The Bailout Miscalculation That Could Crash the Economy
12 May 20
A plan to help homeowners avoid foreclosure was good, in principle. In practice, it's pushed the mortgage business toward yet another potential nightmare
hen Donald Trump signed the $2 trillion CARES Act rescue on March 27, there was immediate praise across the political spectrum for section 4022, concerning homeowners in distress. Under the rule, anyone with a federally-backed mortgage could now receive instant relief.
Forbearance, the law said:
…shall be granted for up to 180 days, and shall be extended for an additional period of up to 180 days at the request of the borrower.
Essentially, anyone with a federally-backed mortgage was now eligible for a six-month break from home payments. Really it was a year, given that a 180-day extension could be granted "at the request of the borrower."
It made sense. The burden of having to continue to make home payments during the coronavirus crisis would be crushing for the millions of people put out of work.
If anything, the measure didn't go far enough, only covering homeowners with federally-backed (a.k.a. "agency") mortgages. Still, six months or a year of relief from mortgage payments was arguably the most valuable up-front benefit of the entire bailout for ordinary people.
Unfortunately, this portion of the CARES Act was conceived so badly that it birthed a potentially disastrous new issue that could have severe systemic ramifications. "Whoever wrote this bill didn't have the faintest fucking clue how mortgages work," is how one financial analyst put it to me.
When homeowners take out mortgages, loans are bundled into pools and turned into securities, which are then sold off to investors, often big institutional players like pension funds.
Once loans are pooled and sold off as securities, the job of collecting home payments from actual people and delivering them to investors in mortgage bonds goes to companies called mortgage servicers. Many of these firms are not banks, and have familiar names like Quicken Loans or Freedom Mortgage.
The mortgage servicing business is relatively uncomplicated – companies are collecting money from one group of people and handing it to another, for a fee – but these quasi-infamous firms still regularly manage to screw it up.
"An industry that is just… not very good," is the generous description of Richard Cordray, former head of the Consumer Financial Protection Bureau.
Because margins in the mortgage service business are relatively small, these firms try to automate as much as possible. Many use outdated computers and have threadbare staffing policies.
Essentially, they make their money collecting in good economic times from the less complicated homeowner accounts, taking electronic payments and paying little personal attention to loan-holders with issues.
They rely on lines of short-term financing from banks and tend to be cash-poor and almost incompetent by design. If you've ever tried to call your servicer (if you even know who it is) and failed to get someone on the phone, that's no accident — unless you're paying, these firms don't much want to hear from you, and they certainly don't want to pay extra to do it. Their cheapness helped provide some savings for customers, but there's a downside to this approach.
Last year, the Financial Stability Oversight Council (FSOC), which includes the heads of the Treasury, the Commodity Futures Trading Commission, the Fed, the aforementioned CFPB and others issued a report claiming mortgage service firms were a systemic threat, because they "rely heavily on short-term funding sources and generally have relatively limited resources to absorb financial shocks."
For Cordray, who has a book out called Watchdog that chronicles his time heading the CFPB, the worry about mortgage servicers was serious.
"Nonbanks are very thinly capitalized," he says. "They haven't been very responsible in building up capital buffers."
Enter the coronavirus. Even if homeowners themselves weren't required to make payments under the CARES Act, servicers like Quicken and Freedom still had to keep paying the bondholders every month.
It might be reasonable to expect a big bank like Wells Fargo or JP Morgan Chase to front six months' worth of principal and interest payments for millions of borrowers. But these fly-by-night servicer firms – overgrown collection agencies – don't have that kind of cash.
How did the worst of these firms react to being told they suddenly had to cover up to a year of home payments? About as you'd expect, by panicking and trying to pass the buck to homeowners.
Soon after the passage of the CARES Act, reporters like Lisa Epstein at Capitol Forum and David Dayen at the American Prospect started hearing stories that servicers were trying to trick customers into skipping the forbearance program. As David wrote a few weeks ago:
I started hearing from borrowers that they were being told that they could apply for three months forbearance (a deferment of their loan payment), but would have to pay all three months back at the end of the period…
It soon came out that many servicers were telling homeowners that even if they thought they were getting a bailout break, they would still have to make it all up in one balloon payment at the end of the deferral period. This was a straight-out lie, but the motivation was obvious. "They're trying to get people to pay any way they can," is how Cordray puts it.
Dayen cited Amerihome Mortgage and Wells Fargo, but other names also started to be associated with the practice. Social media began to fill up with stories from people claiming firms like Mr. Cooper, Bank of America and others were telling them they had to be prepared to make big balloon payments.
Same with the CFPB's complaint database, which began to be filled with comments like the following, about a firm called NewRez LLC:
If you have 4 months of mortgage payments laying around at the end of the COVID-19 pandemic you will be fine if not good buy [sic] to your house. I understand its a business and they will make a lot of money with I'm sure a government bailout and lots of foreclosures from not helping any american home buyers…
Suddenly regulators and politicians alike were faced with a double-edged dilemma. On the one hand, the poorly-designed CARES Act placed servicers in genuine peril, an issue that left unfixed might break the mortgage markets – not a fun experience for America, as we learned in 2008.
