Little has been done by way of loan modifications in the troubled U.K. RMBS sector.
Industry sources said their hands have been tied by the legal limitations of securitizations that do not allow mortgages in these pools to benefit from the modification alternatives that are now available.
Different loan modification options have always been available to servicers, but these became increasingly placed under scrutiny following proposals to alleviate the problems of U.S. subprime borrowers.
"Modifications are becoming more commonplace, and we're seeing the trend spread from the U.S.," said Paul Fenn, managing director in special servicing at HML. "Stateside, modifications are on everybody's agenda, and the U.S. government is rolling out plans to incentivize servicers to grant modifications. For their part, servicers managing assets in securitized transactions are trying to push for as much flexibility as possible, so that there is a level playing field for customers whether their mortgage has been securitized or not."
In January 2008, Capstone, a wholly owned subsidiary of Lehman Brothers that services loans for Southern Pacific Mortgage Loans (SPML) and Preferred Mortgage Loans (PML), announced that it would make loan modifications on a case-by-case basis to minimize borrower arrears and losses if a foreclosure was expected (ASR, 1/21/08).
The servicing strategy has been developed by using expertise gained from Capstone and Lehman's recent U.S. deals and specifically targets borrowers who might suffer difficulties with upcoming rate resets. The suite of loan modifications has been applied on a case-by-case basis to minimize borrower arrears and losses if foreclosure was expected. The strategy was discussed with each of the rating agencies from which feedback was positive.
The Capstone suite of loan modifications includes helping to stave off defaults when the loan is in arrears and a loss is expected based on foreclosure, deferring payments, extending loan maturities, changing the interest rate, amending capital balances, capitalizing arrears and short selling or allowing a property to be sold for less than the amount owed on a mortgages.
Each loan modification was dependent on a full reassessment of the borrower, including his/her propensity to pay following a modification, a revaluation of the property and a full adherence to the Financial Services Authority mortgage guidelines, which include new key features in the document presented to the borrower.
In the year since Capstone initiated the loan modification scheme, information from the investor reports have highlighted the restrictive criteria that are in place before modifications could occur. Each transaction is seeing only three to 10 loans that could be modified. "The Capstone loan mods were intended for a specific borrower that had to meet loads of criteria, and that ultimately restricts the number of borrowers that can benefit from the loan modifications," said Dipesh Mehta, RMBS research analyst at Barclays Capital.
More recently, Rooftop Mortgages announced that it was loosening criteria to better accommodate loan modifications within the U.K. nonconforming Mansard Mortgages transactions. Rooftop Mortgages, who subcontract the servicing capabilities to Crown Mortgage Management, notified the rating agencies of a change in the legal documentation that allows the servicer greater flexibility to help borrowers in arrears by restructuring their mortgage loans.
Mehta said that the changes allow the servicer to restructure the mortgage loan from the current payment plan to "one of three product types already present in the mortgage pool," including converting to an interest-only loan, capital repayment and part-and-part loans to help ease the burden for borrowers. Furthermore, the borrower's mortgage loan can be extended to a maximum of the notes' legal final maturity less two years.
Restrictions are in place to limit the number of conversions within a transaction, and certain conditions must be met for the conversion to happen. However, Mehta said that further details are required before the potential impact on the transaction can be estimated.
"Loan modifications have always been a contentious issue for investors of securitized transactions," he said. "They obviously help the levels of arrears in a transaction, but they may also just be postponing the inevitable foreclosure, which could harm the transaction further in a declining housing market."
It is a balance, Mehta said, between the lack of interest rate payments and a reduction in excess spread when the monthly mortgage payment is reduced. The lack of interest payments occurs when borrowers are in arrears but principal is repaid on the property's foreclosure or of extended interest payments and slower amortization of the notes resulting from lower CPR.
When the Government Steps In
One of the main restrictions to modifying loans in European transactions has been the legal documentation that does not allow such changes to take place. This, Mehta said, is driven by rating agencies that want to be confident that the collateral pool rated at issuance will remain throughout the transaction, and if not, they would have already sized for the additional risk.
"These loan modifications will do just that, affecting loss given default assumptions, excess spread and prepayment rates, thereby changing the pay-down profile of the notes," he said.
The U.K. government, in a bid to limit the level of repossessions, passed the Mortgage Arrears Pre-Action Protocol (PAP) that promotes an active dialogue between lender, borrower and servicer. It is still unclear what impact PAP has had on the level of defaults, but ultimately, it's expected to make the repossession a decision of last resort.
