The Mortgage Mess Settlement Proposal: Off to an Awful Start

Over the weekend, Bloomberg, The New York Times and The Wall Street Journal reported on a proposal for a partial settlement of the mortgage mess offered by a group of state attorneys general and federal regulators. The document apparently addresses mortgage servicing, modification and foreclosure practices, but its focus is strictly on banks' future behaviors. A theoretical punitive bunch of fines for bank misbehaviors and a process to modify more mortgages and reduce borrowers' principal waits in the wings.

Presumably, the logic involved in floating this proposal is similar to the methods by which prosecutors get lesser criminals to cooperate by testifying against bigger fish: The deal to reduce the otherwise-deserved penalty is based on the degree of cooperation the witness provides.

Unfortunately, the proposal as it has been described so far is a joke. The requirements for banks aren't strong enough, and yet The Wall Street Journal refers to them as a "wish list." All the coverage portrays the document as the starting point for "difficult" negotiations, implying that the final document will be even weaker.

For context, let's start by looking at what the proposal reveals about how wrongheaded current bank practices are.

Banks Don't Even Know How Much Homeowners Owe

The Journal reports that the "document also spells out steps for banks to verify the accuracy of amounts owed." Why should state and federal law enforcement have to tell banks how to verify how much people owe them? Because the processes banks currently use don't work.

That's right: As homeowners' attorneys and advocates have been saying for years, the banks are often wrong about even such basic facts as how much they're owed. And that's not just because banks load up "junk fees" and other false charges to inflate the balance. To get a glimpse of the chaos that is bank records, consider my report from a few months ago, especially the Bogar case, or Dana Milbank's recent story of his family's experience. Or consider Linda Almonte's claims in the context of credit card debt.

Why is the industry plagued with such widespread incompetence? Perhaps because the only players who can fire a servicer are the banks that hire them, and those banks and trustees for securitized trusts don't seem to care about servicer incompetence. (Consider that HSBC washed its hands regarding its servicer's use of robo-signers and said its foreclosure moratorium didn't include cases brought by its servicers, despite the fact that those foreclosures are being undertaken for HSBC.) If homeowners could fire loan servicers for incompetence, and if there were a competitive marketplace, servicer competence would skyrocket. But nobody is proposing giving homeowners that kind of power.

So, instead of dictating a process for verifying accuracy, what would a strong proposal look like on this point? How about this: Any homeowner able to show -- after discovery -- that their servicer is wrong about what they owe gets paid triple the amount of the error as punitive damages, plus attorney's fees. No one cares precisely how the verifying is done. We care that it's done accurately, and we can only be sure it will be if there's a strong incentive.

How MERS Created a Clouded-Title Nightmare

Beyond banks' failure to keep track of how much they are owed, lenders have also failed to track their promissory notes and the mortgage documents. They really don't have a handle on where these valuable documents are -- the paperwork that proves who is owed the debt and who has the right to foreclose. As a result, The Journal reports, "The document also includes a list of directives to improve tracking of mortgage notes and the chain of title..."

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A big reason for that is MERS, the private database for tracking mortgage servicing rights, and sometimes, ownership of loans. The MERS database is updated only when its members choose to update it, so a mortgage can change hands multiple times without any of the transactions being recorded. Another MERS problem -- it's not legal everywhere. Judges across the country have ruled against it (though some have ruled for it). As a result, we're left with one of the big clusters of chaos in the foreclosure mess: MERS and its vast array of clouded title issues.

A couple of weeks ago, I wondered if, when MERS was designed, the lawyers involved had researched its interplay with each of the 50 states' laws. After all, real estate law is handled at the state level. This weekend, The New York Times revealed in a longer piece on MERS that the firm in question, Covington & Burling -- a law firm with deep roots at the U.S. Justice Department -- didn't do that analysis. The Times quotes a government official as saying: "So as far as anyone can tell their real theory was: 'If we can get everyone on board, no judge will want to upend something that is reasonable and sensible and would screw up 70 percent of loans.' "

The arrogance behind that theory is breathtaking, and not just because it amounts to: "Who cares if MERS violates the law, if we get enough mortgages in it, the consequences of enforcing the law will be too great for anyone to try." It's even worse, because the claim is that MERS is "reasonable and sensible."

A database that doesn't require ownership to be tracked, that has no quality control for data entry and which is frequently wrong (The Times article says that fewer than 30% of the loans in the database had accurate records) is reasonable and sensible? Only if you're the banks that used this shoddy mess to avoid paying millions in recording fees to local governments.

A Standard of Carelessness

MERS isn't the only reason the banks' records are screwy and title problems are multiplying. Standard practices appear to have violated the terms of securitization contracts and the Uniform Commercial Code.

