Tainted Loans: Fighting Toxic Mortgages in the Courts
It’s not too late to treat toxic loans as the defective product they are.
By Ray Brescia Posted on October 17, 2010
Imagine that millions of homeowners across the United States had used a popular household cleaning product that turned out to be toxic. Homeowners using this product saw the value of their homes plummet: no one wanted to buy homes where it had been used. If such a product had taken this toll on homeowner wealth, lawsuits would pile up, the manufacturer of the product would file for bankruptcy, and homeowners would line up for compensation. This sequence of events has become fairly commonplace in the United States, and the ongoing disaster in the Gulf of Mexico is the most recent example where “toxic tort” litigation follows this path. Lawyers are trolling the streets and harbors for plaintiffs harmed by BP’s actions; they will likely have little trouble finding them.
In the mortgage arena, nearly 8 million American households are now behind on their mortgages, roughly one in seven borrowers. Nearly one in five are “underwater,” owing more on their mortgage than the home is worth. It is estimated that as much as 2 trillion dollars in household wealth will evaporate as a result of the foreclosure crisis. Toxic mortgage products caused this crisis. Many were outright illegal, involving faked assessments or documentation. Vastly more were clearly fraudlent in spirit, involving tactics such as misleading information to the borrower, higher interest rates than borrowers qualified for, and payments that would clearly be unsupportable after an introductory interest rate reset. An internal study conducted by Washington Mutual (and made public at a Senate hearing this Spring) of the loans made at one of its California branches revealed that 83 percent of the loans made involved fraud by bank personnel.
Borrowers saddled with these toxic, often illegal, mortgages must beg banks to modify them. Banks have to be dragged kicking and screaming to the table to modify mortgages, but bankers and the servicers retain complete discretion over whether to modify loans.
The “toxic tort” model of litigation, where the purveyors of a harmful product are brought to justice through the courts and forced to compensate their victims, would apply real to pressure banks to modify mortgages. Despite this, too few have embraced it.
Toxic Mortgage Lawsuit Successes
Early in the foreclosure crisis, several state attorneys general sued Countrywide, the nation’s largest subprime lender, for mortgage fraud. After Bank of America purchased Countrywide, the bank settled these lawsuits, committing over $8 billion to modifying about 100,000 questionable mortgages.
Similarly, Massachusetts filed a suit against Fremont Bank, an aggressive subprime lender, which was settled last year. The Massachusetts high court described Fremont’s practices as follows: “[T]he loans were underwritten in the expectation, reasonable at the time, that housing prices would improve during the introductory loan term, and thus could be refinanced before the higher payments began. However, it was unreasonable, and unfair to the borrower, for Fremont to structure its loans on such unsupportable optimism.”
Of the $10 million settlement, $5 million was directed to Fremont borrowers, $3 million to foreclosure relief and homeowner education, and the rest to the state to cover costs. Under the court order, the bank is also prevented from foreclosing on any remaining mortgages without the court’s permission and is required to attempt to modify any mortgages that might involve any of the practices described in the suit.
This indictment of Fremont’s practices could be applied to the practices of hundreds of subprime lenders during the last decade. The Fremont suit was filed under Massachusetts’s unfair trade practices laws, and many states have similar provisions.
Ray Brescia is an assistant professor at Albany Law School and former associate director of the Urban Justice Center in New York, N.Y. His scholarly articles are available at http://ssrn.com/author=956109 and he is on Twitter at @rbrescia.