A Wall Street Journal article, “Subprime: Point to Where It Hurts,” endeavors to clarify the issues in modifying loans to try to save defaulting mortgage borrowers. Previous stories have mentioned that the fact that most residential mortgages go into mortgage backed securities makes it harder to change terms than in the old days, when the bank that made the loan also held the loan.
The piece feels a bit superficial, since it only deals with mortgage backed securities, and completely neglects to mention what happens to borrowers if their loan goes into an MBS that then gets repacked into a collateralized debt obligation (other stories have suggested that the CDO buyer has to provide a waiver, and that it’s onerous finding the investors, let alone getting the needed releases). However, the Journal story does do a nice job of explaining why holder some classes of MBS paper favor “mods”, as they are called, while others oppose them.
From the Journal:
As defaults on home loans mount, mortgage companies are scrambling to work out deals to help as many borrowers as possible stay in their houses.
On the surface, it seems an obvious tactic. Lenders usually end up losing money on foreclosed homes because of legal and other costs and the need to sell those properties fast, often at a knockdown price. Also, politicians are pressing mortgage companies to minimize the damages foreclosures cause to families and neighborhoods.
Still, the effort to hold down foreclosures threatens to create clashes between mortgage companies and investors in securities backed by bundles of home loans, a $6 trillion market that has been shaken recently by losses on some of the riskier types of mortgage bonds. And because of the way these securities are sold, these efforts can pit groups of holders against each other….
When borrowers can’t keep up, lenders typically consider whether it makes sense to offer a loan modification. Such workout deals, known as “mods,” often involve lowering the interest rate or stretching out the term. Lenders have used mods for years, but the practice is expected to proliferate as defaults rise.
Sharon Greenberg, an analyst for Credit Suisse Group in New York, estimates that before this year modified loans typically accounted for less than 2% of all those outstanding. Within the next couple of years, she says, they may peak at several times that level.
Investors holding mortgage-backed bonds are watching nervously because mods may not always be in their best interest. Some investors fear that loan servicers — the firms, often owned by lenders, that collect payments and deal with defaults — will make too many mods. Generally, investors favor mods that ease a normally reliable borrower through a rough patch, but not those that merely buy time for deadbeats.
Investors doubt some homeowners merit a rescue plan. In some cases, says Kishore Yalamanchili, a fund manager with BlackRock Inc., New York, “by making these people current, you are pushing losses to another year or so.”
Credit Suisse analysts recently examined loans that had been modified over the past few years by one nationwide lender and found that borrowers missed at least one monthly payment after a mod in nearly 40% of the cases. (That failure rate may have been skewed upward by victims of Hurricane Katrina who never returned to their homes.)
If the borrower is unlikely to keep up with payments even after a mod, many investors would prefer that servicers pursue a foreclosure quickly, especially in regions where house prices are falling, reducing the value of the collateral.
Servicers are required by their contracts to act in the interests of the investors and modify loans only when that can be expected to reduce losses. That puts servicers in the tricky position of trying to figure out which borrowers are basically sound and when it makes more sense to foreclose quickly.
One complication is that different classes of investors have different interests, reflecting the complicated mechanics of mortgage securities. Issues of mortgage-backed securities are divided into slices with various ratings, depending on the level of risk. Holders of the highest-rated slices (those with the lowest risk) are first in line to collect payments of interest and principal flowing from the loans. Many such bond issues are structured so that there is initially more than enough cash flow available to cover obligations to all the investors, leaving a cushion to cover potential losses from loan defaults. If after three years or so the loans have performed well enough to meet certain performance measures, the cushion may be reduced.
In that case, some of the excess cash available goes to holders of lower-rated securities and “residuals,” the highest-risk parts of the securities that are last in line for payments.
If loan mods delay the onset of foreclosures, holders of the lower-rated securities and residuals are more likely to get those payments. But, holders of AAA and other high-rated securities may argue that the loan mods have artificially boosted the performance of the loans and that the holders of lower-rated securities and residuals are getting payments that should be preserved to protect owners of higher-rated paper against the risk of a resurgence of defaults later.
Even where there are no clashes among investors, servicers face restrictions on how they modify loans.
Moody’s Investors Service, a ratings provider, recently reviewed roughly 400 subprime mortgage-security transactions issued last year: 5% of those deals prohibit any kind of loan mod; among those that allow mods, about a third stipulate that no more than 5% of the loans backing the securities can be modified. Subprime loans are those to people with spotty credit histories.
“Those restrictions may prevent servicers from doing the things they need to do,” says Larry Litton Jr., chief executive of Litton Loan Servicing, a unit of C-BASS LLC, New York. Mr. Litton says his firm hasn’t bumped up against any ceilings. Still, he favors eliminating restrictions in future issues of mortgage securities to give servicers more flexibility
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One thing I find a bit disingenuous is the notion implied in the BlackRock comment that helping troubled borrowers is merely postponing the inevitable. I imagine it’s more like triage: some borrowers clearly won’t make it even with revised terms; some look like good bets (for instance, the default might be due to a personal crisis that has been resolved), and some are hard to judge. It’s the third category that is most contentious, precisely because reasonable people can differ on whether the borrower will come through. But to judge a borrower that has one missed payment after a loan mod as a complete deadbeat (as the article does) seems unreasonable (a “missed payment” could merely be a late payment, and the source doesn’t indicate what proportion of those who missed a payment were able to make it. That’s the germane number).
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If you can’t afford your subprime loan payments:
1. Bank seizes collateral property
2. Bank sells property at auction
3. Bank applies sale value to total debtor owes
4. Debtor now has remainder of loan period to pay back remaining amount that was borrowed, but not recovered by auction
If debtor was able to qualify for original loan surely they would have no problem paying the reduced amount. Just the fact that the payments wouldn’t include fire insurance nor property tax might be enough to help them meet their contractual obligation.
The bank depositors get all their money back. The failed house flippers get to keep their credit ratings. The housing market is free to set price based upon supply and demand.
Unfortunately the Bushtard has signed legislation removing taxation on the canceled debts. This was exactly opposite of what should have happened. Joe Blow now has every incentive to walk away from his $400k loan on his $200k house, then purchase the nicer $205k house across the street using his spouse’s, uncles, mother’s, sister’s clean credit.
Congress and the Bushtard should have placed a 105% tax on canceled debt, with the proceeds from the tax going to pay FDIC insurance claims of failed banks.