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.
Apart from the kind of fraud exposed in the Fremont case, a great deal of subprime lending at the height of the mortgage frenzy was targeted at African-Americans and Latinos. Comparing borrowers of comparable economic profiles, a Federal Reserve study of home purchase lending in 2006 revealed that 30 percent of loans to African-Americans had subprime features, while only 17 percent of loans to whites had such features. Studies also show that anywhere from 35 to 60 percent of subprime borrowers qualified for prime loans but were steered to subprime loans instead. Research by The New York Times of lending in New York City found that middle-income African-American borrowers were more than five times as likely to hold a subprime loan as whites of similar, or even lower, income. A study of Chicago-area lending revealed that African-Americans earning more than $100,000 a year were more likely to take out a subprime loan than Asian-Americans, whites, and Latinos earning less than $35,000 a year.
Such lending patterns are troubling, but they are also illegal under federal fair lending laws. To date, two types of lawsuits have been filed alleging violation of fair lending laws in mortgage lending: class action lawsuits by borrowers and suits by cities and one state for discriminatory lending practices.
In one series of lawsuits, classes of African-American and Latino borrowers allege they were discriminated against by certain lenders. In these lawsuits, borrowers of color allege that they were offered loans on terms that were more expensive than white borrowers of similar economic profiles. The litigants often point to the more widespread use of yield spread premiums (YSPs) in loans made to borrowers of color. YSPs are commissions paid to mortgage brokers when they convince borrowers to enter into loans at a higher interest rate than the bank would otherwise offer those borrowers. The borrowers do not know that the bank would have offered them a better rate. Because many of the lenders that are defendants in these class-action lawsuits have filed for bankruptcy, the plaintiffs have settled — or are negotiating settlements — through the bankruptcy process.
In the second type of fair lending lawsuit, cities like Baltimore, Md.; Birmingham, Ala.; and Memphis, Tenn., have filed actions against several banks alleging that they steered African-American borrowers to higher-priced subprime loans. The Baltimore and Memphis cases were filed against Wells Fargo, the Birmingham case against Citigroup.
The details of the Memphis case are telling. Former bank employees described a bank culture where African-Americans were targeted for subprime loans because they were seen as less sophisticated and less knowledgeable about the mortgage market: Thomas [a former bank employee] explains that “[i]t was generally assumed that African-American customers were less sophisticated and intelligent and could be manipulated more easily into a subprime loan with expensive terms than white customers.”
The plaintiffs have alleged that Wells Fargo’s subprime lending in the region was carried out along racial lines, with stunning maps to back them up. Similarly, Illinois Attorney General Lisa Madigan has initiated a suit in state court against Wells Fargo alleging discriminatory lending in the Chicago area.
To date, these lawsuits have met with little clear success. After early victories in the Baltimore litigation, the case was dismissed on the grounds that the city could not prove that the harms it suffered due to falling tax revenues could be traced to specific properties on which Wells Fargo held the mortgage. A refiled narrower version of the complaint was also dismissed. The Birmingham case has been dismissed on similar grounds. There has been no judicial action on the Memphis and Illinois litigation to date.
Don’t Give Up Too Soon
Apart from the results in the Countrywide and Fremont cases, clear-cut victories in the mortgage arena may seem elusive. Indeed, another lawsuit, filed by the city of Cleveland against a host of investment banks for promoting loans in a market like Cleveland’s where they were doomed to fail, was also dismissed last year. The city appealed to a three-judge panel of the Court of Appeals for the Sixth Circuit. In July, that panel affirmed the lower court ruling and the city is seeking another hearing by all of the judges of the court. But the toxic tort model of litigation rarely results in landmark judicial rulings and sweeping jury awards. Rather, a hallmark of toxic tort litigation is that lawsuits often lead to settlements. Victories for the plaintiffs convince defendants that it is more costly to litigate cases through to jury trials — where juries might side with the plaintiffs — than to try to reach a global settlement that buys the defendants peace. Asbestos litigation, tobacco litigation, and many lawsuits over defective drugs have unfolded in this way.
If toxic tort-style litigation in the mortgage arena could achieve a few more notable victories, this could convince banks to reach out to borrowers to reduce the risk of future litigation. This could be a powerful tool to bring modifications to the necessary scale. To date, the Obama administration’s mortgage modification efforts have led to just 340,000 permanent loan modifications, while nearly 8 million borrowers are in the foreclosure process or at least 30 days past due. Through the Countrywide settlement described above, roughly 100,000 loans were modified (and a recent expansion of that suit in Massachusetts promises to result in more). Thus, lawsuits against a single bank produced almost one-third the number of voluntary modifications reached with all banks combined. And litigation-induced modifications often stand a greater chance of long-term viability. Litigation, and not voluntary overtures, is more likely to lead banks to do things they otherwise see as unpleasant and harmful to their bottom line, such as principal reductions.
There are some obvious barriers to a toxic tort-style approach to mortgage abuses. Many of the lenders responsible for the mortgage crisis have gone belly-up. According to the mortgage lender “Implode-o-Meter,” nearly 400 subprime lenders have closed their doors since 2006. Those companies’ assets will likely have already been distributed to creditors, and there is no way to access salaries and bonuses paid to bank executives for making these predatory loans. But some banks that are still standing, like Wells Fargo, originated their own loans, and could be defendants in mortgage litigation. And other national banks and investment banks either used subprime lending subsidiaries, or partnered with subprime lenders to generate loans to package as subprime securities. To the extent such banks worked closely with mortgage lenders to target certain communities, or to use questionable products, they too could be targets.
A second barrier is the fact that few borrowers have access to lawyers with the resources to bring these cases. A small number of plaintiff-side law firms have carried out the lion’s share of the litigation described above, but such lawsuits are costly, and require a significant outlay of staff time without any guarantee of compensation. This would be a good place for public officials to step in with public resources to prosecute a number of high profile cases, whether for fraud, discrimination, or both. A few victories would help attract the private lawyers who could bring more sweeping and comprehensive litigation.
Several notable attorneys general, from states like Massachusetts, Illinois, and California, have stepped up efforts to prosecute mortgage fraud and discrimination. The U.S. Department of Justice recently announced the creation of a fair lending unit that will target mortgage discrimination. It also has embarked upon “Operation Stolen Dreams,” which is designed to root out mortgage fraud and has already netted over 500 arrests.
But there is little connection between these efforts and the modifications pursued by Treasury. In fact, the federal government is pouring money into incentives for loan servicers and banks to convince them to modify mortgages voluntarily. Perhaps a share of those funds could be diverted to fraud investigations and litigation.
Whether a mortgage lender pumped up the interest rate without the borrower knowing, gave misleading information to the borrower about the impact of an adjustable rate, or preyed on a borrower of color because of her race, such illegality needs to be rooted out and borrowers freed from the burdens of loans tainted by such practices. There is a long history of attacking toxic products in the courts in order to obtain justice for individual victims and affected communities. There is no good reason to treat tainted loans in any other way.