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How Banks Are Worsening the Foreclosure Crisis

By Brian Grow, Keith Epstein and Robert Berner

The banking industry is undermining efforts to keep people in their houses. And nearly 6 million foreclosures are expected in the next four years.

The bad mortgages that got the current financial crisis started have produced a terrifying wave of home foreclosures. Unless the foreclosure surge eases, even the most extravagant federal stimulus spending won't spur an economic recovery.

The Obama Administration is expected within the next few weeks to announce an initiative of $50 billion or more to help strapped homeowners. But with 1 million residences having fallen into foreclosure since 2006, and an additional 5.9 million expected over the next four years, the Obama plan -- whatever its details -- can't possibly do the job by itself. Lenders and investors will have to acknowledge huge losses and figure out how to keep recession-wracked borrowers making at least some monthly payments.

So far the industry hasn't shown that kind of foresight. One reason foreclosures are so rampant is that banks and their advocates in Washington have delayed, diluted, and obstructed attempts to address the problem. Industry lobbyists are still at it today, working overtime to whittle down legislation backed by President Obama that would give bankruptcy courts the authority to shrink mortgage debt. Lobbyists say they will fight to restrict the types of loans the bankruptcy proposal covers and new powers granted to judges.

The industry strategy all along has been to buy time and thwart regulation, financial-services lobbyists tell BusinessWeek . "We were like the Dutch boy with his finger in the dike," says one business advocate who, like several colleagues, insists on anonymity, fearing career damage. Some admit that, in retrospect, their clients, which include Bank of America, Citigroup, and JPMorgan Chase, would have been better off had they agreed two years ago to address foreclosures systematically rather than pin their hopes on an unlikely housing rebound.

In public, financial institutions insist they've done their best to prevent foreclosures. Most argue that giving bankruptcy courts increased clout, known as cramdown authority, would reward irresponsible borrowers and result in higher borrowing costs. "What we're trying to do now is target the bill to make it as narrow as possible," says Scott Talbott, a lobbyist for the Financial Services Roundtable. On the defensive, the industry nevertheless benefits from one strain of popular opinion that home buyers who took on risky mortgages -- even if the industry pushed those loans -- don't deserve to be rescued.

An Industry in Denial

However the skirmish ends, the industry's contention that it has done as much as possible to limit foreclosures seems hollow. Some statistics it cites appear to be exaggerated. Even pro-industry figures such as Steven C. Preston, a Republican businessman who headed the Housing & Urban Development Dept. late in the Bush Administration, concede that many lenders have dragged their heels. "The industry still has not stepped up to the volume of the problem," Preston says. One program, Hope for Homeowners -- which Bush officials and banks promised last fall would shield 400,000 families from foreclosure -- has so far produced only 25 refinanced loans.

Meanwhile, an already glutted market sinks beneath the weight of more foreclosed homes. Borrowers whose equity has evaporated have nothing to tap into if the recession costs them their jobs. Some lawmakers and regulators are calling for a foreclosure moratorium. "People are falling through the cracks," Preston says. "That's bad for communities, bad for the individuals losing their homes, and bad for investors."

In early 2007, as overextended borrowers began to default on too-good-to-be-true subprime mortgages, housing experts sounded an alarm heard throughout Washington. Christopher Dodd, chairman of the Senate Banking Committee, wanted to push a bill requiring banks to modify loans whose enticingly low "teaser" interest rates soon give way to tougher terms. But he knew that with Republicans strongly opposed, he lacked the muscle, according to Senate aides. So Dodd did what politicians often do. He convened a talkfest: the Homeownership Preservation Summit.

A who's who of banking executives gathered on Apr. 18, 2007, behind closed doors in an ornate hearing room in the marble-faced Dirksen Senate Office Building. Dodd told them they needed to get out in front of the foreclosure fiasco by adjusting loan terms so borrowers would continue to make some payments, rather than stopping altogether. Foreclosure proceedings typically cost banks about 50 percent of a property's value. That's assuming the home can be resold -- not a certainty when empty houses multiply in a neighborhood. "What are you doing?" Dodd asked the executives. "What do you need me to do to help you modify loans?"

