While both the real estate markets and mortgage credit performance have shown signs of bottoming out, the foreclosure picture remains grim. In its delinquency report for the first quarter of 2009, the Mortgage Bankers Association reported that 3.85% of the loans in their population were in some form of foreclosure, and RealtyTrac notes that just under two million homes in the U.S. were in foreclosure as of June. Considering that the annualized rate of existing home sales in June was 4.8 million homes, the size of the foreclosure pipeline is astonishing.

Aside from the surge in delinquencies over the past two years, the massive accumulation of foreclosed homes is attributable in part to servicers' slow progress in working through their inventories of nonperforming loans. In addition to the sheer volume of loans, the process has been slowed by the various foreclosure moratoria, as well as the need to individually screen loans for eligibility for the Obama administration's modification program.

In fact, the size of the foreclosure queue has reportedly caused some lenders to postpone eviction proceedings on seriously delinquent homeowners, temporarily letting them remain in their homes. Allowing nonperforming homeowners to continue occupying their properties lowers the servicers' outlays for home maintenance and repair, reducing both carrying costs and the risk of trashed properties. Lenders are also sensitive to the impact that large-scale foreclosures might have on local real estate prices; in addition to suppressing the value of their REO inventories, a supply-induced plunge in an area's property values might trigger new rounds of defaults on their (currently) performing loan portfolios.

In addition to delaying investors' receipt of recovery proceeds, the elongated foreclosure process generally translates into elevated loss severities (i.e., the total loss as a percentage of a loan's unpaid balance). The items most directly affected by the lengthened timeline are the monthly carrying costs: Interest on the note must be advanced by the servicer (or accrued on the loan's balance, if the servicer stops advancing); taxes and insurance must be escrowed; and (since lawns don't mow themselves) maintenance costs need to be paid. A longer lag between the initiation and conclusion of foreclosure proceedings also increases the holder's exposure to a variety of risks, including continued declines in local real estate prices and damage from vandalism.

The interaction of factors in the foreclosure process greatly complicates the task of projecting loss severities for different products and vintages. For example, option ARMs are generally assumed to have higher loss severities than other products (including subprime loans) as a result of negative amortization. However, the current large difference in note rates between subprime ARMs (which typically reset at 500 to 700 basis points over Libor) and option ARMs (which normally accrue at MTA plus 250 to 300) means that higher interest costs will eventually overtake the effect of negative amortization on loss severities for two otherwise identical properties. (The breakeven point in time will depend on the actual rate differential and the amount of negative amortization; at the current spread, it ranges between one and two years.) Therefore, the standard assumption of higher loss severities for negative amortization loans becomes less accurate as foreclosure timelines lengthen and interest costs pile up.

Depending on their place in the capital structure, returns on private-label MBS will be driven by the collective impact of default rates ("involuntary prepayments"), loss severities, and the recovery lag, particularly if their "voluntary" (i.e., refinancing-based) prepayment speeds remain sluggish. This means that understanding the foreclosure process, and accurately projecting loss severities and lags, will be increasingly important in evaluating investment choices and strategies in the non-agency MBS sector.


Bill Berliner is a consultant based in Southern California. His Web site is www.berlinerconsulting.net.

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