CRL’s Julia Gordon On Dodd-Frank, Principal Reductions And HAMP

PERSON OF THE WEEK: On the heels of the passage of the most sweeping financial regulatory reforms in recent history, MortgageOrb caught up with Julia Gordon, senior policy counsel for the Center for Responsible Lending, to get her thoughts on not only the Dodd-Frank Act, but also the foreclosure crisis and servicers' efforts to help borrowers.

Q: Can I get your top-level impressions on the Dodd-Frank Act and its impact on mortgage banking, specifically? What do you like, and where do you think the act could have been improved?

Julia Gordon: What we like is that, in the mortgage title to Dodd-Frank, we finally got the commonsense rules that have been missing from the mortgage market, which is basically that creditors have to make sure that a borrower can afford to sustain the mortgage and that we should not give originators incentives to steer people into worse loans than they qualify for. And these two basic principles, just by themselves, will go a long way toward realigning some of the misalignment of incentives that led to a lot of the mortgage problems we're cleaning up now.

The most important thing that's missing is cleaning up the mess that's there now. There are a couple provisions in the mortgage title relating to foreclosures. For example, there is the fund created to provide bridge loans to people who have lost their jobs, and there are some minor improvements to the [Home Affordable Modification Program (HAMP)], but we didn't tackle square-on the fact that we have close to 6 million people out there who are either in the foreclosure process or who are more than 60 days delinquent.

For us to get the mortgage market back functioning in a normal and healthy way, we need to deal with that overhang, and it would have been useful to have some provisions included the Dodd-Frank Act, which, after all, was an act designed to both prevent future crises but, to some extent, deal with the crisis we have now.

Q: At the American Legal & Financial Network's Leadership Conference in Washington, D.C., last week, you discussed bankruptcy cramdowns, which the banking community has fiercely fought. Why do you see judicial modifications as a necessity, and what are your thoughts on the criticism that such modifications may present a moral hazard?

Gordon: We have a set of intertwined but separate problems that we're dealing with in terms of this foreclosure crisis. One is the number of homeowners who are underwater on their mortgage. One is the widespread existence of second liens on the mortgages, which complicates any kind of modification process or short sale process. One is the very high back-end consumer debt ratios that many homeowners have that impede their ability to sustain their existing mortgage or even a modified mortgage. And a final one is the fact that of the existing programs aimed at helping people get a mortgage modification or a short refi-type program, all of them are dependent on the servicer to do some kind of action, whether it's put a loan into one of the [Department of Housing and Urban Development] programs or use HAMP. But the homeowners themselves don't have any control over the process.

So these are all problems that people are trying to deal with piecemeal, but the only solution that addresses all of them at one time is permitting a bankruptcy judge to put a person into a Chapter 13 plan, which, as you may know, is a very stringent plan. Living under a Chapter 13 plan is not something most people would choose to do unless they absolutely had to.

But the judge is empowered to deal with all these issues. They're empowered to deal with mortgages that are higher than the current value of home. They're empowered to deal with other consumer debt. They're empowered to deal with securitized loans and second liens. And going into bankruptcy is something that the homeowner can pursue without waiting for the permission of a servicer or for the servicer to do what they're supposed to do.

I've really heard two main arguments against doing it this way. One is – I don't really want to call it a moral-hazard argument, because bankruptcy is not an attractive option – it's not a free way to get your mortgage reduced. So I don't think that we'd see people going into bankruptcy if they didn't need it. To be honest, I find nothing persuasive about the [moral hazard] argument, and just to put that in context, I do find there to be moral-hazard arguments for some other solutions.

I'm not saying that moral hazard is never an issue. I'm saying that in this case, I don't think it is an issue, and in the situation where it might be marginally an issue, we're dealing with an emergency here. There was enormous moral hazard in bailing out the banks in 2008, but we made the choice to do that for our economic well-being, and I think we have to solve the foreclosure crisis if we are to have the economic recovery and well-being that we all want to have.

The other argument is that it will raise the cost of credit. Not to be too glib, but that is the argument that the industry trots out for any type of requirement or regulation anyone might suggest. But anytime you look at the record, whenever there has been a change in rules, the data rarely show that to be true, and I'll give you a couple of examples.

When they passed Chapter 12, which permits bankruptcy judges to assist family farmers, there was the same argument made about raising the cost of credit, and there have been subsequent studies that demonstrate nothing like that happened. Similarly, in our mortgage work around the country, there have been predatory-lending laws passed by states, where the argument has been made that the existence of the laws would raise the cost of credit in the states. We've studied that empirically and found that there was no change.

No one who supports this so-called judicial modification option wants to see 5.7 million people head to bankruptcy court. The system would collapse. But what we know from our work in other areas where bankruptcy judges do have the power to restructure debt is that pretty quickly, you'll see a template emerge within the context of bankruptcy, which lets all of the folks involved on both sides – both the business interests and consumer-side interest -Â have a pretty good sense of where they stand such that they can negotiate outside the context of bankruptcy court, and that's what we believe would happen here. In a way, all this would do is provide more incentives for existing, voluntary measures to work.

Q: Another point you raised at the conference last week was the need for tax liability reform.