Some from the industry denied a foreclosure problem existed, including Sandor E. Samuels, at the time chief legal officer of subprime giant Countrywide Financial. They vowed to continue selling loans with enticing introductory rates as well as those requiring minimal evidence of borrowers' income. "We are going to keep making these loans until the last second they are legal," Samuels later told a fellow participant.

On May 2, 2007, Dodd's office issued a "Statement of Principles" stemming from the summit. It outlined seven vaguely worded industry aspirations, such as making "early contact" with strapped borrowers and offering modifications that could include lowering loan balances. The principles had no effect, some summit participants now concede.

Much of Dodd's attention shifted to his campaign for the Democratic Presidential nomination. Senate Banking Committee spokeswoman Kate Szostak says Dodd aggressively pursued the foreclosure issue, but "both the industry and the Bush Administration refused to heed his warnings." The lawmaker accepted $5.9 million in contributions from the financial-services industry in 2007 and 2008.

Asked about his role at the summit, Samuels confirmed in an e-mail that he "did speak -- formally and informally -- about the performance" of subprime loans. But he declined to elaborate. He now works as a top in-house lawyer for Bank of America, which acquired Countrywide in July 2008.

A major reason financial institutions and investors are so determined to avoid modifying loan terms more aggressively has to do with accounting nuances, say industry lobbyists. If, for example, a bank lowered the balance of a certain mortgage, there would be a strong argument that it would have to reduce the value on its balance sheet of all similar mortgages in the same geographic area to reflect the danger that the region had hit an economic slump. Under this stringent approach, financial industry mortgage-related losses could far surpass even the grim $1.1 trillion estimated by Goldman Sachs in January. A desire to postpone this devastating situation helps explain lenders' intransigence, says Rick Sharga, vice-president of marketing at RealtyTrac, an Irvine (Calif.) firm that analyzes foreclosure patterns.

By mid-2007, Bush Administration officials were deeply worried about the financial industry's unwillingness to confront the growing catastrophe. Even banking lobbyists say they realized that their clients had lapsed into denial. The K Street representatives agreed that Treasury Secretary Henry Paulson needed to step in, says Erick R. Gustafson, then the chief lobbyist for the Mortgage Bankers Assn. "It was like an intervention," he says. "We had to get Treasury involved to get the banks to give us information."

That summer, Paulson, a former CEO of Goldman Sachs, summoned industry executives to the Cash Room, one of Treasury's most elegant venues. There, beneath replica gaslight chandeliers, Neel T. Kashkari, a junior Goldman banker whom Paulson had brought to Treasury, urged industry leaders to move swiftly to keep more consumers from losing their homes. Bankers know how to adjust interest rates, extend loan durations, and, if necessary, lower principal, said Kashkari, who has temporarily remained in his post. A couple of months later, Paulson summoned the executives again, this time to his conference room. "We told them we need to get over the goal line," recalls a former top Treasury official. "Cajoling is a euphemism for what we did. We pounded them."

One product of the Treasury conclaves was the Hope Now Alliance, a government-endorsed private sector organization announced by Paulson on Oct. 10, 2007. Lenders promised to cooperate with nonprofit credit counselors who would help borrowers prevent defaults. Faith Schwartz, a former subprime mortgage executive, was put in charge.

Window Dressing?

The alliance got off to a shaky start. An early press release contended that there had been more foreclosures nationally than the Mortgage Bankers Assn. was conceding at the time. "We looked like the Keystone Kops," says an industry lobbyist. Soon it became apparent that the program was primarily a public-relations effort, the lobbyist says. "Hope Now is really just a vehicle for collecting and marketing information to the Treasury, people on the Hill, and the news media."

In a press release last Dec. 22, Hope Now said it had prevented 2.2 million foreclosures in 2008 by arranging for borrowers to catch up on delinquent payments and, in some cases, easing terms. But the data don't reveal how many borrowers are falling back into default because many modifications don't, in fact, reduce monthly payments. The alliance doesn't receive this information from banks, says Schwartz.