Market sources said that the protocol has done little to affect loans included in securitizations, although they added that government protocol could encourage lenders and servicers to consider loan modifications as an alternative to repossession, which in turn could benefit across whole parts of a transaction structure.
Mehta said that it is unclear if the PAP has had a big impact on repossession rates yet, as it will take at least another quarter's worth of performance data before the market can draw a correlation between slowing repossession rates and PAP. "PAP, in terms of loan modifications, can be a tricky issue for securitization," he said. "As in certain cases, changes will need to be made to the legal documentation to allow such changes to occur, as in a recent case with the Mansard transaction. It will be interesting to see servicers go to court for PAP, citing securitization documentation as a limitation. The government has to look at the wider context of the economy, and, at this point, it is uncertain how this would affect securitizations if they flat-out say that the protocol had to be implemented across the board."
Such a response could take various soft initiatives, although the ultimate government response could be radical and include legislation that incentivizes or forces lenders to modify loans and restore borrower affordability. Whether or not mortgage repossession leniency is consistent with securitization will depend on the degree of reform, explained Deutsche Bank Securities analysts.
"Any 'soft' recommendation would generally be allowable under the terms of U.K. securitization indentures as far as we can tell," analysts said. "However, a more radical government approach to force lenders via legislation into changing loan terms to, say, explicitly forgive a portion of the principal balance ("cram-downs") may be more challenging to enforce, in our view."
U.K. RMBS servicing agreements and warranties typically are versatile and allow the originator/servicer the discretion to deal with delinquent securitized borrowers in the same way that balance sheet loans are managed, Deutsche analysts said. Deal documents normally only call for the servicer to act prudently, with language often designed to expressly allow for different approaches to arrears management, whether out of business practice or because of legislation.
However, RMBS deal documentation and servicing agreements normally do not allow for changes in arrears management that are deemed to be "materially prejudicial" to investors. Any breach on this level would trigger a servicing termination event.
"In terms of RMBS, bondholders will experience cash flow extension under any plan to make arrears management more borrower-friendly," Deutsche analysts said.
The protocol may already be taking effect, Societe Generale said. Fourth-quarter repossession figures reported by the U.K. Council of Mortgage Lenders (CML) and the Ministry of Justice show the same pattern as the previous quarters, with the number of claims in courts and orders to repossess significantly higher than the number of houses effectively repossessed. The total number of first-charge repossessions in the year was an estimated 40,000. This was 5,000 lower than the CML's original forecast for the year. These statistics, analysts said, demonstrate that U.K. servicers are applying PAP as much as possible in a bid to avoid property repossession.
The changes to Mansard could pave the way for more transactions to enact similar changes to securitization documentation to ensure the opportunity for future loan modifications. At the end of 2008, Fitch Ratings predicted that loan modifications would grow to 15% of 2005-2007 vintage U.S. securitized mortgages in 2009. Although much of the loan modifications to date had not affected securitized products, Fitch said that it was likely that loan modifications would have to happen to ensure that borrowers in a securitized pool are being treated equally compared with borrowers whose mortgages are held by a bank, as well as to fulfill the servicers' duties to maximize returns to the trust.
"If the process is well-managed within a transaction, transparency is increased regarding the criteria for a loan modification to take place and the number of conversions limited, we see the improved performance as an overall benefit to the transaction and would not be surprised, given Fitch's stance, by more transactions following this route," Mehta said.
One market source said that although currently loan modification may not seem much of a story, as market fundamentals further deteriorate, it's likely that more transactions will allow for loan modifications. Fenn added that he expects the practice to grow in the U.K., as many industry players are working to keep people in their homes.
To be sure, the CML maintains its forecast of a sharp increase in repossession in 2009, with 75,000 homes repossessed and an increase in the inventory of 90-days-plus arrears loans to 500,000, 2.38x more than in 2008, it's likely the government may step in and add some pressure.
The combination of rate resets with rising unemployment as the economy works through a recession means that investors in securitized transactions will have to undertake further credit work to allow for this additional uncertainty.
A review is needed to find out whether modifications will require changes to the provisions in the securitization documentation or whether servicers can use existing mandates.
"The role of a servicer has always been to act in the best interests of the borrower; therefore, if default for a borrower is avoidable, the benefits would be seen in the wider mortgage market, as increasing arrears can have a snowballing effect, causing house prices to fall further and the downward cycle to accelerate," Mehta said. "But the downside for loan modifications is the risk of adverse selection, as borrowers are made aware that difficulties may lead to potential concessions, though these risks are limited, and the additional uncertainty that these will now bring to securitized transactions."
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