[The Deal Professor by Steven M. Davidoff]

Greenwich Financial Services brought a purported class-action lawsuit against the Countrywide Financial Corporation in New York state court last week. The lawsuit challenges Countrywide’s attempts to modify and reduce payments on as many as 400,000 subprime and pay-option adjustable-rate mortgages with borrowers who are seriously delinquent or about to become seriously delinquent.

Countrywide agreed in October to take this action in connection with a settlement with the attorneys general of at least 15 states. As part of the settlement, Countrywide agreed that it would modify these loans to reduce them by an aggregate amount of $8.4 billion.

Countrywide, which is now part of Bank of America, acted so generously in this regard, because it is taking the position that the reductions in principal should not be borne by Countrywide. Instead, any such reductions in principal should be attributed to the holders of certificate interests in the securitization trusts for these mortgages.

Greenwich owns an interest in one such trust but is bringing a class action with respect to 374 such trusts. Greenwich contends in its lawsuit that Countrywide’s actions are not permitted under Countrywide’s agreements with the trusts.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the legal aspects of mergers, private equity and corporate governance. A former corporate attorney at Shearman & Sterling, he is a professor at the University of Connecticut School of Law. His columns are available at The Deal Professor blog.

This is a clever lawsuit. If, in fact, Countrywide violated the terms of the securitized trust by reducing payments on the loans because of alleged predatory lending, not because of past-due payments by borrowers, then the investors may have a legitimate claim. And even if Countrywide is reducing these payments because of the distress of the borrowers, then the investors may also have a claim.

The resolutions of both issues depends on what the trust terms (and the pooling and servicing agreement, or P.S.A., the agreement between Countrywide as servicer and the trusts) say. Unfortunately for Countrywide, and as The New York Times’s Gretchen Morgenson reported last year, the trust terms and the P.S.A. are not particularly in Countrywide’s favor.

The P.S.A.’s for each of these trusts vary somewhat, but according to Greenwich, in their most common form Section 3.12(a) of these P.S.A.’s requires that:

“The Master Servicer may agree to a modification of any Mortgage Loan (the‘Modified Mortgage Loan’) if … CHL [Countrywide Home Loans] purchases the Modified Mortgage Loan from the Trust Fund immediately following the modification… .”

Countrywide, perhaps aware of this problem modified the language in 2007. The new language in one form (from securitization CWABS 2007-8) reads:

“The master servicer may agree to modifications of a mortgage loan, including reductions in the related mortgage rate, if, among other things, it would be consistent with the customary and usual standards of practice of prudent mortgage loan servicers. Such modifications may occur in connection with workouts involving delinquent mortgage loans. Countrywide Home Loans is not obligated to purchase any such modified mortgage loans,” a clause in a more recent Countrywide-led securitization, CWABS 2007-8, reads”

And here Countrywide was apparently different from most of its competitors. These other securitizers actually did have language allowing for distressed modifications in their P.S.A.’s. Here is one example from a P.S.A. in a Goldman Sachs-sponsored trust:

“Consistent with the terms of this Agreement and subject to the REMIC Provisions if the Mortgage Loans have been transferred to a REMIC, the Servicer may waive, modify or vary any term of any Mortgage Loan or consent to the postponement of strict compliance with any such term or in any manner grant indulgence to any Mortgagor if in the Servicer’s reasonable and prudent determination such waiver,modification, postponement or indulgence is not materially adverse to the Owner.”

From a review of Greenwich’s allegations, it appears that Countrywide is in a bit of a bind — the relevant agreements simply do not appear to contemplate these types of modifications without a repurchase by Countrywide itself. Moreover, Countrywide appears to be shifting the burden for its settlement to the investors while its conduct apparently drove the settlement (I say apparently because Countrywide did not admit any inappropriate conduct in this settlement). And this explains why it was so quick to settle — it isn’t really footing the bill.

If this really is in the economic interests of the bondholders to make a modification to prevent a more loss-consuming default, there are mechanisms in the trust documents to allow the bondholders to agree to this. Surely, this is complicated and has hold-up value that the bondholders can extract from Countrywide, but still given that Countrywide apparently bears some responsibility here, it may be appropriate in this case for them to contribute. And as for helping homeowners, this is really just an issue of whether Countrywide or the bondholders will bear the loss of these modifications.

There is also the related problem of whether these modifications even work. There are the issues of moral hazard, homeowners now desiring to go into default in order to get a modification, and in fact there is a high re-default rate on loan modifications. For example, the Federal Deposit Insurance Corporation has modified all of Indymac’s 5,400 delinquent loans. But, according to The Wall Street Journal, even the F.D.I.C. is using a re-default rate on these loans of 40 percent in its models. Notably, this is less than current figures from the Office of the Comptroller of the Currency, which find a re-default rate exceeding 50 percent on current modifications.

In short, bondholders may not want to do modifications because of this high default rate, instead preferring foreclosure as salvaging more value. But this is an empirical question and still, even among these high figures, 50 percent or so of modified loans do not default. This alone may justify modifications. And of course, the public consensus is that something must be done to assist homeowners.

In this regard, I would expect Countrywide’s defense to scrape together a number of arguments related to this theme and the unusualness of this event — that it simply is not covered by the current P.S.A.’s, which cover only ordinary course modifications — and that the interests of the public require that these modifications be made. In short, Countrywide will try and link itself with the broader issue of loan modifications rather than its own particular conduct. It may even find a sympathetic judge.

Or Countrywide may even try and get Congressional legislation overriding the trust terms. If indeed modifications are in the public interest — and they very well may be — this is one route to go. But Congress should legislate knowing at this point that the losses are merely an apportionment between the investors and Countrywide and should allocate these losses to fit the parties’ prior conduct and agreements.

Of course, Congress should legislate to place appropriate incentives for modifications and other remedial action where desirable. This is quite aspirational, but given the mortgage mess, how they do this in fact is another matter.

The Deal Professor will be on vacation for the next two weeks, and posts during that time period will be intermittent at best.

Go to Complaint from Greenwich Financial »
Go to Article from The New York Times »
Go to Article from The Wall Street Journal »
Go to Chart from the Office of the Comptroller of the Currency »