A month after the Federal Reserve and other banking regulators encouraged lenders to help troubled borrowers avoid foreclosures through loan modifications, doubts are growing as to whether these programs can actually help substantial numbers of borrowers save their homes.
The practice, also known as loan mods, was developed to avoid foreclosures on more than two million adjustable-rate mortgages-approximately $200 billion-due to reset in the next 18 months. A lot of borrowers, however, are not good candidates for a modification because they were already defaulting on their loans before the resets. Meanwhile, many lenders are understaffed and unable to manage the demands of borrowers seeking modifications.
"When we go out and visit servicers, we do a lot of due diligence and a pretty consistent theme we hear is that everyone recognizes the ARM reset is a big problem and will continue to be over the next 18 months or so," said Jason Stewart, portfolio manager for Barrier Investments, a Memphis-based investment adviser. "The flip side is that most people we feel are not adequately prepared to deal with the resets and most don't have a very sophisticated plan on how best to tackle the issue."
These roadblocks were made apparent in a survey released last month by Moody's Investor Service, which studied the modification practices of subprime mortgage servicers that are dealing with borrowers facing an interest rate reset either this year or in 2008. The survey found that most servicers had only modified approximately 1% of loans whose interest rates were reset in January, April and July.
"This is of particular concern given the potential size of the problem-some servicers reported that they could experience in a given quarter interest rate resets on loans which constitute up to 15% of their portfolio during the period from late 2007 to early 2008," Moody's wrote in a special report. The 16 servicers that responded to the survey have a total servicing volume of $950 billion, accounting for about 80% of the subprime market.
Staffing problems will loom large for servicers that are dealing with loan modifications, according to Stewart. "Most of the servicers use loss curves that are based on historical experience to try to project staffing needs," Stewart said. "I think clearly from the performance of the assets we've seen that historical default curves just don't help right now. That's clearly going to be a problem and we think most are going to be understaffed when it comes to hitting reset time."
If servicers lack the staffing and resources to handle the onslaught of loan modification requests coming across their desks, it begs the question of how much responsibility they should be expected to bear.
"Servicers are not designed to [handle foreclosures] in mass, and they are not set up to be paid properly to provide the services really needed by the mortgage owner to minimize the loss," said Richard Benson, president of the Specialty Finance Group, a financial broker to private finance companies. "Unless the servicer is the owner of the loan, who is supposed to pay for
the time and effort in loan modifications anyway?"
A report released last month by Friedman, Billings, Ramsey & Co. echoed Benson's concern about the increased costs servicers incur because of the loan modifications.
"Higher defaults and anticipated defaults caused by the large volume of upcoming ARM resets require an increase in loss mitigation proficiency and staffing levels," wrote the FBR analysts. "Unanticipated expenses that could come with loan workouts or foreclosures may increase costs even more." The analysts also warned that loan mods "increase the risk of over-collateralization release followed by high levels of borrower re-default."
The Center for Responsible Lending maintains that the loan modification programs will not work unless the Chapter 13 bankruptcy law is also amended. "What we're hearing from the responsible lenders is they want to do this but they don't want to be sued," said Ellen Harnick, senior policy counsel at the center. "There is a category of investors who will sue when they lose money no matter what the merits, and that's just a fact of doing business." Currently a judge can modify all forms of debt except a mortgage that is secured by the primary residence.
"If we take out that exclusion and let judges modify, then you give lenders the coverage they need," Harnick said.
How effectively loan modifications help troubled borrowers could depend ultimately on what strategy is employed. The industry should be able to direct about 50% of subprime borrowers to modified Federal Housing Authority programs, according to Stewart. "If what we're left with is 50% [of loans that cannot be modified] then yes, it has helped," he said. "But if the industry is simply trying to modify people instead of getting them into a new loan and a different program, then there are just too many [to help]."
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