March 24 (Bloomberg) -- Understanding President Barack Obama’s predicament in reversing the worst housing slump since the Great Depression may come down to a court fight between hedge fund manager Bruce Rose and billionaire Wilbur Ross over who’s responsible for driving down prices.
Ross’s American Home Mortgage Servicing Inc. and Rose’s Carrington Capital Management LLC are accusing each other of worsening the recession by devaluing homes and the mortgage bonds that sparked it. In a Stamford, Connecticut, lawsuit, Carrington says American Home hurt its hedge funds’ clients by dumping foreclosed homes tied to its subprime bonds at “fire sale” prices. American Home, which countersued on March 20, says Carrington wants to grab bondholders’ money by blighting communities with vacant homes.
Obama’s $75 billion mortgage-relief plan seeks to slow foreclosures by giving banks, investors and servicers incentives to modify loan terms for struggling borrowers. To succeed, he must overcome conflicting interests like those in the Carrington suit and a dozen more around the country.
“This is fundamentally the logjam the government must break,” said Anthony Sanders, a former Deutsche Bank AG mortgage-bond research director who is now an Arizona State University professor in Tempe. “These types of lawsuits show there are really perverse incentives for servicers and mortgage- bond-investor conflicts that have wreaked havoc amid the housing and banking crises.”
Almost 291,000 homes were involved in foreclosure filings in February, up 30 percent from a year ago, following January’s 18 percent rise, according to RealtyTrac Inc., an Irvine, California-based online marketplace for such properties.
Broken Market
Fixing the $10.5 trillion mortgage market, bloated by loans to people earlier this decade who previously didn’t qualify, is key to reviving the U.S. economy, which contracted 6.2 percent in the fourth quarter, the fastest pace since 1982.
Mortgages account for 80 percent of consumer debt, and housing costs represent about 22 percent of the economy, according to Federal Reserve and Hoover Institution data. Home prices have fallen an average of 27 percent since the residential real estate market peaked in July 2006, according to a Standard & Poor’s/Case-Shiller index.
For more than three decades, lenders have been packaging loans into bonds, selling those securities and hiring servicers to distribute money collected from borrowers. Without investors buying mortgage-backed bonds, banks would run short of money for new loans.
Bigger Than Treasuries
About 64 percent of the total value of U.S. home loans is now bundled into bonds -- a $6.7 trillion market that is 10 percent bigger than the sum of all outstanding Treasuries. About 70 percent of that market is guaranteed by government-supported Fannie Mae and Freddie Mac or Ginnie Mae, a federal agency.
The rest -- about $1.8 trillion worth -- has been divvied up by levels of risk and sold. Safer slices, or tranches, offer smaller yields than those with lower-priority claims on homeowners’ interest and principal payments.
“The result is what is known as ‘tranche warfare,’ with the servicer caught in between competing groups of investors,” according to a March 6 report by the congressionally appointed panel overseeing the U.S.’s $700 billion finance industry bailout.
Those dueling interests, “fear of litigation” and related issues discourage negotiations to modify loan terms, which is why “foreclosures that injure both the investor and the homeowner continue to mount,” the report concluded.
Fronting Payments
Carrington’s Feb. 9 suit in Connecticut Superior Court in Stamford accuses Irving, Texas-based American Home of putting its interests ahead of those of bondholders the company is required to protect. The conflicts over handling foreclosed homes are typical in the industry, said Sanders of Arizona State.
When a loan goes into default, servicers like American Home are obligated to front the missed monthly interest and principal payments to bond investors. Servicers have little incentive to rework loans because they are reimbursed more for foreclosure- related expenses, the congressional report said. Once it unloads a property, the servicer recoups money it paid to bondholders and turns over the rest of the proceeds. The quicker American Home sells a home, the sooner it can stop making those monthly payments.
After a foreclosed home is sold, bondholders stop getting principal and interest each month. Holders of the riskiest, lowest-priority bonds often end up getting little or nothing from sale proceeds because other investors have higher-ranking claims on that money. That’s why Greenwich, Connecticut-based Carrington’s hedge funds, which owned the riskiest kinds of bonds, stands to gain from delays.
Salomon Brothers
“The very subordinated tranches are owned by hedge funds,” Ross, 71, said in a Bloomberg Radio interview on Feb. 26. “Those tranches have little or no value, and the hedge funds are trying to use litigation as a means to get something out of nothing.”
Rose, a 50-year-old former Salomon Brothers bond trader, founded Carrington in 2003. One of its hedge funds, Carrington Investment Partners LP, returned 66 percent between its 2004 creation and May 2007, according to a letter to investors at the time. Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall.
Kept Risky Parts
Carrington began one of its funds with $25 million from New Century Financial Corp., then the U.S.’s second-biggest subprime lender, the mortgage company said in Securities and Exchange Commission filings. The hedge fund bought the lender’s loans, packaged them into bonds and sold all but the riskiest tranches, the company said.
