Bank Lawyer's Blog

The Rocky Mountain Lowdown: Loan Collateral Up In Smoke

I asked Steve Mulligan, a partner in the Denver office of the law firm that suffers my presence in their Texas office, to write a guest post for the blog on an issue of concern to lenders in Colorado (and, perhaps, other states) where, after the most recent state and national elections, lighting up a fat boy in public, or growing smokable hemp in  your basement, no longer puts you on the wrong side of local law enforcement. As Steve points out, that's not the end of the story for lenders whose collateral may be a place where some mellow cats are toking up a Rocky Mountain high.

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Bankers & Lenders, Your Real Property Collateral May Be At Risk if Your Borrower Violates Federal Drug Laws

By Steven T. Mulligan, Bieging Shapiro & Barber LLP

Bankers and lenders, if your borrower grows marijuana or rents to people who grow marijuana, your real property collateral may be at risk of forfeiture under federal law despite the fact that such activity might be legal under Colorado state law.

Judge Howard A. Tallman, chief judge of the U.S. Bankruptcy Court in Colorado, had recent occasion to considersuch a situation.  In In re Rent-Rite Super Kegs West Ltd., the Chapter 11 debtor owned a warehouse in Denver and some of its tenants were in the business of growing marijuana.  While this may be a legal activity under Colorado law, it is not under the federal Controlled Substance Act (the “CSA”) unless one receives a certificate of registration from the Drug Enforcement Agency (“DEA”). 

Judge Tallman looked to § 856 of the CSA, known as the “crack house statute,” which provides that it is a federal crime to use real property or allow real property to be used for unlawfully manufacturing, storing, distributing, or using a controlled substance.  Marijuana is a Schedule I controlled substance under the CSA. 

The Judge then looked to the criminal penalties for violating the CSA which includes a potential prison term of not more than twenty years.  As a result, the federal forfeiture statute comes into play.  That statute provides that real property used in connection with activities that violate the CSA and are punishable by more than one year’s imprisonment is subject to forfeiture.

Consequently, Judge Tallman found that the debtor’s illegal activity put the lender’s collateral at risk because of the federal forfeiture statute.  Moreover, since the automatic stay provisions of the Bankruptcy Code do not prevent the U.S. from seizing property under the forfeiture statute, the risk continued every day that the debtor remained in bankruptcy.  The matter was before the court on the secured creditor’s motion to dismiss the debtor’s bankruptcy case. 

In re Rent-Rite highlights the need for lenders to gather important information when underwriting and administering a commercial real estate loan.  Such information should include current rent rolls, copies of any leases, and research on any tenant; it may be that the name is a good indication as to what the tenant’s business is.  If possible, you may want to visit the property to see if any potentially illegal activity is taking place.  An affirmative covenant from the borrower that no activity in violation of state or federal law may also be beneficial.

Additionally, consider requiring the borrower to provide periodic updates and immediate notification if it enters into any new leases or changes its own business to include growing marijuana.  Finally, think about reviewing your default provisions; if the borrower engages in activities that are in violation of the CSA or allows such activities to occur, you may be able to declare a default under the loan documents.

The Worst Deal In History

Last year, when I made an aside about Bank of America's decision to purchase Countrywide as having been, for B of A, "a Pandora's Box, filled with horrors and plenty of pain," a reader wrote to tell disagree, asserting that B of A got plenty of value. I thought the guy was daffy then, and ten months later, I still say he's daffy, and I'm not alone. According to a recent Wall Street Journal article, Countrywide has cost B of A a cool "$40 billion in real-estate losses, legal expenses and settlements with state and federal agencies."

"It is the worst deal in the history of American finance," said Tony Plath, a banking and finance professor at the University of North Carolina at Charlotte. "Hands down."

[...]

The total costs from Countrywide to date, according to people close to the bank, include $34.5 billion chewed up by a combination of consumer real-estate losses since mid-2008 and funds set aside to pay back investors who allege Countrywide wasn't honest about the quality of mortgage-backed securities it issued before the crisis. Additional legal costs from various settlements with federal and state agencies and the initial Countrywide purchase amount push total costs over $40 billion, these people said.

But the tally could go higher. Bank of America has said it could face an additional $5 billion in possible losses, and scores of lawsuits seeking to pin Countrywide's liabilities on Bank of America are pending in courtrooms around the U.S.