If you think about it, it's amazing -- and appalling -- that law enforcement should have to tell banks to keep better track of mortgage notes and their ownership. When the Massachusetts Supreme Judicial Court got a close-up view of the banks' practices, it expressed shock: "[W]hat is surprising about these cases is. . .the utter carelessness with which the plaintiff banks documented the titles to their assets."

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Another indicator of just how bad things are is that the attorneys general felt it necessary to include a requirement that servicers provide a single point of contact for a homeowner so they don't get endlessly passed around and to set deadlines for such basic customer-service duties as acknowledging a modification application was received (10 days) and notifying the borrower the application was rejected (30 days).

The few good aspects of the proposal don't go nearly far enough, particularly for a document that is supposed to be an best-possible-outcome wish list.

For example, banks reportedly will have to make a trial modification permanent if the homeowner makes three payments successfully. On its face, that would be a huge improvement. Many are the horror stories of homeowners being foreclosed upon after making successful trial payments far beyond the initial window: Consider the story of the Galvans, about whom I reported a couple of months ago.

But a much better version of this proposal would start with changing how banks make their initial modification offers.

The Mortgage Modification Dance of Confusion

The banks' analysis of whether or not a homeowner qualifies for a HAMP modification, a proprietary modification or no modification is a mysterious black box that seems to produce different results for the same homeowner at different times, and not just because the banks repeatedly request new financial information. If all the agreement going forward does is force the banks to make successful trial mods permanent, but doesn't bring some clarity to how the decision is made to offer a modification, banks will be able to minimize the impact simple by offering fewer trial modifications.

According to The Journal and Times articles, the only part of the proposal that addresses the question of who qualifies for a mortgage modification says: The banks would be forced "to consider offering loan write downs on under-water borrowers more regularly..." and: "mortgage balances would be cut in "appropriate circumstances."

Forced to "consider" offering? Pretty weak. "Appropriate" as defined by whom? The banks whose incompetence got us to this point, or the law enforcers who don't seem determined to do a thorough investigation before cutting a deal? Somehow, I doubt it will be "appropriate" as defined by common sense.

Here are some commonsense circumstances under which a principal reduction to current market value is appropriate: Any loan that the banks failed to underwrite, whether it issued the loan without proof of the borrower's income, or proof of the borrower's assets, or of the borrower's income and assets, or even the fact that the borrower had a job. Any loan made on an inflated appraisal, when the appraiser wasn't independent of the bank making the loan and/or the bank had other reasons to think the appraisal was inflated. And to get punitive: any loan to which the servicer has failed to appropriately credit payments, or for which they have otherwise failed at the basic tasks of mortgage servicing.

(Of course, if the bankruptcy code made it as easy to keep a home as it does to keep yachts, limos and vacation properties -- as it once did for homes and still does for family farms -- all homeowners willing to go bankrupt could get their principal reduced to market value. But while a legislative fix to the bankruptcy code is a real enough possibility to prompt a warning from Wells Fargo, it's not likely.)

Blocking the Mortgage Modification Bait-and-Switch

Here's one strong part of the proposal, but even it doesn't go far enough: Forbidding foreclosure while a modification is being considered. While that step alone would be a huge relief by ending the banks' current bait-and-switch methods ("Ignore those pesky foreclosure notices," the banks say, "your modification's almost approved. . .oh wait, we're selling your house next week. Didn't you get the letters?"), the requirement would be much more powerful and useful if it were coupled with a rule preventing the banks from initiating foreclosure proceedings if they don't have all their paperwork in order and weren't really ready to proceed.

Foreclosure volume is drowning courts wherever foreclosures require them to be involved. And yet the banks aren't moving the cases forward because they don't have their acts together. Allowing such filings wastes judicial resources, tax dollars and unnecessarily punishes homeowners. Making a "don't file until you're really ready" requirement would also force the banks to do real oversight of the third-party providers and foreclosure counsel they've outsourced the work to, which would be a great thing considering how lousy those entities' practices have been.

Finally, any deal must be enforceable by homeowners. They must be explicitly named "third-party beneficiaries" and be given the right to sue to enforce the agreement's terms. That would ensure compliance by the banks.

So there you have it: We live in a world where banks have failed at the most basic jobs of mortgage servicing to such a breathtaking extent that the titles to millions of properties are clouded and our courts are clogged with suspended and fraudulent foreclosures. And the full scope of the problem has yet to be revealed.

Yet somehow, in spite of this, all the key law-enforcement officers and regulators, working together, have come up with a starting proposal that doesn't even tackle the major parts of the problem. Since we have no reason to expect an end result better than this proposal, and every reason to expect less, that's heartbreaking.

And it just confirms the cynicism that the banks play by a different set of rules than the rest of us do.