03/18/2010 05:12 am ET Updated May 25, 2011

Meaningful Mortgage Relief: Principal Reduction Through Foreclosure Prevention

Recent headlines that suggest that the Obama administration's mortgage relief program is potentially doing more harm than good -- though likely overblown -- point to an unfortunate reality: too few mortgages are being modified on fair and sustainable terms. One important mechanism for meaningful modifications of loans is a reduction in the mortgage principal: the amount of outstanding debt on the loan. Where modifications fail to change this underlying figure, borrowers are often left underwater, saddled with debt that exceeds the value of the home. When underwater, it is harder for borrowers to see the value in maintaining current on their mortgages, even when those mortgages are modified. Without a significant reduction in monthly payments that come from principal reduction, even modified terms are hard to meet. In order for modifications to work, borrowers need to see equity in their homes and reduced monthly payments, and they need a stake in preserving the borrower-lender relationship that comes with having equity in the home. The problem is, lenders and servicers, even those willing to modify mortgages, are often unwilling to reduce the outstanding principal on the loans in their portfolios, placing meaningful and sustainable modifications out of reach.

To "encourage" lenders to reduce mortgage principal requires legal interventions, both through legislation and litigation, at the state and federal level. Such interventions would make it more difficult for lenders to foreclose on properties when their mortgages do not meet minimum standards of fairness, unless those banks first agree to explore meaningful modifications of those loans and strip them of their illegal terms and reduce the outstanding principal on them. Too many tainted loans have entered the foreclosure pipeline; preventing lenders from foreclosing on such loans would slow that pipeline and apply pressure on banks to make meaningful modifications and reduce home loan principal. Banks that refuse to do so would subject themselves to more rigorous review of their loans, and invite litigation to rescind at least some of the loans on their books for fraudulent and illegal terms. One example, from litigation filed in Massachusetts, reveals how such pressure could be applied on banks to both slow foreclosures and encourage meaningful modifications.

In 2007, Attorney General Martha Coakley of Massachusetts (now a candidate for the U.S. Senate) filed a lawsuit against Fremont General Corporation, a California-based subprime lender that had a large portfolio of subprime loans in that state. An investigation by the FDIC had revealed that Fremont had engaged in some unscrupulous activities in its lending practices. The lawsuit followed the collapse of an agreement between Coakley's office and Fremont that required the bank to give notice to the Attorney General when the bank wanted to foreclose on a mortgage loan so lawyers from her office could assess whether the underlying transaction was tainted by any illegal practices.

The lawsuit challenged Fremont's lending practices under the Massachusetts unfair trade practices law and sought an injunction to prevent Fremont from foreclosing on any loan with illegal features. The statute in question makes unlawful any "unfair or deceptive acts or practices in the conduct of any trade or commerce." The accusations against Fremont included the following: that they lured borrowers into Adjustable Rate Mortgage (ARM) loans without taking into account those borrowers' ability to repay the loans once the interest reset; and offering 100% financing options, with the expectation that the borrower could refinance the loan (with a prepayment penalty) after a few years. The highest court in Massachusetts, in reviewing a lower court decision in the matter, summarized Fremont's practices:

[L]oans were made in the understanding that they would have to be refinanced before the end of the introductory period. Fremont suggested in oral argument that the loans were underwritten in the expectation, reasonable at the time, that housing prices would improve during the introductory loan term, and thus could be refinanced before the higher payments began. However, it was unreasonable, and unfair to the borrower, for Fremont to structure its loans on such unsupportable optimism.

This indictment of Fremont's practices is likely applicable to a wide swath of subprime lending during the mortgage mania of the last decade.

Ultimately, the Massachusetts Supreme Judicial Court upheld a lower court's order that prevented Fremont from foreclosing on any residential properties within the state without first providing Coakley's office with notice of any foreclosure. That office would then have an opportunity to raise an objection to the foreclosure on the ground the underlying loan was "presumptively unfair." If the Attorney General raised such an objection, the bank and that office had to confer to try to resolve the office's concerns about the loan; resolution of those differences, it was assumed, would involve the lender refinancing the loan or agreeing to some other concessions with respect to the loan. If the differences could not be resolved, the bank could not foreclose on the property without permission from the trial court. The parties reached a settlement of the litigation in June of last year that resulted in Fremont paying $10 million to Coakley's office to be used in part to assist borrowers, but also made permanent the terms of the trial court's injunction, barring Fremont from foreclosing on properties without the consent of either the Attorney General or the court.

Just last week, in Florida, a state with one of the highest foreclosure rates in the nation that is estimated to have nearly 500,000 foreclosure cases in various stages of litigation in its court system, the state's highest court issued an order requiring all foreclosure actions to first go through mediation before a court will grant the foreclosure request. The court issued the order after the report of its Task Force on Residential Mortgage Foreclosure Cases found that too often there was too little communication between lenders and borrowers. Such lack of communication inhibits opportunities for a sustainable and beneficial resolution of the underlying mortgage dispute.

The court imposed the order after the Task Force compared the glut of foreclosure cases clogging the Florida courts to a traffic jam on the "biggest road out of town" during rush hour, a thunderstorm and a hurricane evacuation, where one lane of the road was closed due to construction "delayed by budget cuts." Out of self-preservation -- the desire to reduce the glut of cases -- the high court imposed the additional step of mandatory mediation on residential mortgage foreclosure actions. Similar mandatory mediation has been imposed in states like New York, where recent legislation requires such mediation before a bank can obtain a foreclosure order from the court.

The practices at the heart of the Fremont litigation were widespread during the subprime mortgage frenzy. Many states have versions of Massachusetts's unfair trade practices law, and federal anti-discrimination and truth in lending laws offer other avenues for recourse. Furthermore, states and court systems can impose mandatory mediation programs, as exist now in New York and Florida. The offices of state attorneys general and the U.S. Department of Justice can pursue affirmative litigation to expose illegal conduct. Coupling mediation with the prospect that questionable loans will be assessed for illegality -- in their terms, in appraisals, in marketing -- may create the type of pressure on banks, as in the Fremont litigation, to enter into meaningful modifications. Without such pressure, it is growing more and more likely that even those modifications that are reached, where they do not reduce principal or lower monthly payments considerably, will not slow the steady stream of foreclosures.