In the world of bank acquisitions, as in many other endeavors, such as professional golf, some days you eat the bear and some days the bear eats you. What Bank of America thought was Jack Nicklaus (the "Golden Bear") turned out to be a Grizzly named Old Nick. Better luck next time, B of A.

And to my erstwhile correspondent: Do NOT listen to the voices in your head that compel you to write me about Countrywide.

Stop Me If You've Heard This One Before

It's not merely the fact that former Wells Fargo CEO Dick Kovacevich complained publicly and loudly in 2008 that Hank Paulsen made him a TARP offer he didn't want but couldn't refuse, it's that, nearly four years later, he..won't...stop...ranting...about...it, that leaves some listeners amazed, others stupified, and still others screaming for someone to stick a knife in their neck in order to end the pain. Moreover, he's gone from "I didn't want it or need it but they threatened me" line to "TARP is likely to cause the end of life on Earth, at least as we know it."

Former Wells Fargo Chairman and CEO Dick Kovacevich says the federal government's bank bailout during the depths of the financial crisis was an "unmitigated disaster" and laid much of the blame for the financial crisis on "ineffective regulators."

"The decision by the U.S. Treasury and the Federal Reserve in October 2008 to make banks take TARP money even if they didn't want it or need it was one of the worst economic decisions in the history of the United States," Kovacevich told about 100 people attending a Stanford Institute for Economic Policy Research event Tuesday evening.

Kovacevich then offered a roster of reasons fueling his criticism of the government's Troubled Asset Relief Program, including "spooking the financial markets," damaging the reputation of financial institutions who did nothing wrong, and institutionalizing the concept that some institutions are too big to fail.

Kovacevich also cites TARP as the genesis of Dodd-Frank, the Ebola and AIDS viruses, as well as the horror now known as "Charlie Sheen."

Dick claims that any pundit who argues that TARP saved the financial system from a China Syndrome-like meltdown is a mere government apologist and spinmeister. In fact, Dick declares that TARP caused the financial meltdown and stock market collapse by stampeding the markets, as if the pre-TARP failure of Lehman Brothers was nothing more than a minor blip on the radar screen. He didn't say this exactly, but I think Dick also suspects that TARP is the reason that supermodel Linda Evangelista has repeatedly spurned his offers of concubinage. As a parting shot, he also blames most of the failed banks on "poor regulation."

This is what we call the "Dick-Cheney-Scattergun-To-The-Face" approach to criticism. If you load up on Double-O buckshot and blast away at close range, you're bound to hit something. If you're really lucky, like the other Dick, you'll bag a lawyer.

Callousness Looms Large

The ICBA's CEO, Cam Fine, isn't happy about the most recent Bank Fail Friday Bloodbath. He calls it a sad day for main street. He also discloses a portion of an email he received from someone with inside knowledge of the way the FDIC takeover team treated the employees of the Bank of Eastern Shore, the only one of the five "too-small-to-save" community banks for which the FDIC did not find a buyer. Cam thinks that the email "speaks volumes about the kind of unequal justice under law and lack of respect that ICBA speaks out against when comparing the treatment of Main Street institutions and their management and staffs with Wall Street, too-big-to-fail institutions and their managements and staffs." I'll let readers draw their own conclusions on that point.

I wish I could share Cam's sense of outrage. After 37 years of witnessing the truth of P.J. O'Rourke's maxim that "giving money and power to government is like giving whiskey and car keys to teenage boys," I'd be shocked if bureaucrats didn't act like what many (but not all) of them are: the folks the jocks in high school stuffed in their lockers and the cool crowd wouldn't talk to, finally getting their payback by using the power of a governmental position to treat others the way they'd been treated during their Wonder Years. Frankly, the only sane inmates seem to be those that escape the asylum. Many of those who become "careerists" support the astuteness of one of Dennis Prager's observations:

The larger the state, the more callous it becomes... the colder its heart. It is also true that the bigger the corporation, the more callous its heart. But unlike the state, corporations have competition and have no police powers.

On the other hand, Prager's assertion regarding corporations always being subject to competition is becoming uncomfortably questionable with respect to the big banks that the Occupy movements love to vilify. In today's Housing Wire, Christopher Whalen criticizes the Obama administration's proposed Homeowner Bill of Rights, and in the course of his critique, has some sobering words about what has become of "competition" among banks, at least with respect to the residential mortgage lending business.

