Research support for this article was provided by the Investigative Fund at The Nation Institute.   Just as the American housing market was starting to recover from its worst battering since the Great Depression, a new scandal, an epidemic of flawed or fraudulent mortgage documents, threatens to send not just the housing market but the entire economy back into a tailspin. As we go to press, forty-nine state attorneys general have announced an investigation of the mortgage-servicing industry, in the wake of decisions by Bank of America, JPMorgan Chase, Ally Financial’s GMAC and other banks to suspend some foreclosures, and amid demands by some lawmakers for a nationwide moratorium on all foreclosures.

It’s impossible to tell at this early stage how deep the new crisis extends, but as they begin their investigation, the attorneys general would do well to re-examine the deeply flawed 2008 agreement with Bank of America in resolving the Countrywide Financial scandal, the largest anti–predatory lending settlement in US history. If they do, maybe they’ll get it right this time.

On October 6, 2008, a scant three weeks after Lehman Brothers filed for bankruptcy, with the financial crisis in full swing, California Attorney General Jerry Brown called a press conference in San Francisco. He announced that day, to great fanfare, "the biggest loan modification in American history." Brown joined Illinois Attorney General Lisa Madigan in leading negotiations for eleven states that had sued Countrywide, the largest mortgage lender in the country. He held up Countrywide, which had been acquired by Bank of America some months earlier, as a symbol of all that had gone wrong in the housing bubble.

"Countrywide exploited the American dream of homeownership," Brown said in announcing his lawsuit the previous June. He charged the lender with deceiving borrowers by misrepresenting loan terms, hiding scheduled payment increases and persuading people to sign up for loans they couldn’t afford. "Countrywide was, in essence, a mass-production loan factory, producing ever increasing streams of debt without regard for borrowers," he said. "Californians…were ripped off by Countrywide’s deceptive scheme."

When Madigan announced her state’s lawsuit, she took to the stage with a single mother who’d lost her home after refinancing a fixed-rate loan with one from Countrywide featuring a ballooning adjustable rate. "Borrowers were in loans that they didn’t understand, they couldn’t afford and they couldn’t get out of," Madigan said. "The failure of these loans is what has caused the foreclosure crisis here in Illinois and across our country. And the aim of today’s lawsuit is to hold Countrywide accountable."

If all fifty states were to sign on to the settlement, Brown’s office estimates (forty-four have so far), it would provide $8.68 billion in reduced payments and fee waivers to some 400,000 Countrywide borrowers struggling to stay in their homes. And a small Foreclosure Relief Fund of $150 million would provide direct payments to Countrywide borrowers who have already lost their homes to foreclosure. Various media called the settlement a "landmark," "a win for homeowners" and "the nation’s most comprehensive mortgage-modification program," reporting that 8,000 homeowners in Ohio, 13,000 in Arizona, 57,000 in Florida and 120,000 in California would all "escape foreclosure" through major loan modifications. Relief Is in Sight, read one headline.

But two years later, many Countrywide borrowers facing foreclosure have not even been notified that they may qualify for the settlement. It has kept, at best, about 134,000 families in their homes, and most of these only temporarily. Countrywide and its parent company, Bank of America, have blocked many subprime borrowers from access to the best aspect of the deal—principal reduction—in favor of short-term fixes that could easily spell disaster down the road. The settlement is silent on the question of second liens—home equity loans—which have played such a significant part in the foreclosure crisis, jeopardizing the possibility of truly affordable modifications. And the biggest loophole of all? Bank of America has the right to foreclose on the victims of Countrywide’s predation whenever its analysts determine—using an undisclosed formula—that it can recoup more money through foreclosure than by modifying the loan.

In fact, the settlement has functioned more as loss mitigation for BofA and investors in mortgage-backed securities than as recompense for victims of predatory lending, says Alan White, an associate professor of law at Valparaiso University and an expert on the subprime crisis. "You are not actually asking [Bank of America] to give up money," says White, who frequently testifies before Congress on mortgage issues. "You are asking them to do something that will make them more money or mitigate their losses. It is a weird way to have somebody pay for past misconduct."

"The state attorneys general have done far more than anyone else, and they were under tremendous pressure not to act," says William Black, an associate professor of economics and law at the University of Missouri, Kansas City, and a federal fraud investigator during the savings and loan scandal. "That said, the settlement does not go to the basic problem, which was fraud by Countrywide."

