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Pensions May Take a Hit from National Mortgage Settlement

Pension investors and bond fund managers have expressed some concern about the $26 billion mortgage settlement announced by the U.S. Government and state Attorneys Generals on Thursday, February 8, 2012. The settlement "is cheap for the loan servicers while costly for bond investors including pension funds," according to Pacific Investment Management Co.'s ("PIMCO") Scott Simon as first reported by Bloomberg Business Week.

Five leading U.S. banks are participating in the agreement, including Ally Financial Inc. (formerly GMAC), Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co. Together, the five banks service loan payments on approximately half of all home loans outstanding, or about 27 million mortgages, according to Inside Mortgage Finance. Other loan servicers are expected to join the program, thereby raising potential benefit levels.

Fannie Mae and Freddie Mac, which together guarantee about 50% of all mortgages in the U.S., are excluded from the settlement.

Of the $26 billion settlement, only $5 billion will be paid in cash by the banks to borrowers who lost their home due to foreclosure. The balance of benefits is calculated as follows:

-- Principal reduction. Underwater borrowers – meaning those who owe more on their mortgage than the loan is worth – will receive at least $10 billion in loan reductions if they are at risk of default.

-- Refinancing. Homeowners who are current on their mortgages may be able to reduce their interest rate by refinancing under more lenient loan-to-value ratios. The value of the refinancing option is targeted at $3 billion

-- Special relief programs. Up to $7 billion is targeted for unemployed borrowers, anti-blight programs, short sales, and service member assistance.

These new mortgage relief programs will be available to homeowners for up to three years. Incentives for loan servicers are written in a way to encourage fast action within the first 12 months.

The settlement will provide direct benefits to borrowers in excess of $20 billion, according to a government fact sheet, since servicers will receive only partial credit for every dollar spent. Some estimates project the economic impact may be equivalent to $32 billion.

Homeowners in Florida and California are expected to be major beneficiaries of this historic mortgage settlement, based on the volume of delinquent loans and a precipitous drop in home values.

Pensions Face Lower Returns on Mortgage Holdings

Pensions, 401(k) plans, and insurance companies are unwitting victims of this record-setting agreement, according to fund managers like PIMCO. Institutional investors lose out when the value of their mortgage-backed securities (“MBS”) decline due to government-induced principal reductions, below-market financing, and forced assistance for the unemployed or military veterans.

Critics Question Projected Mortgage Settlement Benefits

Some critics say the mortgage settlement is too little, too late. While millions of people have lost their homes, for example, the settlement will only affect a relatively small number of them. There is also concern about “moral hazard,” or the danger that more homeowners will default in order to get relief.

In Summary

As states and municipalities struggle to close an already existing $1 trillion gap in unfunded pension liabilities, a potential further reduction in the value of assets is troubling. Plan sponsors and fiduciaries will need to work closely with accountants and auditors to identify any adverse financial impact of the mortgage settlement, and determine off-setting measures to protect funding levels.

February 2012

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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