OCC Consent Orders for Residential Servicers: Bane or Boon?

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 Late last week we saw reports of the Office of the Comptroller of the Currency's enforcement actions against banks and mortgage servicers for "unsafe and unsound" residential mortgage loan collection and foreclosure practices.  

Reactions to the enforcement order vary.  Some look favorably on the mandated independent audits of foreclosures in 2009-2010, from which we should learn more, and the creation of some new rights for wronged borrowers.   Others, including the Atlantic, view the regulatory response as a toothless, relatively inconsequential wristslapping 

It's too early to say.  Time will tell; also, we still have yet to hear from state attorneys general and the outcomes of private investor lawsuits.  Obviously, the bank regulators are under political pressure to respond to widespread perceived failures of the mortgage lending system:  at the same time, they see their task as improving and cleaning up the residential mortgage retail market, not razing it to the ground.

There are a few interesting things we can note about the enforcement order, at this early stage.

No Dual-Track Workouts for Residential Mortgages

One is that the OCC seems to have prohibited "dual-track" workouts for residential mortgages.  These are resolution actions where a lender discusses a possible loan modification or extension with a defaulted borrower, on the one hand, while still proceeding with filings to start the time running on foreclosure, on the other.

Maybe the theory is that the average consumer can't comprehend the idea that they may be bargaining with their bank for a delay, if the foreclosure clock is running at the same time?  I'm not so sure about this one.  In economic downturns, legislators sometimes just pile on lending practices because banks, and foreclosures, are unpopular.

For example, look at the California one-action rules, which put all sorts of procedural hurdles in front of a foreclosing lender, in response to the 1929 Depression.  Those rules largely account for the current wave of borrowers who stop paying and squat in the property they aren’t paying for, knowing that it will take months, or years, for the bank to be able to exercise its lien.

Making legitimate foreclosures even harder might not be the right policy step, here.  While some borrowers may face improper foreclosure efforts (which should be subject to legal challenge), a whole lot of other foreclosures are valid ones, with valid, fair contracts, full disclosure to the borrower and big arrearages.

In other domains, there's nothing strange or fraudulent about having a settlement negotiation running at the same time your dispute is actively heading for trial.  Prohibiting that, in residential mortgage resolutions, might actually make things worse.  In California, for example, the various statutory steps and notice periods ensure that even a simple foreclosure, on perfect documentation with no borrower defenses, will take a minimum of 3 months and 21 days, after the lender sets the process in motion.

Does the new OCC position means that residential mortgage lenders can't even start that clock, if they're willing to also discuss an extension or modification?  If so, an unintended outcome of the rule might be that some lenders will cut off modification talks sooner -- or never start them -- so that they can get the ball rolling on the long, drawn-out process of enforcement.

[Of course, lenders do have an obligation to be clear with borrowers and deal in good faith during workouts.  Recently, a California Court of Appeals supported one borrower's action against a lender who was saying one thing (we’ll modify & reinstate your loan) from one department, but another (we’re foreclosing) from another, in  Aceves v. U.S. Bank  (January 27, 2011).  In that case, the borrower successfully argued that she was falsely induced to agree to a lift of the bankruptcy stay for a modification, then suffered a foreclosure.  Where a lender actively has misled a borrower, remedies are appropriate.  (The Aceves case also reminds us that banks need to keep their interdepartmental lines of communication open during a resolution.)  But the OCC's rule is a big flyswatter, which might bar all enforcement actions, whether or not misleading, if there's any talk of a reinstatement or loan modification.]

Closing the Door After the Cow is Out of the Barn

The other thing that struck me about the OCC order is that it's only going after flaws and misconduct in loan servicing:  the second half of the loan's lifecycle.  Didn't most of our problems start with origination, rather than in the enforcement phase?

Making residential mortgage enforcement better and fairer is a fine goal, and in the current political climate, I'm sure the regulators feel the need to do something visible.  But this step leaves untouched the bulk of the home mortgage market's problems, which were generated earlier in the food chain, at origination rather than the enforcement phase.

Let's be clear:  the current pile-up of distressed assets is not all about lender errors.  Lots of mortgages properly underwritten and documented in 2004 or 2006 still suffered big hits to their loan-to-value ratios, when underlying asset prices fell a few years later.  But at the same time, it seems clear now that a lot of the mortgages in that bubble era were originated poorly from the start:  loans to uncreditworthy borrowers, or on flawed loan documents, or against collateral whose value is overstated or unexamined.  Sometimes all of the above.

By the time a loan is in collection, the first, best chance for safe and sound lending practices -- the application, documentation and appraisal process during origination -- usually is a distant memory.  A genuine regulatory cleanup needs to address the incentives and controls that  permitted or encouraged an abnormal supply of nonperforming, inferior-quality loans.   Some of this will come from the securities markets:  investors in securitized loan pools will have causes of action if the bags of loans that were sold to them weren't as good as the prospectuses said they were.  But the actions and rules of the bank regulators themselves during the go-go bubble still have not been well reviewed.

Those of us with a long memory will remember that, after the "S&L" crisis in the late 1980s, there was a wave of new regulation (including FIRREA) around lending, appraisals and the like.  Charlie Keating and others went to jail.  In a way, the regulators asleep at the wheel did too:  FSLIC was dissolved, new agencies with stricter approaches were chartered, and the regulation of mortgage lending got a genuine re-start.

Now we face a similar inflection point.  Sure, there will be screw-ups and flaws in loan enforcement, and the OCC action is one step to address that.  But we'll be more interested in the bigger-ticket issue of whether the origination market can be fixed.  How will regulators, and the marketplace, better disincentivize making unsound loans in the first place?  And are the folks who let it happen on their watch -- regulators, rating agencies, valuation experts and, yes, lawyers -- going to be the ones who clean it up?