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The lawsuits described a vast "conspiracy" in which Countrywide provided financial incentives to large networks of brokers in exchange for their duping borrowers into taking out toxic loans. In violation of state law, brokers concealed or misrepresented the steep monthly payment increases borrowers faced when mortgage rates readjusted a year or two down the road.

For several years, the scam worked. Countrywide grew from originating $62 billion in loans in 2000 to more than $463 billion in 2006, while the lender’s securities trading volume more than quintupled, from $647 billion in 2000 to $3.8 trillion in 2006. The company’s CEO, the flashily dressed and perma-tanned Angelo Mozilo, became one of the highest-paid executives in the nation, with an influence on markets approaching that of Alan Greenspan.

The state lawsuits expose just how Countrywide built its sprawling empire. One common loan product that came under harsh criticism in the lawsuit was the hybrid adjustable rate mortgage, or ARM, in which mortgage rates were fixed for two to three years while borrowers made interest-only payments. Afterward borrowers got hit with "payment shock" when mortgage principal was added onto their monthly payments just as the starter interest rate converted to a variable rate that could shoot up to as high as 15 percent.

Brown’s lawsuit charges that Countrywide’s goal was to generate loans that paid the highest possible interest rate—not loans that offered the best deal for their customers. Low-income, first-time homebuyers became some of the best targets: the riskier the loan, the higher the interest rate. Countrywide packaged many of these loans into mortgage-backed securities and sold them to Wall Street for windfall profits. Securities comprising Countrywide loans were in turn used to structure collateralized debt obligations, or CDOs, the implosion of which almost brought down the US financial system. Risky Countrywide loans were linked to some of the most toxic CDOs. On July 24, 2007, when Mozilo announced in a call with Wall Street bankers that housing prices would collapse on a scale not seen since the Depression, widespread panic ensued. By the end of 2007, according to Countrywide’s own estimates, a staggering 27 percent of the lender’s subprime loans were delinquent.

Once disaster struck, a quick settlement with the state attorneys general, under which Countrywide accepted no guilt and faced little financial liability, was not such a bad deal for the company. The settlement required Countrywide to make only 50,000 loan modifications nationwide and did not set a dollar amount on how much these modifications had to save borrowers. Most of the loans covered by the settlement fell into one of two major types issued between 2004 and 2007, at the height of the housing boom. One was the notorious pay-option ARM, in which the loan balance increased each month for borrowers who made only the minimum payment. Countrywide absurdly classified these loans as "prime" products—even though many of them went to borrowers with very low credit scores—making it easier to sell them on the secondary market. The other was the subprime ARM, which had a fixed interest rate for a set period and then an adjustable rate for the remainder of the term.

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To comply with the settlement, Bank of America set up the Countrywide National Homeownership Retention Program as a vehicle for providing relief. And the deal appeared, at first, to provide it. Eligible borrowers, according to Brown’s analysis of the deal, may be considered for a range of modifications. Those with pay-option ARMs can reduce their outstanding balance to 95 percent of their home’s current value, getting them out from under water. In addition, borrowers with subprime ARMs may qualify to pay interest for only ten years, get interest-rate reductions and even have their interest rate permanently capped at the introductory rate. But Countrywide has no obligation to offer these terms to any particular eligible borrower.

A key weapon in BofA’s arsenal is something called a foreclosure avoidance budget, which gives the bank the option of foreclosing on homeowners whenever, in the judgment of the bank’s analysts, more money can be recouped by foreclosing than by modifying the loan. Housing advocates speak with frustration of how BofA often refuses to grant modifications to eligible borrowers, based solely on the bank’s analysis of its foreclosure avoidance budget. Yet bank officials have refused to make public how they calculate that budget. Lisa Sitkin, a lawyer with Housing and Economic Rights Advocates, an Oakland-based nonprofit, says she repeatedly attempted to obtain that information from BofA. "One of the things we kept asking," she says, "is, Can we see those analyses? Can we see the foreclosure avoidance budget? The answer was always no." In the end, she simply gave up on using the Countrywide settlement as a means of helping borrowers. Even information on how many homeowners are facing foreclosure under the foreclosure avoidance budget is not publicly available. I requested these numbers from the California attorney general’s office, which directed me to Bank of America, which refused to divulge the data.

Last January I interviewed Terry Francisco, Bank of America’s senior vice president for public relations and communications, at a meeting between BofA executives and distraught homeowners in a church in Antioch, California, and he said something telling: "We don’t call it a settlement, but our agreement with the attorneys general." Apparently BofA doesn’t believe it owes anybody anything.

