At the end of April, the Obama administration announced modification incentives for second lien loans under the Hope for Homeowners program.
Under the new incentives, when a Home Affordable Modification is started on a first lien, servicers that are part of the second lien program will automatically reduce payments on the associated second lien based on pre-set rules.
Alternatively, those servicers will have the option to extinguish the second lien in return for a lump sum payment. This lump sum will be calculated according to conditions set out by the U.S. Treasury Department. This, in effect, allows servicers to target principal extinguishment for borrowers where this is most appropriate.
"It's interesting because when this was first announced it seemed like it was a well kept secret, I only saw a couple news releases on it," said Cheryl Lang, president of Integrated Mortgage Solutions. "My fear was no one would know about this and that yet again those who are designing these programs to help homeowners are not necessarily part of the mortgage business."
Lang said that tracking the owners of the first and second lien loans would be difficult even if both loans are retained by the same servicer. "These two are not tied together and there will be reporting problems," she said. "It's going to be a difficult road to make this successful."
Even for subprime and Alt-A mortgages, about 50% of the distressed loans have a second lien with 20% of the value of the property and use that as a down payment to skirt around paying mortgage insurance. These loans were also often sold servicing released to other servicers. So even these mortgages could be all over the place, according to Lang.
One of the problems, she added, is that there are different ways of going through the waterfall, with the Treasury and both the GSEs having different ways of doing so.
"There are three different things in the modification space, that's going to make it difficult successfully implement those," Lang said.
She explained that sometimes refinancing the loan becomes the better option. "If you go through the waterfall and you have the second lien to deal with, sometimes it's best to just refinance the loan," she said. However, borrowers still have to qualify in order to refinance.
Meanwhile, servicers have a monumental task in front of them, and sometimes have to ask third parties for help with all the different tasks at hand and just to make sure they are in compliance with the investor agreements. Lang said that servicers have taken to outsourcing a piece of the work, stages of it, or even all of it.
"It's a very labor intensive project and servicers' systems are not equipped to do these things," Lang said. Additionally, even though the government is giving servicers sufficient compensation to help homeowners out, the difficult thing would be focusing on the success rates in implementing the second lien program.
Even with these encumbrances, many market participants were positive about the inclusion of incentives for modifying second liens in the Hope for Homeowners program.
"The proposal for the second lien program was highly important because it was a missing piece to the puzzle of the mortgage crisis," said Michael Youngblood, a principal at Five Bridges Capital. "As to whether the financial incentives offered to second lien holders and servicers are adequate, only time will tell, but it's a plausible, good faith effort to fill in a missing piece of mortgage finance."
Youngblood said that there is a higher likelihood of success for the program if the first lien and second lien are held by the same servicer. This is because there would be more consistent information available about the loan and the borrower's financial capacity, and the servicer would be able to maximize the net present value of both mortgages.
When the first and second mortgages are serviced by different parties, and there is a nonzero recovery on the first mortgage, then the servicer of the second mortgage will often decline to waive his or her interest in the loan without some financial consideration or partial payment. A common servicer for the two could align the interest of the first and second lien holders. This would incentivize the second lien holder to agree to the overall modification, therefore allowing the borrower to remain in the home.
"There is a natural antagonism between the first and second lien holders, which will not be resolved as smoothly if the loans were with different servicers," Youngblood explained. "The consent of the second lien holder would generally have to be obtained for the re-subordination of the loan and, obviously, he or she will try to maximize the present value of the loan."
The interest on the second is reduced to 1% or 2% on the government's program, and there is a sharp reduction of the principal, which will be reduced pro-rata with the first mortgage. "But this is clearly a superior result compared with just a cursory $1,000 dollar quick payment offered in many cases," Youngblood said. "It puts the second lien holder in the position of greater recovery and avoids recognition of loss of the full mortgage amount in the current accounting period."
Youngblood said that, given that institutions would like to defer a loss, this is a material benefit. "It's a plausible program essential to increasing the numbers of first liens that could be modified," he said.
He added that for loans that are guaranteed by Freddie Mac and Fannie Mae, it's more than likely that the first and the second lien are being serviced by the same company. It is different in the non-agency space, where the originators of the loan are usually defunct commercial banks such as Accredited Home Lenders, New Century Financial Corp., Saxon Mortgage and Novastar Financial.
Mod Plan's Application
The application and effects of Obama's second-lien modification plan will be less clear-cut when compared to first-lien modifications. "While the possible complications that exist for second liens hold true for first liens as well," said Matthew Tomiak from 12th Street Capital, LLC. "the much higher severities in second liens, as they stand behind the first liens in priority, and the addition of interested parties, such as monoline insurers, will further complicate the process."
Because of the added credit enhancement in second lien securitizations, such as monoline and mortgage insurance policies, the effects of the Obama plan on bond cashflows and credit triggers will be more convoluted, according to Tomiak.
He also added that, "with monoline and mortgage insurance providers experiencing solvency issues, they are going to look at the language governing policy draws with a fresh set of eyes via their legal departments as well as external regulators who are now more involved in their day-to-day operations."
He said the intent of the monoline policies in many transactions, to keep parity between the loans and bonds, may be lost in the dissection of words in the applicable contracts governing any particular securitization by monolines, trustees, servicers and regulators.
Tomiak explained that the lack of standardization in pooling and servicing agreements and monoline policies will make understanding the effects of modifying second liens a case-by-case task. Though principal forgiveness, in most instances, will cause a recognized loss which would be passed on to a monoline, certain issuer's pooling and servicing agreements do not recognize partial losses, so only a total forgiveness of debt would be recognized in the current period. Additionally, because certain issuer's transactions (such as GMAC) require a monoline payment to cover actual recognized losses while other's (such as Countrywide) require a monoline payment based on a reduced stated loan balance, there is a potential discrepancy between transactions on how otherwise equivalent loan modifications at the servicer level will be recognized at the securitization level.
The effects of principal forbearance will be much trickier to assess as most pooling and servicing agreements do not offer specifics on how principal forbearances should be treated. In fact, Tomiak explained that a servicer's classification of a principal forbearance will have a considerable impact on bond payments. For instance, one servicer may report a principal balance on the loan that excludes the amount of the forbearance whereas another servicer may include the amount of principal forbearance in the reported principal balance of the loan (since the borrower ostensibly still owes that amount).
In this way, depending on the method of reporting, one issuer's deals may experience a realized loss and a corresponding monoline payment, while another issuer's deals would not experience a realized loss. For deals where a loan is written down and a corresponding loss applied to the deal, any repayment of the forbearance would be treated as a subsequent recovery.
"These issues will likely slow the mass roll out of second lien modifications as servicers will need to understand how to report, and trustee's and paying agents will need to determine how to interpret, the impact of the modifications within the four corners of the related securitization documents," Tomiak said.
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