Gordon: Right. I mentioned that because there's been a lot of interest in principal reductions, and there's also been a recent uptick in short sales. Now, particularly in a short sale situation or even a foreclosure situation, many homeowners don't realize that they may still owe part of their debt afterward. And they are kind of caught between a rock and a hard place: On the one hand, they need to make sure the servicer waives any deficiency, or else they'll still be on the hook. At the same time, if they do arrange for forgiveness of that debt, they may face a tax liability.

Congress tried in December 2007 to solve the problem of that tax liability, but the way they did it hasn't worked as well as was hoped. As a result, there's an additional risk element still present that will continue to destabilize either the homeowner or former homeowner, or may hurt them in other ways.

For example, if they owed taxes but weren't aware of it, or they weren't aware they could have an exemption to paying those taxes, they might end up with some kind of tax lien against them, which can obviously hurt you in all sorts of ways, from losing other tax credits to wage garnishments or number of things. There's a fairly simple way to fix the problem, and the IRS would like to fix the problem. Unfortunately, when it comes to tax law, we need congressional action.

Q: Is there any indication that's on the radar?

Gordon: Early on in this congressional session, this was nearly dealt with by a bipartisan agreement, but for technical reasons, the version of the bill that had this [provision] attached to it didn't end up being the version of the bill that passed, and it just kind of fell off the radar screen.

And it was hard to do this through Dodd-Frank, because the tax issue has different committees of jurisdictions, and you don't have shared jurisdiction in the Senate. So, in a way, this has been a little bit of an accident. But part of the problem is that the exemption only applies to purchase money, as opposed to refinancings, and so much of the market in the past decade has been refinancing, that that also makes the situation much more complex.

I think a lot of people place some – I guess I would call it moral judgment – on a mortgage that is a refinance, which may have had cash out to pay a medical bill or a student loan, versus a purchase money mortgage. In a way, that's an odd thing, because either way, you have a mortgage, and we're trying to deal with these mortgages, and we don't want rogue tax bills to undermine anyone's efforts in this area.

This issue has been raised with decision-makers who are working on the principal-reduction problem, and it's been surprising to me that no one's addressed it yet.

Q: From the perspective of a consumer advocate like yourself, can you share your thoughts on HAMP and your projections for the program to ultimately reach it's stated goal?

Well, as far as I know, there is no stated goal (laughs). HAMP is a well-intentioned program, and the basic theoretical construct is sound, which is to say that if the net present value of modifying is higher than the net present value of foreclosing, it makes sense to modify. I think any economist would agree with that, and certainly any business person should agree with that.

And even without HAMP, that was presumably the governing assumption of investors and others who count on servicers to pursue their best interests. But now, HAMP has kind of crystallized the net-present-value test and put a template out there for servicers to work with and/or to react off of in creating their own proprietary modification programs.

From that point of view, HAMP has been very useful in creating some standardization where there wasn't much standardization before and in giving us all a common vocabulary. But where it's falling short is in the follow-through. This is still a very voluntary measure, and even though a servicer who's signed up for HAMP might say, 'Well, now that I'm in HAMP, it's all mandatory,’ the fact is, the decisions about the program are made with an eye toward making sure servicers don't withdraw from HAMP.

The whole program is really just governed by contract law. If a servicer doesn't comply with the HAMP guidelines, there are some steps the Treasury can take – most obviously, they can not pay them under the contract, and there may be other kinds of sanctions or penalties they can impose – but that's about it.

Treasury has not been aggressive, even in pursuing the leverage they do have under these contracts. So, what we have seen in the field is widespread violation of HAMP guidelines by HAMP-participating servicers. There are definitely some programmatic problems with HAMP; if we were starting from scratch, I think we would do some things differently. But the main problem with HAMP is that it's not being followed accurately.

Q: Are you hopeful there's time to change that? Do you think Treasury's interested in actual enforcement?

Gordon: I suspect this only changes if there are some more stringent penalties for servicers – either if a homeowner is able to use either lack of consideration for a HAMP mod or an incorrect denial of a HAMP mod as grounds for defense against foreclosure, or if Treasury institutes significant penalties or any different treatment for servicers who don't comply with the guidelines.

There are things happening out there that are relevant. There's certainly, at the congressional level, consideration of making HAMP a statute and making it mandatory, but what we're starting to see is that states are taking this issue into their own hands. And we're starting to see state legislative efforts to, in some way, make HAMP mandatory in that foreclosures may not be able to proceed until a servicer has done what they need to do under HAMP. There's just a ton of frustration out there.

Q: Obviously, the industry's been struggling for years with the foreclosure crisis. But do you believe, looking back a few years, that the industry has made significant progress?

Gordon: There's no doubt that the whole face of the servicing industry looks different than it did three years ago. I would be the first person to explain that what we've seen the industry do is have to completely change its culture and staffing. These were collection agencies who have now turned into, essentially, loan originators. There's a big difference between a staff person who collects and someone who underwrites.

I think it's safe to say that even those of us who work from a consumer perspective have an understanding and appreciation of what has faced servicers. And with HAMP, the way it's been rolled out piecemeal, we have a great appreciation for the challenges posed by that, as well.

But we know from discussions that we've been involved in that the industry has known, for some years now, that this was coming. And these are sophisticated organizations at the top levels. And what our concern is, is that the reason the retooling hasn't happened fast enough and well enough is because the incentives haven't been there – it hasn't been considered important enough.


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