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Too Much Carrot, Too Little Stick: New HAMP Guidelines Continue to Plead with--and not Pressure--Banks, But More Can Be Done

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Late last month, the Obama Administration announced changes to the Home Affordable Modification Program (HAMP)--a federal effort launched early last year to encourage banks to promote mortgage modifications as an alternative to home foreclosures. Progress, though improving, has been slow. The Administration said the program could help as many as 4 million borrowers. To date, fewer than 200,000 borrowers have entered into permanent loan modifications. Welcome changes to the program will strengthen interventions for unemployed borrowers, giving them a temporary reprieve from foreclosure. Other changes, designed to reduce interest rates and outstanding principal on mortgages to better align those loan features with borrower ability to pay and home values, are designed to encourage banks and servicers to assess the benefits of principal reduction. Banks then have the option of reducing principal, but are under no obligation to do so. These changes do nothing to force banks to take into account the fact that at least some of the outstanding mortgages are founded on illegal foundations: either because loan terms are fundamentally illegal, fraudulent appraisals inflated home prices, or discriminatory conduct led to higher priced loans.

Because HAMP's approach to principal reduction is purely voluntary, it fails to apply any real pressure on banks to do what is needed to help chart the swiftest course out of the foreclosure crisis: principal reduction. And the surest way to pursue that course is to identify tainted loans and force banks to modify them on terms that are fair, and legal, including reducing outstanding mortgage principal.

Indeed, an alternative approach--one that emphasized rooting out illegal loans from the foreclosure cue--would apply more pressure on banks to modify loans in ways that offered meaningful reductions to outstanding principal. In some cases, most notably where state attorneys general have taken the lead in suits against subprime lenders, this approach is working. The federal government needs to initiate affirmative litigation to complement HAMP's voluntary approach. Taking it the easy way with banks has only advanced the ball so far; it's time to try the hard way.

Through the end of 2009, all banks participating in HAMP had entered into a combined total of 66,465 permanent modifications. At the same time, Bank of America has been modifying loans to settle a series of lawsuits filed by 11 states against its subsidiary, Countrywide, the notorious subprime lender. Bank of America originally committed over $8 billion to settle those cases, and recently agreed to set aside another $3 billion nationwide to settle claims filed by Massachusetts Attorney General Martha Coakley. These billions are supposed to go towards reducing interest rates and write down principal on hundreds of thousands of mortgages. In fact, Bank of America alone, through December 2009, had modified over 100,000 mortgages as a result of these lawsuits, far more than HAMP had obtained through overtures to all banks participating in the program, combined. The difference between the progress Bank of America has made in modifying mortgages and what HAMP has accomplished can likely be traced to the fact that with Bank of America, the bank agreed to modify loans under threat of court order, whereas with HAMP, at best, banks and servicers are encouraged to enter into loan modifications, but are under no requirement to do so. Admittedly, HAMP has been making steady progress lately. In the first two months of 2010, an additional 100,000 loans have been permanently modified through the program. Bank of America's progress under the settlement agreement during this time is not yet public. Even if its success is not as impressive as HAMP's in the first few months of 2010, it's still just one bank, and HAMP's numbers include modifications accomplished by all banks involved in the program.

In addition to these and other lawsuits filed by state attorneys general, private litigants have pursued discrimination claims against subprime lenders, alleging that loans were made with predatory features based on the race of the borrowers. Many of these suits have passed the initial motion to dismiss stage, which means that courts have said that the allegations of those suits, if proven true, raise solid claims. In this same vein, in January of this year, the U.S. Justice Department announced the creation of a new Fair Lending Unit within the Department's Civil Rights Division that will focus on discriminatory lending, both that which may be occurring now, and that which may have occurred in the lead up to the financial crisis. Such efforts should work hand-in-hand with efforts to root out and modify any loans found to have discriminatory features, reducing the number of borrowers facing oppressive and unmanageable mortgages.

The new changes to HAMP require that servicers certify that a particular borrower is not eligible for HAMP before they refer a particular borrower for foreclosure proceedings. What if servicers were required to certify that each loan they service does not have any illegal features: like discriminatory pricing, an inflated appraisal, or an interest rate that was not deemed suitable for a particular borrower? Borrowers could receive this certification, together with an explanation of the ways that subprime loans might have illegal and predatory features. Admittedly, banks will bristle at such a certification requirement, especially if a false certification would bring with it real penalties. And without stiff penalties for false certifications, there's little likelihood that a bank or servicer would actually admit that loans contained illegal features.

As an alternative to a self-certification requirement, the Department of Justice or HUD could devise a simple and confidential questionnaire that borrowers could fill out online to help assess whether their loans had predatory features. Subprime borrowers could submit their credit scores, income and assets at the time they took out their loan to see if they would have qualified for a prime loan. Such a system could flag questionable practices and follow-up calls by investigators trained to identify illegal features could help locate the illegal loans.