The mortgage industry is comprised of a cartel of the four largest banks, which happen to be the largest loan servicers, as well as the owners of most second liens. Federal bank regulations reinforce the cartel structure of the secondary market for loans by allowing large banks to treat servicer and tax balances as core deposits.

This expanded balance sheet enables the large banks to hold equally big portfolios of mortgage servicing rights and also gives the top four banks — JPMorganChase, Bank America, Wells Fargo and Citigroup — a competitive advantage in dealing with the various federal housing agencies in the creation of mortgage-backed securities.

Thus, when a small bank wants to sell a loan into a securitization with a wrap from Fannie Mae or Freddie Mac, it typically sells the loan for as much as half the origination spread or more to one of the large banks.

The big bank then structures the RMBS that issues bonds to investors and retains the mortgage servicing rights. The large banks control the entire process, yet the Homeowner Bill of Rights does nothing to change this situation. Now you know why large banks seem to be more profitable than smaller banks.

Big government is callous, but so is big business. I think we've plenty to fear from both. Concentrating most of the mortgage business in the mitts of the Gang of Four cannot be a good thing for consumers over the long haul. Beyond the mortgage lending arena, in the banking business generally, the trend seems to be toward concentration in fewer, larger entities. To lovers of big government and big business, that's all fine and dandy, I suppose. To the rest of us, however, that trend is troubling.

Messing With The Market...Again

Bank of America's announcement the week before last that it was "experimenting" with an alternative to traditional foreclosure, that being taking a deed in lieu of foreclosure and renting the house back to the borrower, was greeted in some quarters as a bold new "pilot program." While that might be true for Bank of America, Fannie Mae rolled out a similar program three years ago and it has never generated much interest among homeowners. According to Fortune's Nin-Hai Tseng, that might be because Fannie Mae's servicers never put much effort into marketing this alternative or it might be because it's too difficult to qualify for Fannie Mae's program.

To qualify, borrowers must prove that they can take on monthly rent payments, which would be offered at the market rate. What's more, the balance can't exceed 31% of their gross income. In regular times, that might not be such a biggie – except the program targets homeowners in distress, who have either been tardy on mortgage payments or have stopped making payments altogether.

[...]

If the bank's initiative is going to expand, it might have to be extra forgiving. Compared with Fannie's program, BofA's is somewhat more flexible in that it's open to offering leases at or below the market rate. A program overwhelmingly based on rentals at a discount may or may not work for the bank financially. And it remains to be seen if that will keep the program from expanding much beyond the three test areas.

There's another problem that Tseng notes: the number of markets where single family homes make attractive rental units is limited.

Aside from Las Vegas and parts of California, there aren't very many other places with high foreclosure rates and a robust rental market, says Jed Kolko, chief economist at Trulia, an online real estate site. Much of the overbuilding during the housing boom generally took place in suburbs and further out in rural areas, Kolko adds. However, the demand for rentals is occurring mostly within cities and urban areas.

A few years ago, an economist tried to drag me into an argument on this blog that also involved a leftarded, bank-hating blogger who accused of me of being an "elitist" because I thought the economist's idea of giving bankruptcy judges the power to force lenders to take a deed in lieu of foreclosure and rent the home back to the owner was dumber than a stump. The ensuing brawl in my comments box between opponents and proponents led me to first selectively ban certain antagonists and, finally, to shut down commenting permanently. This blog's a past-time, not a priority. I don't have the time to constantly police the comment moderation function. I've got a day job.

I admit that I'm an elitist, but when you're going up against ideologues and "committed" academics, it's difficult to maintain the proper degree of humility, because they consistently demonstrate that when it comes to factual impediments to their pet theories, they prefer to live in Cloud Cukoo Land, where all scenarios support their foregone conclusions. Keeping a sneer off your face is as formidable a task as not lusting after Catherine Zeta-Jones. It's possible, but not probable.

As Tseng's article illustrates, all of the alternatives to letting the marketplace work through the foreclosure backlog have limitations, not all of them work for every borrower or piece of collateral, and one size does not fit all. I wonder where we would be today if we had dispensed the search for the single magic bullet and quit jacking around with residential real estate. That's too much to ask in a world where so many have opinions and access to the internet is so readily available, and it's an impossible question to answer, but since so many public policy initiatives turn out to be misguided, I might as well engage in more idle speculation myself.

