U.S. homeowners are struggling to stay on top of their mortgages — and the problem is likely to get worse. According to real-estate data firm Black Knight, 4.6 million American homeowners were in some type of non-repayment as of June 16, representing 8.7% of all mortgages.
If precedent is anything to go by, in many cases it’s unlikely that the mortgage lenders will ever see much of the money they’ve lent. I’ve identified one mortgage borrower in foreclosure who hasn’t made a mortgage payment in more than 13 years. This borrower took out a $342,165.10 home loan and made their last payment in August 2006. As of April 2020, they’re still living in their house and don’t appear likely to go anywhere.
This borrower’s loan, on which at least a first payment was made at some point, was bundled with 6,911 other loans into a trust called Carrington 2006-NC1, according to data from the Carrington 2006-NC1 March 2020 remittance report available at Wells Fargo Securities Link. The same bundle of loans lists several houses as “Real Estate Owned” or REO for short. These are bank-owned houses that were foreclosed on. As a group, they have a current actual shortfall that is higher than the original principal value of the loan. That is, the investors who funded these loans are losing more money than the amount they actually lent.
If this seems impossible, think again. At one point following the 2008-09 crisis, the average loss severity of subprime loans — the amount lost as a ratio of the loan amount — was 73%. Lend $250,000 and, eventually, recoup an average of $67,500. Loss severities greater than 100% were not uncommon. In these cases, it was actually costing some investors, relying on work done by servicers, more to repossess houses and then sell them than it would have cost just to give them away.
With the looming spike in home loan problems, banks need to avoid getting themselves into the same kind of mess again. The good news is that they can, thanks to a concept every law student learns in their first-year contracts class: mitigation.
Breach of Contract
Common law requires businesses to mitigate a breach of contract. To understand this idea, imagine you are a primary contractor building a house and have subcontracted someone to dig a hole for the foundation within two days for $2,000. The sub-contracted worker digs half the hole in a day and then disappears. You are acutely aware that if the hole doesn’t get finished, other subcontracted workers will be turning up to work on the foundation, which they won’t be able to do. This delay will cascade down to yet other workers, meaning that any delay in completing the hole could end up costing you a lot of money.
Rather than allowing these costs to accrue, as a contractor you have a legal obligation to mitigate the breach, to make sure it costs the least amount possible. In this case, that means finding a replacement to quickly finish the hole. You’re then entitled to recover from the first person, who walked away from the job, the amounts actually lost. If you purposefully or negligently delay finding the replacement, you cannot recover the additional costs you incur as a result.
Mitigating loss is a legal requirement and it’s also a good business practice. Even if you have the legal right to recover extra from your lost hole digger there’s a good chance that they won’t have it. And the court system wants to avoid being bombarded with litigants hoping for a windfall in the event of a breach. The law strongly prefers you find somebody else to do the work then go back for the actual amount of damages and no more.
For an object lesson in why this is a good idea, let’s look at the experience of Bank of America.
The Case of Countrywide
Bank of America purchased Countrywide Mortgage just as the financial crisis was gaining steam, in January 2008. Countrywide was known for aggressively originating subprime and Alt-A mortgage loans, engaging in practices that at least one jury later determined to constitute outright fraud. Post-acquisition, Bank of America predictably ended up with a collection of terrible loans.
At first, Bank of America acknowledged that many of its acquired home loans were distressed and stated a “goal of keeping distressed mortgage borrowers in their homes when possible.” The bank viewed mortgages as a “relationship product,” a strategic acquisition that would enable Countrywide “customers” to “gain access to a broad set of consumer products including credit cards and deposit services.”
Attitudes changed very quickly, as Countrywide’s mortgage loans started defaulting in ever-increasing numbers. This started a vicious cycle of ever more foreclosures causing lower home values as the repossessed houses were auctioned. In order to demonstrate that it would not be a soft touch, Bank of America, like many other mortgage lenders, started aggressively repossessing the collateral of the defaulting mortgage borrowers, their houses, hiring law firms specialized in high-volume low-cost litigation to act as their agents.
