Why Countrywide is Modifying Mortgages (Plus Its Option ARM Worries)

We noted yesterday that we had reservations about Countrywide’s announcement that it was launching a program to modify terms on up to $16 billion of mortgages, However, the stock market appears to believe the initiative will have some impact, since its stock fell 4% today.

CNBC (hat tip gaius marius), the Wall Street Journal, and the New York Times filled in some pieces of the equation.

It’s important to note that this program isn’t all loan mods but has three components:

A refinancing program for subprime borrowers with good payment histories who aren’t yet in trouble. That is expected to apply to as many as $10 billion of mortgages

A mod program for borrowers who are current now but look unable to cope with an upcoming reset. That is budgeted for $4 billion of loans

A mod program for delinquent borrowers with a “predetermined, preapproved” reduction. Better hope you fit this Procrustean bed. This program is targeted to $2.2 billion of mortgages.

I’m a bit mystified mechanically as to how this will work, since as we have noted repeatedly, mortgage servicers can’t go willy nilly and change loan terms. But the dollar amounts above presumably reflect whatever latitude they have in their existing servicing agreements.

Now given Countrywide’s past rapacious behavior, this program seems like an awfully sudden change of heart. Cynics assume something else besides generosity must be at work.

CNBC offers one theory: the subprime recoveries are so dreadful that salvaging the borrower is a demonstrably better option:

I got an email this morning from Janet Tavakoli of Tavakoli Structured Finance. She practically eats mortgage data for lunch. She says Countrywide may seem like it’s doing this out of the goodness of its big ol’ corporate heart, but really it has to do with the fact that recoveries on subprime loans are far worse than ever anticipated so far. Here’s what she writes:

“Last week I met with a major mortgage servicer of geographically diverse U.S. subprime loans. They work 13-hour days trying to salvage what they can, doing anything to avoid reporting a delinquency or foreclosure. They disclosed disturbing information unavailable even on trustee reports. The servicer asserted the rating agencies are incorrect in their optimism; recovery rates of 60% are unattainable. My average recovery rate assumption of 30% is also currently unattainable.”

Tavakoli says the servicer has been selling loans for 3-6 cents on the dollar. What are the issues? Legal costs relative to the low loan balances are huge and delays are long. Values of the homes are nowhere near what they were, so they’re looking at negative equity.

In other words, Countrywide is saving its own skin, as well as saving home ownership. The company simply has to do this because there is no way it can survive otherwise. Obviously they are seeing the recovery rates and just don’t want to risk it. This is a pre-emptive strike

I’d love to get Tanta to opine as to how the calculus plays out for the servicer. If you are talking only 3-6 cents of value net of transaction costs (let’s be generous and assume double that, since bottom fishers want big discounts to take these problems on), it’s clearly better for the investor to give even a pretty generous loan mod. But how do the economics play out for the servicer? Under normal circumstances, they clearly get paid for their costs in foreclosure, but I wonder if net recoveries this low go beyond what is contemplated in servicing agreements and puts Countrywide’s payments at risk.

Of course, if Countrywide succeeds in keeping a borrower alive, it continues to earn servicing fees, but the tradeoff is it incurs a lot of front-end costs in arranging the mod and it isn’t clear that it can recover all of them. Ah, but Countrywide has a clever solution for that problem. From the Wall Street Journal:

Countrywide, the nation’s largest home-mortgage lender by volume, has reached an agreement with Neighborhood Assistance Corp. of America to restructure loans for people at risk of losing their homes, Countrywide and the NACA said. The agreement is notable because it teams the Calabasas, Calif., company with an organization that recently called for a boycott of Countrywide and held noisy protests outside its branches.

Mr. Marks said in an interview late yesterday that the agreement will require Countrywide to reduce many borrowers’ payments to levels they can afford, based on an analysis of individual household budgets by the NACA, which fights lending abuses, helps arrange affordable loans and advises borrowers through a network of 33 offices nationwide.

Mr. Marks said he believes the cooperation will help tens of thousands of Countrywide borrowers. He hopes to enlist other lenders to adopt the same approach. Countrywide approached the NACA less than two weeks ago about cooperating on loan workouts, Mr. Marks said.

Now on paper, this looks brilliant. Countrywide, in a single stroke, gets good PR, neuters its chief critic and gets not only free labor but on the ground infrastructure to implement the borrower salvage operation. And by involving a third party, it will also hopefully forestall any charges of bias or capriciousness in determining who participates.

It would be better if I were wrong, but despite the obvious benefits, I have serious doubts as to whether this program will work. The tipoff is that this deal was struck in less than two weeks. The arrangement between Countrywide and the NACA is effectively a joint venture. I have never seen an effective JV arrived at with so little planning and discussion. This was a marriage of convenience, and for Countrywide’s convenience, and its genesis will show.

