With the massive number of bad loans that servicers are being bombarded with, these companies are faced with seemingly insurmountable capacity, legal and tax issues. Can they handle the onslaught?
Modifications continue to receive bad press because of the subprime association, which makes servicers and lenders nervous about adopting an overall "modification strategy" relating to the portfolios they service, said Cheryl Lang, president of Integrated Mortgage Solutions.
According to Moody's Investors Service, there is a re-default rate within 10 months of roughly two thirds of subprime loan products modified at the end of 2007. Clearly, this shows that typical modifications are not effective means of loss mitigation.
"With the servicing agreements unclear or silent regarding any type of modification of the existing terms of the loan, it makes it even more challenging for the lender or servicer to adopt any type of loss mitigation strategy until the GSEs or the Mortgage Bankers Association take the lead," Lang said. "I believe that will be seen within the very near future, within a matter of weeks or a couple of months."
The mortgage banking industry, she said, is working together to come up with creative loss mitigation strategies that include more than just a reduction of rate for a short-term period - which is what most servicers and lenders have adopted as a short-term solution to a long-term problem.
She added that the market "will see many options to keep borrowers in their homes." These options include rate reductions with loans that recast with a 40-year amortization and balloon in 30 years. She also mentioned adding arrearages to the loan balance. These could be arrearages of principal, interest, taxes and insurance or whatever the issue is that is preventing borrowers from retaining their home. This would be done along with writing down balances to the appropriate loan-to-value ratio, as well as offering interest-only loans for a stated period of time. "Affordability is the key," Lang said.
Bill Berliner, a financial consultant based in Southern California, said there is an inherent tension in how loan modifications work and how servicers conduct their business.
"The administration's efforts to increase modifications haven't really borne fruit because of the fundamental nature of servicing," Berliner said. "Servicers would like to accomplish their work as efficiently as possible while modifications require that you look at individual borrowers on a case-by-case basis."
For instance, Berliner said that there are cases where the interests of the first- and second-lien holders are not aligned and the second lien holder can veto a modification. An example of this conflict is where a potential short sale is involved. If the servicer wants to sell the property at a loss, the second-lien holder will take a complete loss in most cases. Therefore, the second-lien holders have an interest in hanging on to the loan, while the first-lien holder might want to go ahead and pocket something on the sale.
Rating Agency Issues
One of the trends that analysts from Moody's are seeing is a move toward servicers streamlining evaluations of borrowers, even for loans that are current, according to Bill Fricke, vice president, and senior credit officer, and Gene Berman, analyst, at the rating agency.
With the increase in problematic loans, Fricke said that the servicers are dealing with capacity issues by focusing their efforts on the loss mitigation side of the business, transferring resources from other parts of the business, including underwriting.
Fricke said that the recent downgrades by the rating agency on the servicing side were based on the financial stability of the company - rather than the performance of these servicers.
"We look at a servicer's ability and stability in rating servicers - key metrics that we focus on are collection roll rates, loss mitigation results, and foreclosure and real-estate-owned (REO) timelines," Berman said. "Financial stability, management experience, technology and staffing also all roll up to our overall rating. We are currently heavily focused on loss mitigation."
With servicers experiencing capacity constraints, the issue now, according to Moody's analysts, is whether a given staff has the relevant experience in collections and loss mitigation. Compared with other asset classes such as autos and credit cards, there are more workout alternatives that need to be offered in the mortgage sector, and there is also more exposure to the servicing company.
One issue that is becoming more prevalent is the ramp-up in loss mitigation by second-lien servicers, said Fricke. "There is some communication that needs to go on between the first- and second-lien servicers, although it's much easier if it's the same servicer for both loans, as this could be done simultaneously," he said.
Berman added that principal write-downs at this stage are not used frequently. What the market is seeing, according to Berman, are servicers trying to be proactive in the initial stages by offering trial periods on modification, which often last for three months; when this period expires, a more formal modification is initiated. "This reduces the re-default rates on these mortgages," he said.
Legal Considerations
Steve Molitor, a partner at Dechert, said that performing modifications might be limited by a number of factors.
Servicers are typically required to act in accordance with "accepted servicing practices" and in the best interest of the securitization trusts, so modifications generally must be consistent with prudent market practice.
Servicers are faced with contractual and tax issues that they have to deal with in modifying loans, said Stephen F.J. Ornstein, a partner at Thacher Proffitt. "Servicers are contractually obligated to act in the best interest of the investor and they have to service loans to maximize the proceeds of the trust," he said.
He added that with these contractual and tax considerations, there's a limit to the number and type of modifications that servicers could perform, therefore limiting their scope. An example, he said, are 2/38 or 3/37 ARM loans, which could have a two- or three-year period where the borrower pays the introductory rate and might have some difficulty paying the adjusted rate. "The question of whether servicers could freeze the loan at the introductory rate might not address the issue squarely," Ornstein said.
Also, the REMIC rules impose restrictions on modifications in cases where the loan is not in default or the servicer has not determined that default is reasonably foreseeable. Servicers also need the staff to identify loans that might default in the foreseeable future.
Furthermore, there are sometimes constraints that are drafted in the pooling and servicing agreements, such as a limit to the number of modifications that are allowed.
"There's sometimes a cap as to how many loans can be modified that's drafted into these agreements," Molitor said.
But in today's market, unless borrowers are repeatedly delinquent on their mortgages, a modification is a much better option than a foreclosure, Ornstein said.
