With subprime borrowers facing resets on interest rates within the next few months and lacking the ability to refinance, loan modifications may be the "best and possibly the only option remaining in order to keep these borrowers in their homes," according to a recent report from Fitch Ratings.
However, conflicting investor interests, plus the time and money needed to modify the loan coupled with the risk of redefault, raise questions whether the juice is worth the squeeze. Market players seem to think so, and volume is on the rise.
Based on projections from servicers, modifications over the next 12 to 18 months could be used on as many as 10% of the loans, based on the original outstanding balance of the deal, and might be the only viable loss-mitigation tool for as much as 50% of the loans in default or facing a default scenario, Fitch reported. Moreover, modifications are increasing in servicers' loss-mitigation programs, with the use of modifications rising to 10% to 20% over the next 12 to 18 months, from less than 1%, Fitch predicted.
However, recent market talk has zoned in on possible discord among investors in affected securitizations. Triple-A investors are perhaps more likely to want servicers to recognize losses as soon as possible and move on, as opposed to work out credit enhancement. More specifically, triple-A investors will be less inclined to modify the loan if the result is a reduction of excess spread and a delay in loss recognition, according to a recent report from Deutsche Bank.
Residual holders, however, may prefer to do whatever it takes to keep the loans from converting in to a loss, despite the potential to reduce excess spread or extend term maturities. Investors in more subordinate positions may also press to renegotiate servicing fees, which are typically 50 basis points, to a higher level in order to create more incentive for loss-mitigation efforts, Deutsche Bank said.
However, the argument might arise only if the servicer requests changes to the pooling and servicing agreement (PSA). If the servicer is doing loss mitigation allowed by the PSA, a conflict of interest within the capital structure should not be an issue, said Thomas Crowe, director at Fitch. "However, if the servicer is restricted in doing modifications by the agreement and seeks to have the PSA amended, then you may see competing interests come into play," he said.
Further, market surveillance will offset abuse of interests. The industry will closely monitor servicers' modification practices, said Kathy Tillwitz, senior vice president at Dominion Bond Rating Service. "If they feel that an abuse is taking place to benefit a residual holder," she said, "they will make it known to the industry and stop investing in that particular firm's bonds, which will cost [the firm] more in the long run than it will gain in the short term."
Redefaults are another cause of concern against loan modifications. Now at 35% to 40%, the redefault rate is expected to increase, according to Fitch's survey, though the rating agency noted that the sample of modified loans is small.
Yet despite the potential to redefault on the loans, buying added time may still be in the loan's best interest. "Even though there may be a high redefault rate for modified loans, if you are able to get cash flow out of the loans for a longer period of time, you may be better off," Crowe said. While the borrower is paying under the modification, there is a possibility that the borrower's financial situation or the property's market value may improve, he said. And the risk of reward from modifications appears to be greater than the automatic loss taken in a foreclosure. "If we foreclose on a property and include all the expenses related to foreclosure, most of these houses will get sold at a loss because we are in a down market," Tillwitz said. "So if you think about it, if 35% of borrowers redefault, there is still a large percentage that won't, so I think it is worth a shot to modify a loan when the analysis indicates there is a strong likelihood that the borrower will pay."
Trial and Error
A trial modification has become a nice segue for market participants into a complete modification of the loan. In a trial modification, the trust can save additional expenses if the borrower can show willingness and ability to make payments under the new terms. The trial modification could average three months, enough to evaluate whether the borrower could make payments under the new structure.
While modifications are situational, one of the more talked about modifications this year entails extending the fixed-rate period on 228 ARMs for another one to two years and re-evaluating the loans.
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