Despite Bank of America’s failure to help hundreds of thousands of homeowners ruined by Countrywide, the bank claims it is on track to fulfill its obligations under the settlement. According to the one publicly available page of a quarterly compliance report the bank is required to file with the state attorneys general, as of the end of the second quarter of 2010, BofA had modified a total of 134,217 loans under the settlement, achieved an expected interest and principal savings for borrowers of $3.4 billion and provided $177.6 million in relief to people who had lost their homes to foreclosure.

These numbers look impressive, at first glance. But a September 2009 study by Citibank of the loans covered by the settlement projected that 50 percent of the modified loans are so untenable they will re-default within a year. The terms being offered are so bad that many lawyers are not bothering to seek relief, says Nathan Fransen, an attorney representing underwater borrowers northeast of Los Angeles. Fransen estimates that in the past three years he has worked with about 1,000 clients seeking modifications, half of them from Countrywide. He projects that for borrowers who get the five-year, interest-only payments, there is going to be major trouble down the line. "We haven’t seen the effect yet," he says. "They took them out of one loan that was a ticking time bomb and put them into another loan with ticking time bomb features."

Bank of America officials concede that re-default is a major threat, projecting a rate of 20–30 percent. But they claim most of these defaults will be a product of growing unemployment, not unfair loan modifications. Housing counselors and attorneys tell a different story. They say the modifications BofA is offering under the settlement are not sustainable even for many borrowers with jobs. "As far as I know, none of our clients have gotten a modification under this program," says Sheri Powers, an attorney and director of the Unity Council, a nonprofit community development corporation based in Oakland. "The offers I have seen so far are basically a low-interest-only, fixed rate for five years, and then the loan converts to a principal and interest, which of course, depending on the total amount due, could be a huge jump in the person’s total monthly payment."

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As it turns out, BofA has had good reason not to make its modifications affordable for mortgages now owned by a third party, such as the public employee pension funds that invested heavily, and disastrously, in Countrywide’s mortgage-backed securities. From 2004 to 2007, the years covered by the settlement, Countrywide sold most of its first-lien subprime loans as mortgage-backed securities or loan packages, but it generally kept the lucrative servicing contracts. BAC Home Loan Servicing (formerly Countrywide Home Loans Inc.), Countrywide’s servicing arm, acts as a bill collector, gathering mortgage payments from borrowers and distributing these payments to the investors who actually own the mortgages. Servicers earn a small percentage of mortgage payments, but what has made the business especially profitable are late fees and other ancillary costs such as property inspections, collected from borrowers in delinquency and in default.

Those revenues will be lost through the settlement with the state attorneys general, which requires BofA to waive outstanding late fees for delinquent Countrywide borrowers who receive a modification. But BofA can start the lucrative late-fee gravy train all over for all the borrowers who re-default on modified loans—a staggering number, if the Citibank projections prove to be accurate. When these financially exhausted borrowers finally go into foreclosure, any outstanding late fees can be tacked onto the bill BofA submits to investors.

Only about 12 percent of the first-lien loans initiated by Countrywide remain on BofA’s books. Investors in mortgage-backed securities, including major pension funds like CalPERS (the California Public Employees’ Retirement System), own the other 88 percent, and it is these investors who will bear most of the expense of complying with the settlement, in the form of permanently reduced principal and interest payments on their bond holdings. Believe it or not, this aspect of the deal was overlooked by the settlement. Richard Blumenthal, attorney general of Connecticut, one of the original parties to the suit, seems to have missed it entirely, claiming in his October 2008 announcement, "This settlement will cost BofA as much as $8.6 billion, but no cost, not a dime, to taxpayers."

In fact, as it turned out later, much of the settlement’s cost would be covered by taxpayers. Bank of America is allowed to use federal incentives under President Obama’s $75 billion Home Affordable Modification Program (HAMP) toward the loan modifications it is required to make as the mortgage servicer for the Countrywide portfolio. In total, of its entire Countrywide financial servicing portfolio—which goes beyond the loans covered by the settlement—BofA is eligible for as much as $4.5 billion in federal incentives for completed modifications, according to an analysis by the Center for Public Integrity as reported in Mother Jones. That’s a hefty government rebate.

There are indications that Bank of America’s slow progress on loan modifications is intentional. Many service providers on the front lines of the crisis were unaware of the settlement more than a year after it took effect. Take Walter Dees, a team leader in the housing department of Clearpoint Credit Counseling, a HUD-approved counseling agency in Los Angeles. Of the hundreds of Countrywide borrowers he’s tried to obtain loan modifications for, "not one of them has mentioned anything regarding the attorneys general modification," he says.