Not Cancelable? Not Really

A recent story from Longmont, Colorado, contained some disturbing news about the consequences arising from last year's failure of Longmont-based (and ironically-named) First Tier Bank. No, it's not the fact that the bank's failure resulted in a developer losing the right to additional funding draws under his acquisition and development loan with the bank and the letter of credit that backed his obligation to the city to put in the top 1-1/2 inches of pavement on a residential development's streets (a condition for the City of Longmont to accept their dedication as public rights-of-way). Rather, it's the implications of this statement by the developer's CFO when the city tried to draw on the letter of credit of credit after the bank's failure and the FDIC told the city to take a hike.

"I didn't think you could cancel a letter of credit," Knirk said. "It says it's not cancelable. But they did. And we had no way of doing anything about it."

Dude, seriously? You had no idea that if a bank fails, the FDIC can reject contingent obligations such as those under a standby letter of credit?

John Podvin and Erin Burrows of Haynes & Boone wrote an article for the The Banking Law Journal a couple of years ago entitled "Revisiting The FDIC's 'Superpowers'." Reading that article could have saved the developer and the city a lot of surprise and (perhaps) frustration. As Burrows and Podvin note:

Virtually any type of contract to which the bank is a party can be repudiated, including financial instruments issued by the bank (such as loan agreements, bonds, certificates of deposits and certain letters of credit), leases, employment contracts, and employee benefits, to name just a few.

The subject matter is more complicated than that (lawyers are involved, after all), but that's a good basic starting point for any borrower or letter of credit beneficiary that is dealing with a bank that is in a potential death spiral. It's a good idea to involve knowledgeable counsel at an early stage and start looking for means to protect yourself, including securing alternative lenders. In the case of the development in Longmont, I'm guessing (because the article doesn't enlighten us) that the developer didn't have an alternative lender to which it could turn to take over the unfunded loan (and the letter of credit) obligations.

On the other hand, the city is willing to step in and finish the streets. The developer will have to find another source to fund the cost of the improvements and pay back the city or the city will slap a tax lien on the property and, eventually, foreclose on that lien, if necessary. The developer says that this alternative does have a silver lining.

[Developer Kiki] Wallace said there is one consolation. The city got better prices on the finishing work than he could have.

"Accidentally, I came out better, because the city has more purchasing power than I do," he said. "I couldn't have planned it. It's not like they go out planning to save developers money. The circumstances just dictated the situation here."

The developer assures the reporter that the last thing the developer wants to do is to "stiff the city," and that it plans to pay the city back. I hope that happens. It's always refreshing in times like these to read about a rare "lemons-to-lemonade" outcome.

I'm sure that whatever happens from hereon, both the developer and the city are going to treat letters of credit that state they are not "cancelable" with a healthy does of caution.

Walkaway Joe? Oh, No!

The New Yorker's James Surowiecki advises underwater homeowners who can still afford to pay their home loan to walk away from their homes because commercial businesses do it all the time and those business are considered to be "smart" for doing so. The Atlantic's Megan McArdle disagrees, calling homeowners who keep paying on their underwater loans responsible, and positing that, by not walking away, they are helping to save their neighborhoods.

In most states, if you simply walk away from a home loan and the lender suffers a loss after foreclosing upon and selling the house (which you would expect would be the case with an "underwater" mortgage), the lender may very well pursue you to collect the deficiency. The borrowers can always file bankruptcy, of course, but that has severely adverse consequences to borrowers over the short-term, and has the likely long-term adverse consequence of limiting their ability to obtain credit on "prime" (or any) terms for a number of years.

Even in those states that have anti-deficiency statutes, which prohibit a lender of a first lien residential mortgage loan from pursuing a deficiency against the borrower, there is sentiment that the law needs to be changed. For example, in Arizona, a state lawmaker from Surprise wants to surprise underwater homeowners by removing the current anti-deficiency provision of Arizona law.

Rep. Jack Harper, R-Surprise, says Arizona’s status as one of a handful of “non-recourse’’ states is keeping the real estate market from recovering here. He contends that having people abandon their homes further depresses the value of nearby homes.

The idea is to keep people from being encouraged to just walk away from their house any time they’re a little bit upside-down’’ on their mortgage, he said.