First, Countrywide probably has greatly underestimated how much effort it will take to leverage the NACA people. Remember all the information is in Countrywide’s hands and Countrywide, not NACA, is responsible for any decisions. So the activities of the NACA staffers will have to be reviewed before they are implemented. I would not expect there to be any net labor savings; what you do hope to get are better decisions.

Second, the two organizations are guaranteed to have radically different cultures. It will take a great deal of effort to get them to work together smoothly, and I doubt anyone has anticipated how significant an issue this will be and has taken measures to improve coordination.

Third, there is a real risk that as the NACA team members work with Countrywide customers, they become disenchanted with Countrywide. Remember, they will not only get the borrowers’ records but will almost certainly hear their stories. What happens if they uncover behavior that they feel was fraudulent?

I imagine Countrywide has contemplated this possibility and will have NACA and the individuals who work on this program sign confidentiality agreements (ostensibly to protect the borrower, of course). I am not a lawyer, but I believe that private agreements are not enforceable if they are in violation of public policy, and therefore Countrywide would not be able to gag NACA if it were to discover that Countrywide had engaged in consumer fraud. But even so, one would expect Countrywide to aim all its legal firepower at NACA. The not-for-profit would be faced with a difficult choice of diverting funds from its programs to stand up for its principles.

A separate story in the Journal discussed at considerable length that another mortgage product in which Coutrywide became a leader, option ARMs, are also going south at a rapid clip. As the chart below, from the IMF via Econbrowser shows, these option ARMs have the potential to become a serious problem as subprimes in the 2010-2011 timeframe, when the market may be just beginning to recover from subprime woes:

However, keep in mind that Countrywide’s option ARMs, at least so far, are performing worse than its competitors, so it isn’t yet clear how badly the product as a whole will fare. From the Journal:

Subprime mortgages aren’t the only challenge facing Countrywide Financial Corp., the nation’s biggest home-mortgage lender. Some loans classified as prime when they were originated are now going bad at a rapid pace.

These loans are known as option adjustable-rate mortgages, or option ARMs. They typically have low introductory rates and allow minimal payments in the early years of the mortgage. Multiple payment choices include a minimum payment that covers none of the principal and only part of the interest normally due. If borrowers choose that minimum payment, their loan balances grow — a phenomenon known as “negative amortization.”

Countrywide first offered these loans in 2003 and quickly became a leader in this profitable and growing part of the mortgage market. Mortgage brokers liked the higher commissions and borrowers were drawn to low payments. As lending standards loosened, more of these loans included less-than-full documentation.

An analysis prepared for The Wall Street Journal by UBS AG shows that 3.55% of option ARMs originated by Countrywide in 2006 and packaged into securities sold to investors are at least 60 days past due. That compares with an average option-ARM delinquency rate of 2.56% for the industry as a whole and is the highest of six companies analyzed by UBS….

Among option ARMs held in its own portfolio, 5.7% were at least 30 days past due as of June 30, the measure Countrywide uses. That’s up from 1.6% a year earlier. Countrywide held $27.8 billion of option ARMs as of June 30, accounting for about 41% of the loans held as investments by its savings bank. An additional $122 billion have been packaged into securities sold to investors, according to UBS…..

The deteriorating performance of option ARMs is evidence that lax underwriting that led to problems in subprime loans is showing up in the prime market, where defaults typically are minimal. Challenges could grow, as from 2009 to 2011, monthly payments on some $229 billion of option ARMs will be adjusted to include market-rate interest and principal, according to Moody’s Economy.com….

A Countrywide spokesman said the UBS comparison could be misleading because lenders’ policies for which loans are sold can vary and geographic differences also could skew the comparison. Countrywide says its potential losses on option ARMs are partially covered by insurance….

It now appears that many borrowers who moved into option ARMs were attracted by the low payments and may have been staving off other financial problems. More than 80% of borrowers who are current on these loans make only the minimum payment, according to UBS.

Mr. Mozilo told investors in September 2006 that he was “shocked” so many people were making the minimum payment. He called a sampling of borrowers to find out why. The “general answer…was that the value of my home is going up at a faster rate than the negative amortization,” he said. “I realized I was talking to a group…that had never seen in their adult life real-estate values go down.”….

But after a specified period, often five years, when borrowers must start repaying principal and meeting full interest payments, monthly payments can more than double. If the balance outstanding gets too high — the ceiling generally is 110% to 125% of the original amount borrowed — borrowers can face sharply higher payments even sooner. Some borrowers could find themselves in the painful position of owing more than the value of their home….

Of the option ARMs it issued last year, 91% were “low-doc” mortgages in which the borrower didn’t fully document income or assets, according to UBS, compared with an industry average of 88% that year. In 2004, 78% of Countrywide’s option ARMs carried less than full documentation….
By 2006, nearly 29% of the option ARMs originated by Countrywide and packaged into mortgage securities had a combined loan-to-value of 90% or more, up from just 15% in 2004, according to UBS..