Why don’t borrowers know about the settlement? If they received a notification letter like the one Bank of America officials gave me after weeks of prodding, they would have no clue they were one of the covered homeowners. Nowhere in the letter is there explicit mention of the settlement. There’s no mention of borrowers’ rights, such as waiving of late fees for those who qualify for modification. And the letter fails to mention the settlement’s most attractive modification option: principal write-down, the only measure that could make a significant difference to borrowers who have seen the value of their homes decline by 50 percent or more.

Bank of America’s opaque public outreach apparently passes muster with the California attorney general. An official in the AG’s office who declined to be named told me the notification letter "is not necessarily going to reference the settlement." He went on to express concern about the plaintiffs themselves, the very people the settlement was designed to protect. "There is a moral hazard problem with all of this, which is that you don’t want to encourage borrowers who can afford their loans to default, or borrowers who don’t believe they were victims of fraud to default," he says. "So there is a fine line that had to be walked in figuring out how to publicize, announce and communicate with borrowers."

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The settlement’s most fatal flaw may be its failure to cover second liens. Bank of America still owns a large number of Countrywide’s second liens outright, including its once popular Home Equity Lines of Credit (HELOCs). Today the bank is the largest holder of second-lien loans in the country, which are valued at $145 billion. (Second-lien loans, which are tacked onto the original first-lien mortgage, include home-equity loans used to finance everything from home improvements to hospitalization to coverage of 15–20 percent of the purchase price of a house.)

Brown alleges that Countrywide employees broke the same laws in selling those loans as they did in selling first liens. According to the California lawsuit, Countrywide loan officers "further[ed] their deceptive scheme" by "urging borrowers to encumber their homes up to 100% (or more) of the assessed value; and placing borrowers in ‘piggyback’ second mortgages in the form of higher interest HELOCs while obscuring their monthly payment obligations."

A settlement that covered second liens would have improved the prospects for victims of Countrywide’s predations. Federal officials and mortgage analysts have identified second liens as a major factor in at least half the mortgages in danger of default. Such a loan works against borrowers in several ways. Not only does it stick them with a greater debt burden; it also stands in the way of principal reduction on the first mortgage, since a second lien must usually be wiped out before principal can be written down on the first loan.

The attorneys general seem to have left this gaping loophole for pure expediency. "We do allege misconduct related to the origination of second liens and HELOCs," says the California AG official. "However, for purposes of settling the case, we wanted to craft a settlement that, while not perfect, would have the most effective chance of saving homeowners as quickly as possible. We were in a situation where the housing crisis was expanding by the moment. They [Bank of America] could have dragged out the negotiations for two years, during which time innumerable residents of California and other states could have lost their homes to foreclosure."

Earlier this year Bank of America finally indicated some willingness to address the second-lien issue. On January 26 the bank announced to much positive press that it was the first servicer to sign up for a resuscitated federal effort known as the Second Lien Modification Program, which the Obama administration had been trying to get off the ground since spring 2009.

In March, facing additional legal action over Countrywide’s predatory lending practices, Bank of America reached another settlement, this one with Massachusetts. Under that deal, the settlement Brown negotiated was expanded—Bank of America would now offer principal reductions to about 45,000 severely underwater Countrywide borrowers. Notably, BofA will offer these principal reductions only to borrowers who qualify for HAMP, under which the bank gets bailed out by taxpayers.

The Countrywide settlement, says Kevin Stein, associate director of the California Reinvestment Coalition, a statewide organization that advocates for low-income communities, has failed to protect homeowners who were the victims of predatory lending on an epidemic scale. "Fraud and predatory lending really created this crisis we are in, and nobody is taking that into account," says Stein. "That was a concern we had with the original settlement. They don’t admit any fraud."

Now state attorneys general might finally have an opportunity to help the thousands of defrauded Countrywide borrowers who have fallen through the cracks. On October 8 Bank of America announced that it was temporarily suspending foreclosures in all fifty states in response to revelations of false or fraudulent documentation and at least one BofA "robo-signer" who approved thousands of foreclosure papers without proper review. Even so, BofA appears confident that it has done nothing wrong. "We will stop foreclosure sales until our assessment has been satisfactorily completed," states a BofA press release. "Our ongoing assessment shows the basis for our past foreclosure decisions is accurate. We continue to serve the interests of our customers, investors and communities. Providing solutions for distressed homeowners remains our primary focus."

It’s up to the attorneys general, in their newly announced investigation, to hold BofA to its word.