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Last week the Department of Justice announced the largest civil settlement ever from a single entity, an eye-popping $16.65 billion from Bank of America. The settlement arose from the handling of residential mortgages by Bank of America and subsidiaries Countrywide and Merrill Lynch.
Here’s this week’s reader question:
I just read about the B of A settlement and I’m wondering how it will affect people who had a B of A mortgage that was then sold to Countrywide? Will we see any monetary relief from this settlement or will it all go to pay off the lawyers and the fines? — Beth
Before we answer Beth’s question, here’s a video we did a few months back called “The Golden Rules of Mortgage Shopping.”
Now, let’s look into what Bank of America did to deserve this unprecedented penalty and if American homeowners will see any of the proceeds.
To understand what B of A did wrong, you first have to wrap your mind around the basics of the American mortgage market. Not to worry: While it may sound mind-numbingly dull, how mortgages work is kind of interesting and not all that complicated.
How mortgage markets work
When you borrow money for a 30-year mortgage, you get a lump sum of cash now in exchange for agreeing to make monthly payments for the next 30 years. But the lender doesn’t want to wait 30 years to collect its money and interest. If it did, it would soon run out of cash and be unable to make new loans.
Solution? Lenders make mortgage loans, then immediately turn around and sell them. The buyer is Wall Street, which packages loans into pools, then sells those pools as securities, aptly named “residential mortgage-backed securities,” or RMBS. The mortgage-backed securities are sold to both institutional and individual investors. (You might even have some within a mutual fund in your 401(k) plan at work.)
Having an active market for mortgage loans allows a lender to give you money for a mortgage and recoup it by selling your loan. It’s then able to lend that same money again, benefiting the next homebuyer in need of a loan. The mortgage-backed securities that result provide investors worldwide with safe, diversified, income-producing investments.
In theory, everybody wins.
But there’s a potential fly in the ointment. Those investing in mortgage-backed securities need to know that the mortgages they’re buying are safe. They need to believe that lenders are carefully scrutinizing borrowers to be sure they can make their mortgage payments. They also need to know that if the borrower can’t pay, the house securing the loan can be sold for more than the loan amount. These are the fundamentals that make these investments sound.
In short, in order for this system to work, lenders have to be careful whom they lend to. Because if too many borrowers default, investors in mortgage-backed securities get burned. And if they get burned, no more mortgage market.
Which leads us to B of A.
What Bank of America did wrong
A Department of Justice press release explains the allegations against Bank of America, Merrill Lynch and Countrywide Financial Corp. Here’s an example:
Merrill Lynch regularly told investors the loans it was securitizing were made to borrowers who were likely and able to repay their debts. Merrill Lynch made these representations even though it knew, based on the due diligence it had performed on samples of the loans, that a significant number of those loans had material underwriting and compliance defects — including as many as 55 percent in a single pool.
In other words, Merrill Lynch knew it was packaging and selling mortgages taken out by borrowers unlikely to be able to repay their debts. But that didn’t stop it from assuring investors the mortgage pools were safe.
Now all that’s left is finding out where the $16.65 billion is heading.
Where’s the money going?
Unfortunately, while the Justice Department did release some details of how the record settlement will be divided, there’s not enough information yet to specifically answer Beth’s question.
Here’s what we know so far.
From the DOJ press release:
Of the record-breaking $16.65 billion resolution, almost $10 billion will be paid to settle federal and state civil claims by various entities related to RMBS, CDOs and other types of fraud.
Bank of America will provide the remaining $7 billion in the form of relief to aid hundreds of thousands of consumers harmed by the financial crisis precipitated by the unlawful conduct of Bank of America, Merrill Lynch and Countrywide. That relief will take various forms, including principal reduction loan modifications that result in numerous homeowners no longer being underwater on their mortgages and finally having substantial equity in their homes. It will also include new loans to creditworthy borrowers struggling to get a loan, donations to assist communities in recovering from the financial crisis, and financing for affordable rental housing.
So while borrowers like Beth may benefit, likely by a small amount, the details of exactly when, who and how much have yet to be announced. She’ll have to watch the media, including this website, for updates.
Is Bank of America in trouble?
If you have money with Bank of America, you might understandably wonder if this spells the end of the banking behemoth. After all, there are probably countries that could be bankrupted by a $17 billion hit, much less companies.
But if you’re worried about the solvency of Bank of America, fear not. According to Bloomberg, the day the settlement was announced, the stock went up as investors bet the bank will see rosier days. They’re probably right. The same article predicts B of A will earn a familiar sum, $17 billion, next year alone.
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The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.
I founded Money Talks News in 1991. I’ve earned a CPA (now inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. If you’ve got time to kill, you can learn more about me here.