entire amount in two subprime loans that required a
total monthly payment of $3,000. A representative of their lender,
Countrywide, told them not to worry, says Stefanie: They would be able
to refinance in a year.
By mid-2007 they were running late on payments, and refinancing options
had dried up. With their monthly bill scheduled to jump to more than
$4,000 this January due to a rising mortgage rate, Stefanie contacted
Countrywide last summer. She asked for a loan modification so they could
avoid default. In December the lender said it would be willing to
increase their payment by $600. That was better than the scheduled rise
of $1,100, so the Smiths agreed.
But now they are struggling to pay the higher amount. Countrywide’s
parent, BofA, declined to comment, citing the Smiths’ privacy. After
BusinessWeek’s questions, though, Countrywide called them to discuss
cutting their payments.
“We knew when we bought that the payments would be a stretch,” says
Stefanie. She regrets assuming they would be able to refinance at a
lower rate. “We are not deadbeats,” she adds. “All we want is a mortgage
we can afford.”
