Lehman Brothers is making a lot of noise about its new U.K. RMBS loan modification program through which the firm aims to protect its nonconforming RMBS transactions. The loan modification process consists of a number of potential alternative strategies such as payment deferrals and the extension of maturity dates, among others.
Since 2003, the bank has invested heavily to combine the servicing operations of its U.K. mortgage lenders, Southern Pacific Mortgage (SPML) and Preferred Mortgages (PML), into Capstone Mortgage Services (Capstone), its wholly owned mortgage servicer. Lehman bankers said that the modification program has been in the works over the past five to six months. "We have a reasonable degree of payment shock and lots of our customers won't have refinancing opportunities, so we want to get them to a point where they are re-performing on the loans," a source at the bank said.
Across the U.K.'s nonconforming mortgage sector, a significant number of borrowers who took mortgages out from late 2005 onwards will face marked mortgage payment increases this year as their loans reset after the two-year discount or fixed-rate period. In a recent survey, the Bank of England said that U.K. mortgage rates have risen despite the cut in rates and fall in two-year swaps, a widely used rate benchmark for U.K. mortgage products.
Lehman said that some of its customers face increases as high as 40%. Once the terms of their original loans run out, borrowers would essentially be trapped in higher-rate loans since there are currently no refinancing options for them. "Although the Libor concern has mitigated itself to a fair degree and, over the remainder of the year, we expect the Bank of England to continue its rate cuts, having this program feels like the right thing to do," the Lehman source said. "It's better to be prepared."
A number of market players worry that the loan modifications are just a way to delay the inevitable. With concerns still looming over the continued performance deterioration in the nonconforming sector, some believe that even if the securitization market reopens, there will be limited appetite for this product.
"We see the potential (loan modification) changes as positive for junior notes, where forced disposals can be avoided, maximizing returns," Societe Generale analysts said. "However, for senior notes, the reduced principal payments collected as fewer loans are enforced are a negative, thus reducing CPR rates. It is also unlikely that cleanup calls will be exercised in the current marketplace."
But, particularly for interest-only mortgages, Fitch Ratings said that modifying loans simply postpones defaults instead of preventing them. This effectively means that these loans default later in the life of the deal when excess spread to cover losses is reduced, and, possibly, home prices have declined more severely. Fitch stated that it is watching how the modifications work out before deciding if any rating action is needed on the transactions it rates.
Any foreseeable risk to the senior noteholder would not have allowed the application of the loan modification terms since this would put investors at risk, the Lehman bankers said.
"We recognize customers that won't be able to pay and we can see how changing the terms would get them current on payments," a source on the Lehman loan modification team said. "It's true that when we look for an affordable payment scheme, we don't consider how that will affect the junior versus the senior noteholder but in the end, what this technique does is maximize cashflows for the securitization as a whole."
While the Lehman team recognizes that there is a potential for defaults, the source said that they aim to stay as transparent as possible by offering investors monthly data takes. The team has drawn on the extensive servicing and risk management experience within Capstone, the trading and risk management expertise within Lehman's fixed-income business and the direct experience of the team's U.S.-based servicing colleagues.
By the end of 1Q08, the special servicing operation will have approximately 230 staff members. Capstone is also on target to increase staffing for its collections and litigation division by 78%, from 90 to 160 by the end of the first quarter.
"Modifications also benefit the wider market as reduced volumes of forced disposals reduce the likelihood of rapid house price declines," SocGen analysts said. "For those shorting junior tranches, the news will prove as unwelcome as U.S. subprime modifications, but for those with long credit risk, it will be broadly positive with some negatives on principal timings."
This is a positive story for Lehman, particularly because, unlike its competitors, it has its own internal staff. "Outsourcing to people like Homeloan Management causes more constraints," one source said.
"We have more flexibility and more control and, as we move on, we believe that increasingly people will look to servicing as an integral part to how these deals perform."
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