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JPMorgan Chase Argues Against Mortgage Modifications, Citing Sanctity Of Contracts

Big Banks

First Posted: 06/12/10 06:12 AM ET Updated: 05/25/11 05:10 PM ET

With millions of homeowners losing their homes to foreclosure during this recession, megabank JPMorgan Chase plans to argue against the Obama administration's latest weapon in its fight to stem the problem -- principal cuts for struggling borrowers -- by citing the sanctity of contracts and the borrower's "promise to repay."

In testimony to be delivered Tuesday afternoon, David Lowman, chief executive officer for home lending at the "Too Big To Fail" behemoth, will fight back against the program which calls for lenders and investors to decrease the outstanding debt owed on a home mortgage. While his competitors at Bank of America, Wells Fargo and Citigroup plan to dance around the issue -- judging from their prepared remarks -- Lowman cut right to it: borrowers don't deserve it.

"Like all loans, mortgage contracts are based on a promise to repay money borrowed," Lowman's prepared remarks read. "Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral -- be it a home, a car or a stock market investment -- depreciates.

"If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?"

In January, the firm's chairman and chief executive, Jamie Dimon, told the panel investigating the roots of the financial crisis that, prior to the collapse, JPMorgan Chase did not conduct any stress tests that showed house prices falling.

"I would say that was probably one of the big misses," Dimon said. "We stressed almost everything else, but we didn't see home prices going down 40 percent."

So the firm made loans, arguably not knowing that the value of the assets backing those loans might one day significantly decline in value.

Lowman will effectively tell the House Financial Services Committee that it's the homeowner's responsibility to bear the losses that came as a result.

JPMorgan Chase received $25 billion in a taxpayer-funded bailout, which it has since repaid; it absorbed Bear Stearns and Washington Mutual in 2008 through sweetheart deals that offloaded most of the cost and risk onto taxpayers; and it also received $41 billion in cheap funding through a taxpayer-backed debt issuance program from the FDIC, money that has not been repaid.

The bank's arguments against principal cuts amount to an "argument against modifications in general," said Alan White, a law professor and contracts expert at Valparaiso University who has written extensively on mortgages and foreclosures.

"The point about the sanctity of contracts is okay, but where does that get us in the discussion?" he asked. "The moral absolutism of the contract doesn't advance the discussion of how you deal with a national crisis."

White also pointed out that "the contract is not absolute." Bankruptcy, in which some debts are completely extinguished, is just one example in which contracts are rewritten. "People go back and rewrite contracts all the time," he said. "Just look at AIG and the United States, for instance."

Congress wants to know why the administration's foreclosure-prevention efforts haven't performed as promised. Its principal initiative, the Home Affordable Modification Program, seeks to lower troubled borrowers' monthly payments by modifying their mortgages primarily through lower interest rates. But not enough homeowners have been helped. And the program does virtually nothing to help homeowners who owe more on their mortgage than the home is worth, otherwise known as being "underwater."

Enter principal cuts. Mortgage bond analysts, consumer advocates, economists, and housing experts nearly unanimously agree that the best way to modify a mortgage that keeps homeowners out of foreclosure is to cut the overall amount owed -- the principal.

That hasn't happened, though. Megabanks and investors are locked in a battle -- the banks don't want to cut principal, while investors do -- with distressed homeowners stuck in the middle. The chair of the House panel calling Tuesday's hearing, Barney Frank (D-Mass.), has called for the megabanks to write down mortgage principal -- now.

Here's what's going on:

The nation's four biggest banks collectively own about $448 billion in junior liens -- those loans taken out on a property in addition to the more standard first-lien mortgage, like second liens, home equity loans and so forth -- as of Dec. 31, 2009, according to regulatory filings with the Federal Reserve. That's nearly 45 percent of all outstanding junior-lien home mortgages in the U.S., Federal Reserve data show.

The problem is that it's those holdings that are complicating efforts to modify home mortgages. Nearly two-thirds of all home mortgages are held as securities by investors worldwide, most of which are based on first-lien debt. Banks only hold a bit more than a quarter of all outstanding home mortgage debt, Fed data show.

If a borrower loses his home to foreclosure, the first lien is repaid first off the subsequent sale. Whatever proceeds are left go to second and subsequent liens; if nothing is left -- for instance, if an underwater borrower is foreclosed on and the sale of the foreclosed home doesn't even satisfy the outstanding first lien -- then the second and subsequent liens are worthless. They don't get a penny.

Based on that priority of payments, holders of first lien mortgage debt argue that those holding junior liens should take the first hit when it comes to modifying mortgages -- after all, if the home enters foreclosure, that's how it will play out.

Since nearly all mortgage modifications involve homeowners who are likely to default, investors argue that the second-lien holders should write down their holdings, take their losses, and get out of the way so troubled homeowners -- free of junior-lien debt obligations -- will have a chance to stay in their homes. Investors, after all, want homeowners to stay in their homes so they can continue getting paid; a foreclosed home rarely results in a profit to investors.

Megabanks, thus, should reduce the amount borrowers owe them on those junior liens, argue investors, economics, consumer advocates and mortgage bond analysts.

Their argument is "quite reasonable," White said.

But the big banks that own that junior lien debt aren't going to cut mortgage principal and take losses on their holdings without a fight, as emphasized by JP Morgan Chase's Lowman in his remarks.

"Realistically, as the process winds through, those second [liens] are going to get wiped out," White said. "[The banks are] just in denial about that."

The problem is so huge -- $448 billion huge -- that if the banks were to write down their positions and take the appropriate losses, some think it could necessitate a second bailout.

But until those homes are actually sold in a forced sale -- like a foreclosure sale -- the banks can keep pretending their holdings are worth more than they really are, White said.

"I guess the banks would rather keep getting those monthly payments," he said. "And if they can get payments for another six months to a year, they figure, why not?

"The problem with that logic is if the home is foreclosed, the second lien is going to go away," White said.

Last year lenders foreclosed on more than 2.8 million homes, according to real estate research firm RealtyTrac. The firm estimates three million homes will get foreclosure notices this year; more than one million of them will be repossessed by lenders.

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