An analysis conducted for the Wall Street Journal found that well over 50% of subprime borrowers studied, and as many as 61% who took out loans in 2006, would have qualified for prime loans, but instead were saddled with mortgages with subprime features. What happened to these otherwise prime borrowers? Were they duped by mortgage brokers to accept higher priced loans? Often, brokers received a higher commission from mortgage lenders if the brokers were able to convince borrowers to take a higher priced loan. In fact, the size of the broker commission (called a yield spread premium) was often pegged to how high an interest rate the broker could push the borrower into accepting--against his or her best interests and without his or her knowledge--despite the borrower being qualified for a lower priced loan. Were borrowers using brokers who were compensated in this way illegally channeled into subprime loans despite being qualified for less expensive loans? Are they now saddled with considerably higher monthly loan payments because they do not have a prime, fixed rate loan?

Such fact-finding would likely yield patterns of deceit and illegality. For example, it could point to communities in which a particular bank engaged in especially suspicious activity, or could reveal a pattern of lending to African-Americans that was different qualitatively to the manner in which banks made loans to Whites. According to data analysis conducted by the Federal Reserve, for loans made in 2006, African-American borrowers were nearly twice as likely to be channeled into subprime loans as Whites, even when controlling for income and other economic characteristics. A study by the New York Times revealed that in New York City, middle-income African-Americans were placed in subprime loans at a rate nearly five times that of Whites of similar, or even lower, income. Such predatory and discriminatory lending should not go unpunished, and borrowers should not have to continue to pay on loans with such discriminatory features.

Another alternative would involve a review by federal officials of the files of banks covered by TARP, records of those banks that have been taken over by the FDIC, and those loans now on the books of Fannie Mae and Freddie Mac. Such loans could be sampled based on certain identifiable trouble spots: like Cleveland, Baltimore, Buffalo, and Detroit, where aggressive lending was unsupportable given the underlying weakness of the housing market; or in overheated markets like parts of California and Arizona, where appraisals were changing from day-to-day in order to bulk up home prices and loan sizes. The Obama Administration has directed heightened foreclosure prevention efforts to five states: Arizona, California, Florida, Michigan and New Mexico. Assessing the legality of the loans facing foreclosure in those communities would be a great place to start. Focusing such a campaign on those states where foreclosure rates are already high, and where it is most likely that predatory lenders flourished, will likely yield the most evidence of predatory lending, and help identify a high number of illegal loans.

Once illegal loans are identified, and patterns and practices of certain banks, in certain communities, are rooted out, it is unlikely that either the federal government or states would have to bring many suits to prevent foreclosure on illegal loans. The threat alone of such suits, even if a small number of them are commenced and are successful, will likely lead banks to seek to avoid them, and the bad press they would likely bring. Identifying loans with illegal features and forcing their modification on legal terms could move borrowers' mortgages from the delinquent column into the performing one. If fewer loans were in the foreclosure cue, there would be fewer borrowers on the brink and fewer borrowers unwittingly paying on loans with illegal features, dragging down such borrowers and the communities in which they live.

The HAMP approach is voluntary. It appears to be working, but slowly, and, as the TARP Special Inspector General has pointed out, without principal reduction, there is a serious risk of re-default on those mortgages modified through the program. But banks presently have little incentive to make meaningful changes to their loans--like reducing principal--that have more of a likelihood of long-term success. Moreover, whether a borrower is or is not delinquent on his or her mortgages, still, that borrower is paying thousands more a year if a loan has illegal terms; that is money that could be better spent on other, more productive uses. An approach to modifications that is only voluntary and seeks to encourage banks to write down principal, even when the loan the bank holds may have illegal features, seems both unwise and unjust. Permitting such loans to stand unchecked creates a drain on local economies, permits lenders to get away with illegal activity, and casts borrowers as the villains for not staying current on their mortgages, when, in reality, many are simply victims.

When testifying before the TARP Congressional Oversight Panel, Treasury Secretary Timothy Geithner stated that to the Treasury Department made a conscious choice not to focus on principal reduction at the outset of HAMP: "We thought it would be dramatically more expensive for the American taxpayer, harder to justify, create much greater risk of unfairness."

Chair of the panel, Elizabeth Warren, challenged the Treasury Secretary on this point, commenting that modifications without principal reduction merely delays foreclosures and "kick[s] the can down the road."

Politely asking banks to consider rewriting tainted loans will only reduce foreclosures to the extent banks are willing. What truly runs the "greatest risk of unfairness"--to paraphrase Secretary Geithner--is forcing borrowers to continue to languish under oppressive and illegal loan terms while banks drag their feet on more meaningful loan modifications. The carrots are only getting us so far. Time for a little stick.