The firm did the same with subprime loans from other lenders, including H&R Block Inc.’s Option One, according to bond filings.
After New Century failed in 2007, Carrington bought the Irvine, California-based company’s servicing business for $188 million, giving it more control over loans backing bonds it owned or might buy.
Ross, based in New York, profited from buying and selling bankrupt steel and textile companies, including LTV Corp. Last year, his WL Ross & Co. bought mortgage-servicing units from American Home and Option One for a total of $1.8 billion and combined them.
Among Option One’s assets were contracts that gave Carrington “special rights” to dictate how loans backing its bonds were managed, the hedge-fund firm said in its suit. In prospectuses, investors in other bonds backed by those loans were warned that Carrington’s special rights were “potentially adverse to their own interests,” it said in the suit.
Delayed Sales
Carrington used its rights to force American Home to delay foreclosure sales, according to the hedge fund’s complaint. That diverted money from investors in higher-ranking bonds because the more money a servicer pays all bondholders each month, the more it recoups when the home is sold, leaving less principal for the senior bondholders.
American Home, running out of the credit it needed to continue payments on defaulted loans, stopped obeying Carrington, the suit says. On Sept. 17, two days after Lehman Brothers Holdings Inc.’s collapse sent financial markets into a tailspin, American Home told Carrington in a letter that it no longer believed the firm had the right to direct its actions.
Carrington alleges that American Home then began unloading foreclosed homes. The servicer used that money to reimburse itself and, in response to lender demands, pay down $200 million of its $1.2 billion in debt, the suit says.
In ‘Self-Interest’
American Home officials were “acting in their own self- interest, so they could reduce the company’s outstanding borrowing,” said Sean O’Shea, a lawyer with New York-based O’Shea Partners representing Carrington.
Brian Otero, a lawyer in New York at Hunton & Williams representing Ross’s firm, said American Home’s credit issues didn’t “motivate” the foreclosure sales. The company needed to liquidate homes that were depreciating as property prices slumped to protect bond investors, Otero said. The sales were at “market prices” and also benefited surrounding homeowners because many of the homes had been vacant, he said.
“Public officials in communities where there has been a high toll from the subprime crisis are very much worried about having a lot of vacant properties sitting there,” Otero said.
O’Shea said American Home could have rented out the homes while waiting for better prices. That’s what Carrington’s own servicing business often does, sometimes allowing previous owners to remain as tenants, the lawyer said.
Obama’s Plan
“I’m not saying that’s because they’re heroic,” O’Shea said. “It’s because they think its good business. It’s good for them, and it’s good for homeowners.”
Obama’s mortgage plan is meant to address conflicts like these. The government will cover some costs of reducing homeowner payments and pay investors to limit losses from further home-price declines.
That way, greater numbers of bondholders will have more to gain from loan modifications than foreclosures. As things stand now, high-risk bondholders get nothing if interest rates are reduced too much. Some lower-risk investors may reap less from years of smaller payments and additional defaults than from just selling the homes now.
The government also will pay servicers to hire the staff needed to contact borrowers and modify loans. Encouraging servicers to rework loans isn’t without risk because they have little to lose from lowering borrowers’ monthly payments, said Sean Dobson, chief executive officer of Amherst Securities Group LP, an Austin, Texas, firm that focuses on home debt.
Back in Default
“Most modifications are a sham done in the servicers’ self-interest, and they do nothing to benefit the homeowner,” Dobson said. Fifty-eight percent of modifications made during 2008’s first quarter ended up back in default, according to the U.S. Treasury’s Office of the Comptroller of the Currency.
The congressional bailout panel called the incentives in Obama’s program “encouraging,” though its report said their reach was limited because only lenders who accept new bailout assistance are obligated to take part. That means many won’t have to. The congressional report also said Obama’s program lacked protection from lawsuits for servicers who change loan terms. Lawmakers are debating a proposal to provide such legal shelter.
Even if the government’s plan alleviates some of the conflicts, investors fret that it will create new ones, said Laurie Goodman, a senior managing director at Amherst. She said shielding servicers from lawsuits may remove the “last line of defense” against self-interest: Banks that own home-equity loans tied to mortgages they service but don’t own would be tempted to rework the latter just to improve performance on the former, she said.
The suit is Carrington Asset Holding Company LLC, et al v. American Home Mortgage Servicing Inc., FST-CV 09-5012095-S, Connecticut Superior Court (Stamford, Connecticut). The countersuit is American Home Mortgage Servicing Inc. vs. Bruce Rose, et al, FST-CV-09-5010834-S (Stamford).
To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.
Last Updated: March 24, 2009 00:00 EDT
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