Task Force to Encourage More Mortgage Modifications

I’m late to this item, “Task Force Will Seek More Loan Revisions,” which appeared in the Saturday Wall Street Journal. It seemed to merit comment and I haven’t seen much online. Here’s the premise:

Attorneys general and banking regulators from 10 states have formed a task force hoping to persuade mortgage-servicing companies and investors in mortgage-backed securities to increase the number of troubled subprime loans they restructure, to stem the tide of foreclosures.

Notice the operative word, persuade. It would really be for the best if I am proven wrong, since loan modifications are the best solution for borrowers that have a reasonable ability to make payments,. However, I doubt this initiative will yield much.

It’s better to raise these issues on a state level (my understanding is that the mortgage servicing agreements are governed by state law), and it’s also probably good for the servicers to meet with the AGs and regulators (the tone of the article is that this a a problem-solving effort, not a witch hunt. However, the servicers probably recognize that anything they say might later be used against them).

However, there are at least three impediments. The first is the servicers already have reasonably good incentives to enter into mods. A foreclosure means the borrower leaves the pool, so bye bye servicing fees. And in a tough housing market, whatever fees a servicer normally gets for foreclosure may not be as attractive as in a more normal housing market. Similarly, it isn’t clear how many sinking homeowners can really be salvaged. Dean Baker pointed out that some borrowers defaulted before reset, which suggests that pre-existing financial stress may have played a role:

[M]any of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance.

Borrowers who go under that fast probably don’t even begin to have the income for a mod to succeed. So it remains to be seen how many borrowers are in that never-never land of “good enough to be rescued, but somehow overlooked by their servicer.”

The second issue is that the servicers are contractually obligated to perform on behalf of the investors. They have no responsibility to the poor chump borrowers. Now the AGs and regulators can wink and nod all they want to about having the servicers get more creative about how they interpret their obligations, but the servicers have limited degrees of freedom. Some indentures restrict mods entirely, others limit them to a certain proportion of a the pool. And even in agreements with no restrictions, I would have to imagine that the servicer faces more general requirements to act in the best economic interest of the investors.

Some of the ideas strike me as having zero chance of being adopted voluntarily:

A policy paper prepared as part of the effort by Iowa Assistant Attorney General Patrick Madigan suggests, among other things, that servicers boost their loan-modification staffs, create teams dedicated to handling loan modifications, increase training and provide front-line employees with financial incentives that would encourage them to save homes rather than moving borrowers toward foreclosure. It also suggests that investors remove provisions in trust agreements that limit modifications, and pay servicers an extra fee for loan modifications that make sense for both the borrower and the investor.

The first suggestion, that servicers increase their loan mod staffs, probably will occur just to keep the industry in the good graces of the regulators. The other ideas are increasingly unlikely. The notion of staff incentives is odd (these are not bonus-intensive or sales driven environments. Servicers are back office operations).

And the suggestion that investors “remove provisions” in trust agreements and agree to pay additional fees to servicers is daft. Investors in mortgage paper with subprime exposure, unless they got in recently, are in a loss position. Asking them to pay additional fees and make themselves worse off is not a wining proposition. Moreover, some, if not many, investors are fiduciaries (think money managers, pension fund managers) and they may reasonably take the view that their duty to their investors prohibits them from voting for a measure that further reduces their income. Someone has to make an economic, not a social interest, argument.

Finally, the obstacles to altering the terms of the indentures to these agreements are considerable. My impression (and anyone with a better vantage please speak up) is that changes to the indenture require at least a majority vote, and in many cases a larger proportion (60 to 75%) of the economic interests of each class of holder. That is a very large hurdle to overcome. Given how these securities are tranched, some classes of investor may do better or believe they will do better, given their view of risks and interest rate trends) with a foreclosure (that produces an accelerated payment of principal) that a successful mod.

And remember too that the results of these votes are not made public, so institutions that vote against the little guy need not fear a public scolding.