Investors who buy mortgage-backed securities shouldn’t be shielded from lawsuits by homeowners who are placed in abusive or predatory loans, consumer groups told lawmakers this week.
In the latest hearing on the troubled subprime mortgage lending industry, members of the House Financial Services Committee on Tuesday turned their attention to the securitization of mortgage loans for sale on Wall Street.
Critics say the demand for mortgage-backed securities backed by subprime mortgage loans led originators to loosen their underwriting practices, with a resulting increase in delinquencies and foreclosures.
But those engaged in the business of pooling and securitizing mortgage loans say that making investors liable for the practices of loan originators would chase investment capital out of the secondary market, raising the cost of borrowing for consumers.
Existing law largely protects investors in mortgage-backed securities from class-action lawsuits by borrowers who claim they were the victims of illegal or abusive lending practices.
Consumer groups like the Center for Responsible Lending argue that the limits on “assignee liability” for mortgage-backed securities go too far. If investors don’t have to worry about how home loans are originated, they will tolerate or even encourage abusive practices, the argument goes.
“In the simplest terms, the secondary market has enabled the subprime crisis,” said Michael Calhoun, president of the Center for Responsible Lending, in his prepared testimony before the Subcommittee on Financial Institutions and Consumer Credit. “Much of the growth in subprime lending has been spurred by investors’ appetite for high-risk mortgages that provide a high yield.”
Hybrid adjustable-rate mortgages with two- or three-year initial “teaser” rates (2/28 and 3/27 ARMs) made up 81 percent of the subprime loans packaged as investment securities in the first half of 2006, Calhoun said, compared with 64 percent in 2002.
Such loans had “extremely high prepayment rates,” as borrowers refinanced to avoid higher monthly payments when interest rates on the loans adjusted, Calhoun said.
Prepayment is usually a risk investors in mortgage-backed securities try to avoid. But Calhoun said investors in some tranches of MBS received “significant income” from prepayment penalties borrowers paid in order to refinance.
Calhoun said the short loan terms of ARM loans — typically 2 1/2 years — benefit brokers and lenders, who earn fees based on the number of loans they originate, and the ratings agencies and investment banks who profit from pooling loans and selling them as securities.
“The only actor that doesn’t benefit from these market dynamics, of course, is the family receiving the loans,” Calhoun said.
Assuming they are able to refinance their loan — which has become more difficult for many as home-price appreciation has slowed — a family can expect to pay a 3 percent prepayment penalty, plus 3 percent in upfront points and fees, and up to 2 percent in third-party fees, Calhoun testified.
Those expenses are partially offset by the 1.3 percent savings afforded by the ARM loan’s low initial teaser rate. But Calhoun estimated that all in all, the cost of refinancing a subprime loan can total 6.7 percent of the loan’s value. That’s $13,000 on a $200,000 mortgage “needlessly expended … because (the borrower was) placed in a loan they had no prospect of staying in,” he said.
Subprime loans are often made even riskier because only about one in four includes an escrow account that’s used to pay a borrower’s property tax and insurance by incorporating those expenses in their monthly payments, Calhoun said.
“When a broker is selling a loan, if escrow is excluded, he can present what appears to be a lower monthly payment,” Calhoun said — particularly if the borrower’s existing loan has an escrow account. That can lead to problems down the line if the borrower is unable to pay those expenses when they come due.
Mortgage brokers originate 71 percent of subprime mortgages and have “very little reason to consider the loans’ future performance,” Calhoun said. While investors do eventually pay a price if too many loans default, by then, hundreds of thousands or millions of families have been harmed, Calhoun said. In a study released last year, the Center projected 2.2 million borrowers will lose or have lost their homes because they are unable to make their loan payments.
Although many lenders say they’ve tightened underwriting standards and are working with borrowers who are having trouble making their loan payments to avoid foreclosure, Calhoun said that’s often not the case. Lenders continue to make risky loans, he said, and loan servicers are often prevented from modifying the loan terms of borrowers facing foreclosure because of restrictions in the agreements under which the loans are securitized and sold to investors.
A typical mortgage loan passes through many hands, Calhoun said, moving from broker to lender to loan servicers and investors. Calhoun urged lawmakers to pass legislation that would create “accountability for loan quality … wherever it goes.”
“The problem is right now without rules and protection, the players with the lowest standards drive the market,” Calhoun said.
Those who originate, pool, securitize and sell mortgage loans say lawmakers could make things worse if they go too far in strengthening assignee liability. Investors will be reluctant to buy mortgage-backed securities if they think they will be exposed to lawsuits, industry leaders said.
“The securitization market thrives on certainty, and loathes uncertainty,” said Howard Mulligan, a lawyer who represents the lending industry.
In his prepared testimony, Mulligan said imposing “unquantifiable” assignee liability for “abuses committed by mortgage originators” would “severely affect investors’ willingness to assume mortgage risk.”
In passing legislation intended to curb predatory lending, some states created “opaque and subjective” triggers for assignee liability, Mulligan said. Some laws required determinations of whether loans were in the “best interests” of individual borrowers or met “vague standards of suitability,” he said.
Georgia passed assignee-liability legislation “so expansive and stringent” that many lenders refused to purchase any Georgia loans, Mulligan said. Major rating agencies announced that they could not rate securities “containing a single loan subject to the Georgia statute,” and Georgia had to go back and amend its predatory lending laws to “remove several of its most onerous provisions,” Mulligan said. That’s a pattern that’s been repeated in states like Rhode Island, New Jersey and Ohio, he said.
At the federal level, the Home Ownership and Equity Protection Act of 1994 (HOEPA) contains similar problems, said another industry lawyer and lobbyist, Donald Lampe.
“Any federal law that begins with amendments to existing HOEPA likely will be freighted with HOEPA’s effects,” Lampe said in his prepared testimony. “Hardly anyone … in the secondary market funds or purchases HOEPA loans.”
If Congress amends HOEPA to cover more loans, either by expanding the loan types it covers or by lowering APR or points and fees thresholds, it should amend the law’s assignee-liability provisions, Lampe said. Otherwise, he said, “Those loans in all likelihood will not be marketable in secondary market transactions.”
Lampe said Georgia’s mortgage lending market “returned to vitality” when the predatory lending laws were changed to allow investors to prove they had exercised due diligence in avoiding purchases of prohibitively high-cost loans.
Such “diligence-based safe harbor” provisions giving investors some protection from lawsuits have been adopted by other states in their predatory lending laws, Lampe said.
Georgia also limited lawsuits to individual, rather than class-action suits, and capped damages at the remaining balance of a loan and attorney fees — provisions Lampe recommended federal lawmakers consider adopting.
Lampe and others said the place to address abusive lending practices is with originators end, and that Congress shouldn’t force investors to police mortgage brokers.
Sen. Charles Schumer, D-N.Y, has introduced legislation that would increase federal oversight of mortgage brokers.
Rep. Carolyn Maloney, D-N.Y., chairwoman of the Subcommittee on Financial Institutions and Consumer Credit, said lawmakers will introduce more legislation if lenders don’t act.
“This committee is by no means waiting for the private sector to do what it thinks is right to solve this rapidly growing crisis,” Maloney said.
Two Harvard reports issued last month called for strengthened assignee liability and increased oversight of investment firms that securitize and sell mortgage loans to Wall Street investors.