It sounds "a little bit disingenuous" to allege that homeowners are encouraged to walk away from their homes when they are only a "little bit underwater." According to fairly recent reports, half of home loans in Arizona are underwater (second only to Nevada) by an average of $60,000. That's a lot more than "a little bit." It's a deep hole. And to allege that underwater homeowners who are walking away from their homes are "keeping the real estate market in Arizona from recovering" is a whopper that would make Bill Clinton blush.  Moreover, how smart is it to pick this particular time, when so many Americans are suffering and the popularity of banks (and politicians) is at its historical nadir, to promote legislation that favors lenders over consumers, especially when lenders have been living with the anti-deficiency statutes for a long time and should have priced the risk into their mortgages? It takes a tone-deaf oppressor of the proletariat to play that particular tune at this specific moment.

Regardless of all the back-and-forth among politicians and MSM pundits, many underwater borrowers seem to be ignoring Surowiecki's advice. A couple of days ago, "60 Minutes" ran a featured story entitled "There Goes The Neighborhood," about how many underwater borrowers were still paying their mortgages, no matter how much pain it caused them. One homeowner told interviewer Scott Pelley why.

Pelley: You know there are lots of people all over the country. Many thousands of people who are mailing the keys to the bank and walking away. They can't figure out how it makes sense to put more money into a mortgage that's underwater.

Hubbard: Can't speak for them. I can only speak for me. And my reputation that I have to uphold.

Pelley: Your signature means something.

Hubbard: It does. It does.

Huh. Imagine that.

At Least It's An Ethos

As readers not living in Minnesota may not know, the state government of Minnesota may shut down soon as the result of a budget crisis. Big Labor is telling Big Banks, specifically US Bank and Wells Fargo, that if school districts turn to them to borrow money during the shut down, the dastardly banks better not even THINK about charging ANY interest on those borrowed funds, or they will face the wrath of the kind of rationalists who put Jimmy Hoffa under a New Jersey bridge abutment. The SEIU circulated a petition to its members asking them to sign on to a grim warning to those two big banks:

When our nation's banks were in trouble it was working families who bailed them out. Now we need you to do the right thing and live up to your place as leaders in our financial community.

That would be a stupid argument even if the alleged "facts" were not fabricated. The truth ("You can't handle the truth!") of the matter is that neither Wells Fargo nor US Bank was "bailed out" by US "working families" (the top 1% of taxpayers pay more income taxes than the bottom 95%, and the top 1% are not considered "working families"). As reported in October 2008, Wells Fargo's Chairman Richard Kovacevich told Hank Paulson that Wells Fargo didn't need no stinkin' TARP. In response, Hammerin' Hank made Dick an offer he couldn't refuse, so Dick took one for the team. As for US Bancorp, its CEO, Richard Davis, famously declared that TARP was a "big fat lie."

"We were told to take it so that we could help Darwin synthesize the weaker banks and acquire those and put them under different leadership," Davis said..."We are not even allowed to mention that. ...We were supposed to say the TARP money was used for lending." He went on to say he would be "darned" if US Bancorp were to become part of of the "collateral damage" from the government's "sloppy attempt at nationalizing the [banking] industry."

But don't let facts get in the way of propaganda, SEIU. After all, you're feeling the pinch of your decreasing membership every time the Obama administration cracks down on employers who hire illegal immigrants, so we realize that you can't let truth stand in the way of a good spin around Pravda Park on the Goebbles-mobile while spouting a variation on the theme of "schools can't afford to pay [the banks'] profits." Who then, is supposed to "pay the banks' profits?" What's that you say, SEIU? Banks aren't supposed to make profits? Banks are either public utilities or eleemosynary institutions? Charging interest to borrowers on money lent is un-American? The banks need to screw their shareholders based upon lies and nonsense?

Here's another suggestion about how to "do the right thing": Instead of paying attention to Big Labor, let's all start paying attention to The Big Lebowski. After all, there are worse things in life than "socialists."

Walter Sobchak: Nihilists! [Expletive deleted] me. I mean, say what you like about the tenets of National Socialism, Dude, at least it's an ethos.

Push For Principal Reductions Generates Pushback

As the American Banker's "cheat sheet" summary of the 27-page settlement proposal presented by state attorneys general to the large loan servicers makes clear, the state attorneys general are pushing principal reductions on loan servicers.

Servicers are pushed to consider principal reduction as a first option when possible, although the term sheet makes it clear that the subject has also been "reserved for further discussion." Servicers must evaluate certain delinquent loans with a loan to value ratio of greater than 100%, and offer principal reduction if that would result in a better net present value than a standard modification.