For one, a modification is more cost-efficient. Borrowers facing foreclosure need to be under special servicing, which is staff-intensive. There are also a lot of litigation costs, Ornstein said, adding that foreclosure laws are getting stricter and the waiting periods are longer as lawyers have to look into each foreclosure on an individual basis, which could impede foreclosure proceedings. Servicers also have to deal with the fact that there isn't a robust market for REO sales right now.
"There's more of a benefit when you have an income stream from a loan being modified, compared with the cost involved in servicing an REO," Ornstein said. "After a cost-benefit analysis, the benefits of modifying a loan outweigh the cost of a foreclosure."
Meanwhile, Lang said, "A potential explosive issue is what type of law suit will be waiting around the corner?" Legal action looms with disgruntled shareholders who might challenge the authenticity of the prospectus, or with those angry borrowers who cannot be helped.
Paying Up for Services
Capacity is also an issue for servicers. "Capacity can vary significantly from one servicer to another - some are more constrained than others," Molitor said. "Everyone is looking at staffing across the industry, since a lot of these modifications are labor-intensive, one-off processes that can require a lot of work. That's something that the industry needs to be aware of."
There has been some talk of increasing the amount designated to pay servicers to compensate for the additional work involved in the current environment.
"In increasing servicer compensation, servicers would be more proactive in helping borrowers," Ornstein said. "Starting the process of loss mitigation sooner rather than later ameliorates the problem."
As for increasing the fees for servicers through the trusts, "It would be very difficult to increase servicing fees with respect to existing transactions," Molitor said, adding that it might be a little easier if the deal is in the process of a servicing transfer to increase what servicers charge.
Berliner pointed out that servicing operations are highly automated, with large fixed overhead but low variable costs.
The current push toward large-scale loan modifications throws the economics out of balance, as variable costs are increased. A possible solution to cover the potential cost of servicing in a bad real estate market is to compensate servicers in part based on variable costs and not solely on a fixed-payment basis, Berliner said.
"Paying servicers based in part on variable costs would compensate them for their high fixed costs while giving them an incentive to do more case-by-case analysis," said Berliner. In any case, he expects a fundamental change in the nature of servicing in the future. "Servicing is one area where the interests of lenders and investors can be balanced," he said, with limits on the sale of servicing rights and loss recoveries creating incentives for prudent lending practices.
"Servicers and lenders make their money from collecting payments, paying taxes and insurance, assessing junk fees, optional insurance, etc.," Lang said. "Once that goes away, why stay in the business? If you can save a loan, continue to collect a monthly servicing fee, be profitable and be that 'good neighbor' by encouraging home retention, that is the responsible approach to take to this huge problem." She added that servicers exist to help those who can and want to achieve homeownership while generating profits at the same time.
For now, servicers have to deal with a housing market that has experienced a lot of price depreciation. "Servicers need to cope with the labor-intensive work and be prudent about it," Molitor said, adding that an improvement in the housing market is the best hope for alleviating some of the servicers' work.
It's Also On the Borrower's End
Sources said that, unlike when the efforts at modification initially started, processes to modify loans are now pretty much streamlined. "Profiling is being done to set up parameters to assess which strategy could create the highest present value of return to the trust on the asset," a source said. Profiling helps to do away with the labor-intensive process of cobbling together individual deals.
However, despite the streamlining of the modification process, not all borrowers are taking advantage of this alternative because modification is not always the more economical choice. "It's not totally a capacity issue," the source said, adding that some borrowers would rather walk away, especially when their properties are underwater.
As evidence, recent statistics from Federal Deposit Insurance Corp. showed that less than 50% of the qualified IndyMac Bank borrowers took advantage of the outreach program, which was considered "fairly streamlined and borrower-friendly." "No amount of staffing would solve that, short of personally handing borrowers documents to sign," the source said.
In fact, servicers have used creative techniques including, in some instances, giving borrowers gift cards, but borrowers have not really responded. "Why keep the house when renting across the street would be cheaper?," the source said.
TARP: Part of the Solution?
"Currently, many servicers are taking a "wait and see" approach until they can explore how troubled assets relief program (TARP) will assist on the borrower level," Lang said. However, it has been repeatedly said that the $700 billion effort is aimed at restoring confidence in the credit markets and not for bailing out Main Street.
"We have talked to the major investors, and all of their servicers want more money, need more money, but ultimately, where will it come from?," she asked. The cash flow could be a part of TARP, although that is unclear at this point. If the purchase and sales or pooling agreement state an exact servicing fee to be paid to the lender, there will need to be a consensus among the shareholders to change those terms, Lang explained.
"These shareholders are global," Lang said. "It is not the little old lady that gets her monthly Federal Housing Administration (FHA) security holder check anymore. Some of these pools of loans are a mix of seasonality, loan products, underlying collateral, credit quality, lenders, etc., so it is next to impossible to renegotiate service fees."
Projections are that this crisis will last until 2012, Lang said.
"I believe that making up TARP as we go is a mistake, but those decisions are not within our direct control," she said. "The industry needs to divide and conquer - find trusted partners. Let lenders and servicers do what they do best: collecting payments, paying taxes and insurance, collecting junk fees, paying shareholders, as well as outsource the costly tasks and have that cost be shared by all stakeholders, not just the servicer. Everyone loses with a real-estate-owned property: the servicer, the investor, the shareholder, the neighborhood, and all Americans."
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