WASHINGTON — Facing solid opposition from federal banking regulators, House lawmakers appeared willing Thursday to retool legislation that would protect servicers from investor lawsuits if they engaged in widespread loan modifications.
As currently drafted, the bill from Rep. Mike Castle, R-Del., would create a temporary safe harbor for creditors, assignees, servicers, and securitizers of residential mortgages while modifications are under way. But that idea hit a brick wall Thursday, with regulators saying it could cause problems in the secondary market.
"The legislation may create a new field of potential litigation that is more challenging and inhibits loan modification efforts just as much, if not more, than the legal issues industry participants are facing today," Comptroller of the Currency John Dugan said in his written testimony at a House Financial Services Committee hearing.
Though Federal Deposit Insurance Corp. Chairman Sheila Bair said her agency was neutral on the bill, she also said that in its current form it could violate the Constitution.
"As originally drafted, the legislation would appear to override existing contracts, which could create a constitutional issue," she said.
Redrafting the language could clear up ambiguity, Ms. Bair said, but she was not sure legislation was needed.
"I think legislation that clarifies what we do in current law and creates some clarification could be done. I don't know if it would be necessary," she said.
House Financial Services Chairman Barney Frank said he agreed with Ms. Bair's point.
"I would agree that the existing authority is there, but we've all been told that … people are nervous," the Massachusetts Democrat said.
Lawmakers who support the intent behind Rep. Castle's bill want to reassure the market, he said.
"We are not … [changing] anything with regard to existing regulation, but if you codify it to give people more reassurance, the securitizers who hold the assets … would be less likely to be sued," Rep. Frank said. "We've been told in that context that this sort of reassurance helps."
At issue is whether servicers risk lawsuits if they engage in loan modifications. Critics of workouts argue that investors have been promised a given rate of return on mortgage-backed securities and would sue if servicers reworked loans to keep the interest rate low. Industry representatives, while backing Treasury Secretary Henry Paulson's modification plan, have said liability is a primary concern.
Rep. Castle said he is trying to alleviate that issue.
"I remain quite concerned that at any point some party could file suit, and many or maybe all the efforts being made to modify loans would come to an abrupt stop. That would be most unfortunate," he said.
But Mr. Dugan argued that enacting the bill could wreak havoc in the secondary market and further undermine the economy.
"The retroactive application" of the bill "could create additional anxiety in the mortgage markets about the reliability of legal obligations upon which investors' expectations are based," he said. "If the legislation is enacted, will investors face new qualms about investing in mortgage-backed securities?"
Lawmakers appeared uncertain on how to move forward. Rep. Castle said he was open to input on retooling the bill, but he was still deciding how to proceed.
"I don't know for sure," he said in an interview. "Mr. Dugan's concerns were a little broader … but they talked about an extension of time. We could certainly look at that. Perhaps a more precise definition of what mortgages could be included, we could certainly look at that. I think all the suggestions were at least in the realm of being reasonable."
Ultimately, he said, the concern should be addressed in some way.
"This is a key step. We think this needs to be addressed, because the risk of litigation concerns are significant," Rep. Castle said. "Having a hearing helps to spur all the discussion. … I didn't go into this with the idea of putting in something that's worth nothing, so we are really trying to tie it up."
Gov. Randall Kroszner of the Federal Reserve Board acknowledged that modifying loans could increase litigation risk, but he said he hoped stakeholders could come to terms to avoid that on their own.
"When servicers modify loans, however, they may face potential litigation risk from investors, because of their contractual obligations under the servicing agreements. … We are hopeful that the industry can resolve these conflicts on a consensual basis," he said in his testimony. "In trying to help homeowners, we must also be careful to recognize the existing legal rights of investors, avoid actions that may have the unintended consequence of disrupting the orderly functioning of the market, or unnecessarily reducing future access to credit. Provisions intended to immunize servicers from liability should be crafted to avoid creating moral hazard of parties' disregarding their contractual obligations."
Rep. Spencer Bachus of Alabama, the panel's top Republican, said in an interview that he had not developed a position on Rep. Castle's bill, but that he shares the concerns that the Treasury Department's modification plan could spark suits.
"You could have 10,000 investors, and each of them could potentially have a right to sue to protect their investment," Rep. Bachus said. "If you had a challenge, and you had an injunction, you could drag things out. I think the [loan modification] proposals, if we get consent of the parties, that's great. I'm not criticizing the plan. I'm just saying there are problems, and one is the potential for litigation."
Rep. Brad Miller, D-N.C., also agreed with the concept of encouraging servicers to reach out to borrowers with workout agreements.
"The premise of Castle's bill is to make clearer what the servicer can agree to, so the servicer isn't frozen in place, unable to negotiate for fear of liability," he said in an interview.
"The premise behind it is one that I agree with it, and I think Barney has said that he agrees with the premise of the bill, so I'm sort of willing to consider that as one of the several things that we should be doing — not as 'the' thing that we should be doing, but one of the things."
