Why Subprime Mortgages Aren’t Getting "Mods"

From time to time, we’ve written that the hope of many policymakers, that struggling subprime borrowers would be salvaged by loan modifications, aka “mods”, would likely be disappointed. A Financial Times story, “Mortgage lenders in subprime ‘traffic jam’,” bears this thesis out.

Let’s back up and note that loan modifications are often the best course of action for troubled borrowers, Even though the bank must write down the loan if it modifies the terms so as to lower the borrower’s payments (we’ll omit the sham of adding the foregone payments to principal), it also faces a writeoff if it forecloses. In the stone ages when banks held loans to maturity, they often concluded the borrower was worth more to them alive than dead.

But in our Brave New World of securitized finance, the fate of the borrower lies not with the lender but with the mortgage servicer. And despite the entreaties of various banking regulators for servicers to take more proactive steps to salvage borrowers, like contacting them before rates reset to higher levels to work out a plan, little of that sort of thing has happened.

One reason is that in many cases, the servicers’ hands are tied. Most agreements restrict loan modifications, and our impression is that in many cases that extends to loss mitigation mods (it’s standard to restrict mods that aren’t related to loss mitigation; you don’t want the servicer enabling what is tantamount to refinance to take advantage of falling interest rates, for instance. The servicer would get the same fee as before, but you the investor would get less income). A Bloomberg story notes:

Even if loan-servicing companies want to make changes, their contractual obligations may block them.

Eight of the 31 subprime-mortgage deals that Credit Suisse Group bond analyst Rod Dubitsky looked at for an April report capped the amount of loan modifications that can be done at 5 percent of either the total loan number or their balances.

Banks and borrowers also may be worse off if they delay inevitable foreclosures because slumping home prices may create even lower resale prices, according to Josh Rosner, managing director at the New York investment research firm Graham Fisher & Co.

The last point, that delaying foreclosure may be a bad strategy financially, is important. Servicers would be reluctant to take actions that could easily be argued to have been to the investors’ detriment. So that is a further deterrent to mods in a falling housing price environment.

Today’s Financial Times article looks at a completely different sort of obstacle: operational and profit considerations of the servicer. The servicing companies don’t have the staff or the margins to take on a customized, time consuming activity (remember, the key to profitability as a servicer is running an efficient factory, which means standardizing and automating tasks whenever possible).

This story seems to be an effort to get to the bottom of the survey finding announced by Moody’s on September 21, that lenders have relaxed terms on only 1% of subprime mortgages. Contrast this with the roughly 20% level of subprime defaults (and that was as of May) and you can see this mod level is so low that it can only be called cosmetic.

From the Financial Times:

US mortgage companies are being overwhelmed by the large numbers of homebuyers who need to renegotiate their loans to avoid default, creating a “subprime traffic jam” that could frustrate efforts by regulators to prevent foreclosures, experts say.

Mortgage servicers, the operations that collect loans, say they are having trouble making profits because of record levels of late payments and delinquencies. Litton Loan Servicing estimates that costs have increased 20 per cent in the last year for mortgage servicers, who even in good times depend on razor-thin profit margins.

The result is that few subprime mortgages are being renegotiated. Moody’s, the ratings agency, found that lenders had eased terms on just 1 per cent of subprime loans resetting at higher interest rates in January, April and July this year.

“Servicers have failed because there’s a huge resourcing issue,” said Barefoot Bankhead, managing director at Navigant Consulting. “As lenders have gone out of business, the servicing arms have been in transition without the resources to handle the enormous number of requests for loan modifications and restructuring.”

The problem could grow more severe as more than $350bn in adjustable-rate mortgages reset at higher rates in the next 18 months.

“Servicer inactivity could turn the subprime traffic jam into a monumental pile-up, because the longer people wait to make decisions, the worse the situation gets,” said Don Brownstein, chief executive of Structured Portfolio Management, a hedge fund.

Moody’s found that few servicers made telephone calls to borrowers facing interest-rate resets in the near future. It said the majority of large servicers continued to rely on letters to contact borrowers.

Moody’s said this was of “particular concern” given the potential size of the problem. Moody’s said servicer data showed that borrowers who were making payments before the reset and did not have their loans modified fell into arrears at a rate of up to 10 per cent. Analysts estimate that resets could boost payments for borrowers by between 30 and 50 per cent.

Another complication in renegotiating mortgages is that most loans have been packaged into securities and sold to investors. Some modifications are being held up by disputes between investors with differing interests in the same pool of loans.