Instead of forbearing on principal, the draft agreement says servicers shall begin "conditional forgiveness of principal" if a loan modification performs well.

"Standard shall be that one-third of forborne amount is forgiven for each successive year that the borrower complies with loan modification terms over a three year period," according to the term sheet.

The state AGs and other federal enforcement agencies are also pushing for the reduction of mortgage debt in the bankruptcy process.

"Servicer shall consider implementation of a special loan modification process for bankruptcy cases where the borrower (a) is considered for voluntary principal reduction to fair market value of property while other unsecured debt is discharged; or (b) as part of a Chapter 13 plan, the interest on the borrower's first lien is reduced to zero for five years and then reamortized at a market rate for 25 years at the conclusion of the five year payment plan," the term sheet says.

The term sheet also touches on second liens, requiring that for all loan modifications, including principal reductions, second loans must be modified proportionately to the first lien or extinguished at the time the modification is offered.

As the New York Post noted today in an exclusive article, loan servicers are responding to this pressure by telling the AGs that they can do something that is physically impossible to themselves, although likely to be quite pleasurable if such an act could, in fact, be consummated.

The deal proposed by federal regulators and state attorneys general in a 27-page draft settlement distributed to the nation's five largest mortgage lenders last week is a "non-starter," sources told The Post.

One bank official said that the draft, if implemented in its current form, would force many of the nation's banks to stop underwriting mortgages altogether because they wouldn't be able to manage the new costs of servicing home loans under the proposed agreement.

While some pundits think that servicers are merely posturing at this point (including threats contained in the Post article to get out of "Mortgage Dodge" altogether), the loud and increasingly bitter grumblings I've heard from long-time mortgage bankers in this relatively stable portion of the US lead me to believe that the settlement, coupled with the trifecta avalanche of upcoming Dodd-Frank regulations, recent FRB regulations in the mortgage area, and the prospect of the CFPB's loving ministrations, have many smaller-to-mid-sized mortgage originators seriously considering (and in some cases, actively seeking) other lines of business. Sure, there will always be someone available to make a loan secured by a house, perhaps the Guido ("Bananna Lips") Spignoli Mortgage Company or the King Faisal bin Abdul-Aziz Al Saud Memorial Sovereign Wealth Mortgage Fund for Boys, but I think that making it increasingly more cumbersome and expensive to make, service, and/or invest in mortgage loans will accelerate the trend I've previously noted: the concentration of the mortgage origination and servicing business in the hands of a few very large "players."

The "principal reductions suck" crowd got a boost from three Federal Reserve Bank economists (h/t Calculated Risk), who argue that principal reductions don't work. The closing three paragraphs of their position papaer are worth reading in full.

Ultimately the reason principal reduction doesn't work is what economists call asymmetric information: only the borrowers have all the information about whether they really can or want to repay their mortgages, information that lenders don’t have access to. If lenders weren't faced with this asymmetric information problem—if they really knew exactly who was going to default and who wasn't—all foreclosures could be profitably prevented using principal reduction. In that sense, foreclosure is always inefficient—with perfect information, we could make everyone better off. But that sort of inefficiency is exactly what theory predicts with asymmetric information.

And, in all this discussion, we have ignored the fact that borrowers can often control the variables that lenders use to try to narrow down the pool of borrowers that will likely default. For example, most of the current mortgage modification programs (like the Home Affordable Modification Program, or HAMP) require borrowers to have missed a certain number of mortgage payments (usually two) in order to qualify. This is a reasonable requirement since we would like to focus assistance on troubled borrowers need help. But it is quite easy to purposefully miss a couple of mortgage payments, and it might be a very desirable thing to do if it means qualifying for a generous concession from the lender such as a reduction in the principal balance of the mortgage.

Economists are usually ridiculed for spinning theories based on unrealistic assumptions about the world, but in this case, it is the economists (us) who are trying to be realistic. The argument for principal reduction depends on superhuman levels of foresight among lenders as well as honest behavior by the borrowers who are not in need of assistance. Thus far, the minimal success of broad-based modification programs like HAMP should make us think twice about the validity of these assumptions. There are likely good reasons for the lack of principal reduction efforts on the part of lenders thus far in this crisis that are related to the above discussion, so the claim that such efforts constitute a win-win solution should, at the very least, be met with a healthy dose of skepticism by policymakers.