It wasn’t long before consumer attorneys realized that chaotic loan originations combined with hastily prepared lawsuits presented an opportunity to effectively defend foreclosure lawsuits brought by mortgage lenders by delaying a repossession or forcing a renegotiation of the underlying obligation. Lawyers engaged by defendants in these cases soon found questionable patterns in loan origination and foreclosure proceedings including even outright fraud (multiple instances were uncovered in which Countrywide loan assessors advised would-be borrowers to falsify their mortgage applications). The fight was on between Bank of America and the new customers they’d hoped to bring into the fold with the Countrywide acquisition.
The Court of Public Opinion
A company the size of Bank of America can certainly litigate a reasonable number of lawsuits at once, but the sheer volume quickly became overwhelming with hundreds of thousands of concurrent cases. In Florida, where lawsuits are obligatory to repossess a house, banks lobbied for retired judges to preside over the tidal wave of litigation. In what are called summary judgment hearings, informally referred to as the “rocket docket,” foreclosure lawyers literally lined defendants up before the judges for one-minute hearings.
Bank of America soon faced a logistical and reputational nightmare. The publication 24/7 Wall St. rated Bank of America the most hated company in the United States. News articles recounted instances where the high-volume law firms mixed up files and attempted to repossess houses the bank did not own, at least one of which did not have a mortgage. In 2011 alone, Bank of America lost $11.2 billion in brand equity while spending an incremental $4 billion on loan servicing.
Besides the reputational damage and increased operational costs, Bank of America paid $11.8 billion into the 2012 landmark $26 billion National Mortgage Settlement for foreclosure abuses, the third largest settlement in U.S. history. In 2013, the bank paid $10.3 billion to Fannie Mae for poor loans Countrywide sold to the agency. Later, in 2014, they’d pay an additional $16.65 billion in fraud-related fines, including $5 billion earmarked to help struggling consumers.
Announcing the 2012 settlement, President Obama noted: “In many cases, [bank representatives] didn’t even verify that these foreclosures were actually legitimate. Some of the people they hired to process foreclosures used fake signatures to — on fake documents to speed up the foreclosure process. Some of them didn’t read what they were signing at all. We’ve got to think about that. You work and you save your entire life to buy a home. That’s where you raise your family. That’s where your kids’ memories are formed. That’s your stake, your claim on the American Dream. And the person signing the document couldn’t take enough time to even make sure that the foreclosure was legitimate.”
Eventually, Bank of America recognized that it was impossible to run a consumer business while alienating hundreds of thousands of people. They quietly pivoted towards a more collaborative approach — writing off an enormous amount of principal and writing down interest rates — and their costs went down while their reputation and stock price went up, more than doubling between 2012 and 2014. The problematic Countrywide “borrowers” became the potentially profitable “customers” the bank originally acquired. Bankers tried to find outcomes that worked for both the bank and their customers in what was an admittedly lousy situation.
There are several possible explanations for why Bank of America’s executives decided against working with Countrywide’s customers to mitigate the losses. To begin with the concept of “moral hazard” is deeply engrained among bankers, who are afraid that going easy on defaults will only encourage other borrowers to default. (It was, let’s not forget, fear of moral hazard that stopped the Fed and the U.S. Treasury from putting together a rescue package for Lehman.)
Government policies may also have played a part in the response to the last crisis. For example, U.S. owned Government Sponsored Entities (GSE’s) Fannie Mae and Freddie Mac strongly encouraged banks to use pre-approved foreclosure law firms, at least one of which was led by an attorney eventually disbarred due to shoddy foreclosure practices. The Home Affordable Modification Program (HAMP) suffered poor oversight and borrowers routinely found themselves in foreclosure after attempting to modify a loan. Finally, the Federal Housing Finance Agency (FHFA) did not allow principal reductions, since recognized as a sometimes-vital tool in effective loss mitigation, until 2016.
Whatever the explanation for the mistakes of Bank of America — and many other financial institutions as well — one thing is clear: We cannot afford a repeat. With tens of millions of people unemployed and loan delinquencies higher than they have ever been, a future round of far more numerous defaults appears inevitable. And if we do see another big round of defaults, let’s remember that doing things the hard way didn’t work out well for anyone last time. This time around, lenders would do well to put the principle of mitigation ahead of moral hazard. Let’s hope that the lessons of Countrywide have been learned.