In the war against rising mortgage delinquencies, industry participants have rallied together to develop a loan modification framework that would not only help borrowers continue to pay their mortgage obligations, but also maximize proceeds for investors.
The latest guidance to hit the market is from the Internal Revenue Service (IRS), which published Revenue Procedure 2008-28 (Rev. Proc.) last month.
The framework allows for certain modifications of residential mortgage loans in REMICS or investment trusts before the loan goes into default, without the IRS challenging the tax status of these vehicles. The guidance also gives servicers a greater command over the modification process, including permission to modify the loan without any direct contact with the borrower, an area where the previous framework has fallen short, market participants agree.
Earlier this year, the American Securitization Forum (ASF) published ASF Streamlined Foreclosure and Loss Avoidance Framework in conjunction with a plan from the Bush Administration that would help "fast track" up to 1.2 million borrowers for a loan modification or refinancing. While the market commended its efforts, most servicers complained that its narrow requirements rejected many of the loans in their portfolios.
"I think right from the start servicers started calling the [IRS] and saying, [the ASF framework] is great, but we have so many loans that fall out of those parameters that we need more guidance on this,'" said Andrea Mandell, partner in the tax group at Thacher Proffitt & Wood.
The ASF said it is currently reviewing and considering whether it will submit comments to the IRS by the July 15 feedback deadline.
While the IRS framework appears to piggy-back off these guidelines, specifically that the property securing the loan should be owner occupied, it gives the servicer more control over the modification process. The Rev. Proc. does not specify that a servicer's program must meet certain conditions or take into account certain factors, like FICO score or LTV ratio, when determining whether a loan is at risk of foreclosure.
"Servicers to date have been modifying loans pursuant to their own programs, so this doesn't upset the apple cart,' if you will, in terms of causing servicers to go back to the drawing board," said Alison Utermohlen, associate vice president of government affairs at the Mortgage Bankers Association.
A Personal Touch
Indeed, many servicers have developed their own proprietary foreclosure-prevention plans, which they are able to utilize under the IRS guidance to determine whether there is significant risk of foreclosure on the original loan. "[The Rev. Proc.] allows servicers to take into account any number of factors that could have a bearing on whether a loan will go to foreclosure or not," Utermohlen said.
The new guidance permits certain modifications prior to an event of default if there is a foreseeable foreclosure event, without challenging the vehicle's qualification as a REMIC or investment trust.
These modifications may include interest rate reductions, principal forgiveness, extensions of maturity and alterations in the timing of interest rate resets, which were not permissible under the REMIC and investment trust rules until the loan went into default.
Under the Rev. Proc., no more than 10% of the stated principal balance of the total assets of the vehicle can be 30- days delinquent or more at the time of the closing date of the transaction. This is to assure that the foreclosure prevention plans are used in loans that were true performing loans.
The framework also does not require the servicer to be in direct contact with the borrower to modify the loan, a notable improvement, according to market participants.
"One of the important points to this Rev. Proc. is that you don't need to actually contact the borrower," Mandell said. "Servicers are having such a hard time because once [a borrower] falls behind, they don't want to pick up that phone call," she said, noting that she has even heard of some servicers offering up gift certificates to Home Depot just for returning their calls.
However, the rules are not without their own nebulousness. One of the areas already drawing comments and questions from the market is the requirement that the 30-day delinquency status of a loan be determined as of the closing date of the deal or the "startup date" rather than the cut-off date, which is what data supplied to investors is based on, according to a report from Thacher Proffitt. Servicers will not be able to look at the delinquency information in the prospectuses or use current delinquency information to evaluate the payment status, which will add more time and expense to the evaluation process.
It is also still unclear whether it is in the best interest of the investors to modify loan or foreclose. Given the current state of mortgage lending and housing markets, it is critical to keep the loans' cash flowing, said Fitch Ratings in a recent report, citing loss severity expectations of 58% for the 2006 subprime vintage and 64% for 2007 collateral.
But since servicers do not have an obligation to the borrower of the house, ultimately servicers are going to abide by the terms of the legal documents and their agreements with investors. In this case, investors may opt to foreclose and sell the property in order to maximize proceeds, Mandell said, although the REO market has diminished.
As for the ratings impact of these modifications, it remains to be seen whether a loan modification will alter the ratings of the REMICs or investment trusts. "The impact that modifications potentially have on any one transaction is highly deal-specific and depends on the circumstances of that transaction," said Vincent Barberio, a managing director in Fitch's RMBS group. Some of these circumstances may include triggers currently passing or failing, the proportion of the loans about to reset and the collateral profile of the transaction, among other things.
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