Don't expect politically and ideologically driven "settlement" demands to ever be derailed by "a healthy dose of skepticism" or, for that matter, an acceptance of reality. It's not the way the world is that matters to many of the people pushing political agendas in the banking world these days, it's the way they want the world to be. That's why these types of efforts usually unleash the power of the law of unintended consequences, and why the results of the operation of that law are so often so unpleasant.

The Biggest Loser

When Ally Bank and Bank of America settled with Fannie Mae and Freddie Mac several weeks ago on repurchase request claims made by the GSEs, there was speculation in the trade press that these settlements might pave the way for other big banks subject to similar repurchase requests from Uncle Freddie and Auntie Fannie to pay up. There was also talk (including by this blog's bloviator) that the settlement terms looked a wee bit generous to the banks.

Well, Bank of America and Ally may have decided to "fold 'em," but Wells Fargo has decided to tell the GSEs that they can continue to "hold 'em." What's more, the creator of Stagecoach Island told the press that it doesn't think those settlements by its competitors were as generous as some of us might have thought.

Wells Fargo said Wednesday that it won’t follow Bank of America in reaching settlements with Fannie Mae or Freddie Mac on disputed mortgages sold to the mortgage financing giants.

Wells Chief Financial Officer Howard Atkins said the settlements reached by its competitors may not be as generous as some perceived them to be.

You can see the logic in Wells Fargo's "hang tough" attitude when you realize that the GSEs' demands for loan repurchases fell for the second consecutive quarter, and that all repurchase claims against Wells Fargo, including those from private investors and private mortgage insurers, are now down from an original face value of $3 billion to half that amount. Heck, if stiff-arming worked so well all the time for everyone, nobody would repurchase a dollar's worth of loans from the GSEs. If I were standing in Wells Fargo's shoes, I, too, might not think that the generous terms offered BofA were generous enough.

I guess the next step is up to the GSEs. Do they want to press forward aggressively with lawsuits against Wells Fargo, on the basis that if it continues to thumb its nose at its beloved Uncle and Aunt, no member of the family will ever again give them an ounce of respect when they make a repurchase demand? Or, perhaps, do they want to "rethink" their outstanding repurchase requests and make Wells an even better offer than they made Ally or BofA, an offer even a hard case like Wells wouldn't refuse? 20% of remaining  face? 10%? Throw in a snuggy with a picture of Franklin Raines on it?

After all, when your only business is buying and securitizing loans, you don't want to terminally alienate the nation's top mortgage loan originator any more than you can afford to terminally alienate any of the other top six originators (including Bank of America and Ally) who, combined, originate over two-thirds of the mortgage loans in this country (such has been the consolidation in the mortgage loan business since the subprime meltdown). There's no doubt that by making all these repurchase demands against the big banks, the GSEs have fundamentally changed the quality of loan originations by the major loan originators. I mean, look at Citigroup.

Three years after bad home loans helped trigger the recession and six weeks after the government cashed in the last of its $45 billion Citigroup investment, the New York-based bank is still selling mortgages that violate quality standards, according to an internal Freddie Mac review obtained by Bloomberg.

Fifteen percent of the performing loans Citigroup sold to the government-owned mortgage-finance company in the second half of 2009 and the first half of 2010 had such flaws as missing appraisals or insurance documents or income miscalculations, according to the review of 375 mortgages. The target for defects should be about 5 percent, said Tim Rood, a former executive with Freddie’s sister agency, Fannie Mae, and now managing director at Washington-based advisory firm Collingwood Group LLC.

So, the GSEs have proved their point, and maybe it's time to put all this nastiness behind us, link arms, and mosey on down the highway, to a land where the taxpayer picks up Fannie's and Freddie's ultimate tab, which will include not only unrecovered losses on bum loans that weren't repurchased by big banks, but $160 million in legal fees for former officers of Fannie and Freddie who are accused by the government of making massive mistakes, if not engaging in outright wrongdoing. Unlike big banks, however, the taxpayer doesn't get a steep discount on his or her tax bill when it comes due each April merely by "hanging tough."

It's an interesting staring game going on, and, thus far, it appears to some of us that the GSEs are blinking. The ultimate loser of the game won't be Fannie or Freddie, however. To find that loser, all you have to do is to look in the mirror.