Do Mass Modifications Benefit Wall Street or Main Street?

The big news this weekend was JP Morgan’s announcement that they would modify substantial amounts of loans on their own balance sheet. Like anyone, I would like to see modifications help borrowers where possible. But while many continue to maintain that mass modifications are per se beneficial, there remain substantial reasons to be wary. Three important issues remain to be resolved before any servicer embarks upon widespread modifications. Those include how servicers will report modifications and subsequent performance, the underwriting standards to be applied to modifications, and how those standards and reports can be used to distinguish between meaningful modifications and abusive or predatory modification.

Servicer reporting is woefully inadequate, both with respect to servicer performance in general and modifications in particular. Servicers, like any other business, face a budget constraint. Servicers are either paid set fees to service large portfolios of mortgages on behalf of investors or they operate as a subsidiary of a mortgage underwriter servicing the underwriter’s own portfolio. Most servicers do both. The point in either case, therefore, is that the interest rate of the loan includes some amount set aside to cover the cost of servicing.

When loan performance sours, servicing costs rise substantially. Not only do servicers face increased costs arising from the need to contact borrowers via additional mailings, telephone calls, and legal filings to extract payments, but servicers also must pass along payments to investors as if they are made in full until the property is seized in foreclosure and sold. Hence, as I presented in my October 2007 white paper, servicing costs on a typical $144,000 loan can rise from roughly $50 per year to over $1,000 per year while the loan is in delinquency and over $2,000 per year when the loan enters the foreclosure process. (Mason, Joseph R., Mortgage Loan Modification: Promises and Pitfalls, SSRN Working Paper: http://ssrn.com/abstract=1027470 , October 2007.)

The problem is that as the servicer is forced to spend more servicing delinquent and foreclosed loans, it has less money to spend on servicing performing loans. When servicers do not have sufficient funds to cover the costs of promptly pursuing new delinquencies, those new delinquencies have a greater probability of rolling into foreclosure. When servicers face budget shortfalls, they cannot follow up promptly on contacting borrowers who are late making payments for the first time. Lags of even a few days in such follow-up have been shown to make a big difference in the propensity for the borrower to become more delinquent, rolling from 30-days to 60-days delinquent, and then 90-days and into foreclosure.

Costs increase further because servicers must “advance” delinquent borrower payments to investors “as if” the money was received from those loans and only recovers that money upon foreclosure and sale of the property. Modification expenses add unknown magnitudes to those costs.

A big question on RMBS and mortgage bank investors’ minds these days, therefore, is whether servicers have sufficient cash flow to maintain servicing quality. If RMBS investors judge servicers cannot perform adequately, investors have the right to sell servicing rights to a servicer that does have such resources. As I pointed out in my September 18, 2008 testimony before the Senate Committee on Banking, Housing, and Urban Affairs, investors must make that replacement before a servicer enters bankruptcy, since a bankruptcy court may not allow replacement of the servicer because servicer rights can be considered part of the debtor’s estate.

But servicers do not routinely and systematically report roll rates, advance rates (the money the servicer has to pay to investors “as if” it had been received from loans in delinquency) or modifications and related costs to either RMBS or mortgage bank investors, nor to regulators. Worse yet, as the crisis had deepened servicers who do produce such reports for their own use have become more reluctant to share their internally-generated reports with outside parties. Hence, investors and regulators alike have almost no means of judging whether modification programs are beneficial to borrowers or lenders. Investors are therefore reluctant to buy new RMBS and have little ability to judge the impact of servicer performance on the value of existing RMBS, while mortgage bank investors and regulators similarly have little means of judging bank safety and soundness and bank performance.

But the situation is worse than that. Monitoring servicer performance requires – at the least – defining what a modification is and the procedural means by which it is to be administered. The first hurdle faced by Hope Now and OCC reporting on modifications was the mere definition of a modification, and that hurdle has still not been overcome. Recall that lenders have already accommodated many borrowers through “repayment programs.” Some observers say that repayment programs are not modifications, while others maintain they are. We still don’t have an answer to that most basic question, nor do we have systematic reporting to track modification activity and subsequent performance.

The goal of modification is to bring the loan current again, but we also still do not have regulatory rules for reaging modified loans. Do modified loans have to post three consecutive on-time payments to be considered current again, like other delinquent loans made by commercial banks? Should the standard be tougher, since the modified borrower can be considered worse off than a historically typical borrower that cures their delinquency without assistance? Will such a definition be applied outside commercial banks? Without answers to these questions investors in RMBS and mortgage banks have no ability to distinguish whether modification is mere accounting “window dressing” or truly valuable.

Last, neither JP Morgan nor the FDIC IndyMac or other modification programs are revealing their underwriting standards for granting modifications. The concern therefore becomes are the modifications resulting in what we might historically consider “sound” loans, “subprime” loans, or perhaps “sub-subprime” loans? In other words, from a policy perspective are we truly helping borrowers achieve homeownership by addressing financial planning shortcomings or are we just pushing the aggregate problem down the road while squeezing the last few dollars out of subprime borrowers’ pockets? Without clearly delineated standards of modification, both problem and non-problem borrowers will see the programs as a lottery and some servicers will assuredly abuse the programs to the detriment of their real economic benefit.

Whether we realize it or not, the industry is already experiencing the fallout of poorly documented and administered modification programs. Several lenders face lawsuits in the Gulf Coast region from allegedly abusive modifications offered to borrowers after Hurricanes Katrina and Rita. Without adequate standardization and reporting – whether imposed externally by regulators or internally by clearly defined codes of best practice – policymakers risk extending similar lawsuits and potential liability across the entire U.S. when random borrowers still cannot afford payments on undocumented and poorly administered modifications. We can do better.