On Tuesday, JP Morgan Chase Bank agreed to a settlement with the US government for $13 billion regarding problematic mortgages that were sold on the secondary market. If 13 billion sounds like a big number, it’s because it is — it is the largest settlement ever coming from a single entity.
What was essentially happening was that many lenders were giving out high risk home loans and then selling them on the secondary market, under the pretense of meeting specific guidelines and being more secure than they actually were. As soon as these loans were sold on the secondary market, the lenders had their money and didn’t have to worry about the possible consequences of the loan defaulting. In the years leading up to and immediately following the housing bust and great recession, many of these loans defaulted.
The two biggest entities that bought these home loans on the secondary market were Fannie Mae and Freddie Mac, government sponsored entities (GSEs). Having these two players in the secondary market helps free up banks and other lenders to make other investments and loans, so the lenders do not have their money tied up for 30 years per loan (the typical length of a mortgage). So the (very simplified) lending chain for a home loan looks something like this:
In this chain, there were lots and lots of places where the loans could go wrong (and it needs to be noted that misrepresentation happened in nearly every form imaginable from many different individuals and entities – not just lenders). As these loans defaulted for various reasons, it was Fannie and Freddie who took the financial hit, not the banks. The banks had already gotten their money from Fannie and Freddie, but as the borrowers defaulted and stopped paying, Fannie and Freddie suffered.
Because so many of these loans defaulted, these GSEs decided to go back through and actually take a closer look at some of these loans that they had purchased from banks and lenders such as Chase. (Actually, they hired quality control and risk management companies to do this for them.) In a lot of cases, they found some type of misrepresentation of the mortgages – the loan was much riskier than what they were told and/or it did not meet the guidelines that Fannie or Freddie had stipulated when they purchased the loans. In short, the product they were told they had purchased was quite different than what they got.
In the cases of egregious misrepresentation, Fannie and Freddie went to court to recoup their money from the banks the bad loans. With the thousands and thousands of the loans given out during this time period for trillions of dollars, several big banks (and likely more to come) have decided that it was in their best interest to negotiate and settle for a lump sum instead of continuing to pay them back piece by piece. This is exactly the case in this newest and largest $13 billion settlement from Chase.
Of course, when any large corporation gets punished and fined, the question of will they actually have to pay up comes to the forefront. It’s not all that uncommon for corporations or individuals involved in various white collar crimes to be fined large amounts, but never actually held accountable to pay in entirety. In this case, the negotiations have already spelled out where the fine money should end up, with a good chunk going back to the consumers in the form of mortgage relief programs to help consumers stay in their homes rather than foreclose. Only time will tell.
Interestingly enough, a lot of these bad lending practices helped to create a new (or at least newly important) sector in the lending industry, “forensic loan analysis.” There is now a need for companies that are able to accurately analyze and assess loan risk to go back to these defaulted (or “dead”) loan files to investigate what went wrong. Much like a forensic examiner looks at evidence to determine the cause of death, a forensic loan analyst (sometimes referred to as a loan review analyst or forensic underwriter) examines various evidence to determine why a loan defaulted. “Was everything properly disclosed and documented?”, and “were all of the necessary guidelines met for the particular loan to be sold on the secondary market?” are two of the most central questions to this type of forensic work. If the answer to either of these questions is “no” then Fannie or Freddie may have a legitimate claim to recoup their money from that purchase.
Now, more stringent regulations have been put into place when it comes to giving out home loans, in the hope of preventing a similar situation from happening again. (The Dodd-Frank Act is one example, with new pieces that will roll out soon as well.) Instead of waiting until there is a need for forensic analysis, there is also discussion of regulations that will call for an independent quality control review before the loan is approved.
The new analytic strategies and quality control practices of these companies, along with these new lending regulations should help to make mortgages and home loans much safer.
A few helpful articles:
Critique of the Chase settlement:
Countrywide in a similar situation – just a few weeks ago: http://money.cnn.com/2013/10/23/news/economy/countrywide-fannie-freddie/