Contract law and loan mods: not quite as scary a combination as it might seem

A Wall Street Journal article today describes the growing anxiety among mortgage investors that the Obama administration´s new foreclosure prevention plan would make it impossible for them to sue servicers over loan modifications. Meanwhile, servicers cite their own worries about investor lawsuits as a reason for not going ahead with more loan mods. To both groups, a simple message: Get on with it!

The more quickly investors start suing servicers over loan mods, the more quickly the issue will dissipate. Precedents in case law will begin to determine the kinds of lawsuits that have a chance of succeeding and those that are hopeless, thus boosting servicers´ confidence in their decisions and allowing investors to get a better sense of how their contracts will hold up under the extreme and ever-changing conditions brought about by the financial crisis. This would be progress.

And servicers might be pleasantly surprised.

"I think fear of lawsuits is greatly exaggerated," said Valparaiso University law professor Alan White. "I think the basic problem with investors suing servicers for modified mortgages is that they´d have to prove damages. They´d have to prove that the trust had lost money because of modified loans and in the current environment, with the alternative of foreclosure being even more expensive, it would be hard to do that."

White pointed out that while many servicers have used the fear of lawsuits as an excuse to put off doing loan mods, two servicers have gone ahead at full force. One of them, Ocwen, has made "aggressive" modifications to the mortgages it services, some of which have involved principal writedowns, and has yet to be sued.

Investors that do choose to file suits will be disappointed, White predicted. "The first couple cases are going to lose; they´re going to lose very quickly," he said. "They´re going to lose because no investor is going to be able to show that a well-designed loan modification program is going to lose them more money than a foreclosure."

"Courts will defer to the business judgment of the servicers just as in a case where shareholders sue a corporation to challenge a management decision," he added.

White said servicers should dive into the process of loan mods, and that investors would benefit. Data for the month of January that White collected from investors showed an average loss through foreclosure of $150,000 on a property, with the average mortgage for those properties ranging from $225,000 to $250,000. "So that´s over 50%," he explained. "That´s a very different context for making voluntary agreements to take 10% or 20% off."

Though investors may find real problems with the undermining of contract law that occurs in the event of a loan modification, its outcome may ultimately help them. That´s why, said Mr. White, servicers might find it important to "test the waters and see first of all if anyone is going to bring a lawsuit at all."