The obvious solution was to use some of the apparently limitless funding ammunition in the Federal Reserve to help servicers maintain their responsibilities. The problem was the firms that needed such help the most were openly swindling homeowners. If there's such a thing as regulatory blackmail, this was it.
Should the Fed open its war chest and create a "liquidity facility" to help mortgage servicers? It seemed like the obvious move — this really was a problem caused by a bailout that encouraged even people who didn't need forbearance to accept it — but how could this be done in a way that didn't put homeowners at more risk?
"This is the script of a heist flick, where homeowners get screwed in the end while servicers get the money," says Carter Dougherty of Americans for Financial Reform. "If you combine money for servicers with strong consumer protections and a vigorous regulator, then the film could have a happy ending. But I'm not holding my breath."
In early April, a group of Senators led by Virginia's Mark Warner sent a letter that pleaded with Treasury Secretary Steven Mnuchin to use some of the $455 billion economic stabilization fund to solve the problem. The letter included a passage that essentially says, "We know these companies suck, but there's no choice but to bail them out":
While we understand that some nonbank lenders may have adopted practices that made them particularly susceptible to constraints on their liquidity during a severe downturn, imposing a broad liquidity shock to the entire servicing sector is not the way to go about reform…
The Senators put the problem in perspective, noting that as much as $100 billion in payments might be forborne under the CARES Act. This was a major hit to an industry that last year "had total net profits of less than $10 billion."
The CARES Act was written in March with such speed that it became law before anyone even had a chance to catch, say, a $90 billion-sized hole in the bailout's reasoning. Still, when the forbearances began and it started to look like the servicers might fail, there was talk among regulators and members of congress alike of letting failures happen, to teach the idiots a lesson.
But the Senators on the letter (including also Tim Kaine, Bob Menendez and Jerry Moran) decided this would ultimately be counterproductive, i.e. letting the economy collapse might be an unacceptably high price for the sending of a message to a handful of companies.
"The focus now should not be on longer-term reform, but on ensuring that the crisis now unfolding does as little damage to the economy as possible," is how the letter put it.
Although the letter urged the creation of a new bailout facility to contain the mortgage-servicer ick, that didn't happen, even after mortgage servicers stepped up lobbying campaigns. In mid-April, a string of news stories appeared in which servicers warned reporters of snowballing market terror – as the New York Times put it, the "strain is expected to intensify" – that would only be solved with a bailout.
No dice. In a repeat of the often-halting, often illogical responses to mushrooming crises of 2008, the first pass at a solution came in the form of a move by the Federal Housing Finance Agency (FHFA), the overseer of Fannie and Freddie.
On April 21, FHFA announced they were coming to the rescue: servicers would no longer need to come up with six months of payments. From now on, it would only be four:
Today's instruction establishes a four-month advance obligation limit for Fannie Mae scheduled servicing for loans and servicers which is consistent with the current policy at Freddie Mac.
Which was fine, except for one thing: from the standpoint of most of these undercapitalized servicing firms, having to cover four months of payments is not a whole lot easier than covering six. "It still might as well be ten years for these guys," is how one analyst put it.
Absent an intervention from the Fed, a bunch of these servicing firms will go bust. There will be chaos if even a few disappear. As we found out in 2008, homeowners facing servicer disruptions can immediately be confronted with all sorts of problems, from taxes going unpaid to payments vanishing to incorrect foreclosure proceedings taking place. Such problems can take years to resolve. Service issues helped seriously prolong the last crisis, as I wrote about in 2010.
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Also, if your servicer disappears, someone still has to do the grunt work of managing your loan. To make sure your home payments are collected and moved to the right place, some entity will have to acquire what are known as the Mortgage Servicing Rights (MSRs) to your loan.
But MSRs have almost no value in a battered economy, which means it's likely no big company like a bank will be interested in acquiring them in the event of mass failures, absent some kind of inducement. "They're not going to want that grief," is how one hill staffer puts it.
A third problem is that if some of these nonbank servicers go kablooey, a likely scenario would involve their businesses being swallowed up by big banks, perhaps with the aid of incentives tossed in from yet another bailout package.
This would again mirror 2008, in that a regulatory response would worsen the hyper-concentration problem and make big, systemically dangerous banks bigger and more dangerous, again.
As Dougherty says, the simplest solution would be opening a Fed facility to contain the servicer disaster, coupling aid with new measures designed to a) force servicers to keep more money on hand for a rainy day and b) stop screwing homeowners.
But the more likely scenario is just a bailout for now, with a vague promise to reform later. This would lead either to an over-generous rescue of some of our worst companies, or an industry wipeout followed by another power grab by Too Big To Fail banks.
The whole episode is a classic example of how governmental ignorance married to corporate irresponsibility can lead to systemic FUBAR, though we still don't know how this particular version will play out. As Cordray puts it, it's not easy to predict where failures in the mortgage servicer industry might lead.
"What's easy to predict, though," he says, "is that it will be a mess."
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