Mortgage Modification, Full Speed Ahead!

Yesterday’s Washington Post article on mortgage servicer meetings with Administration officials and today’s Wall Street Journal on the same topic both seem to have overlooked yesterday’s Joint Economic Committee hearing on mortgage modification, entitled “Current Trends in Foreclosure and What More Can Be Done to Prevent Them.” The hearing was interesting and informative, albeit sometimes not for the reasons intended.

First, it appears by all indications of both the Administration meeting and the hearing that modification policy will be proceeding with the philosophy of “damn the torpedoes, full speed ahead!” So, even while we are seeing a roughly seventy-five percent one-year redefault rate on modifications – compared to the industry average forty percent two-year redefault rates I cited in my Fall 2007 paper, Mortgage Modification Promises and Pitfalls (http://ssrn.com/abstract=1027470) – the Administration appears committed to pushing for more modifications, regardless.

Apologists reason that the modifications of the past were not the “right” modifications. That is, those modifications did not relieve principal balances and reduce payments. But those modifications already removed fees and charges meant to cover the thousands of dollars spent on delinquency management, arrears, and processing incurred to the current state of the loan. So with all those up-front expenses and a seventy-five percent redefault rate – wherein the servicer forecloses anyway – indeed, foreclosure is often cheaper than modification.

The important point is who will pay for the principal balance reductions? The Administration is still largely blind to how some servicers are using the modification push to increase the value of their own junior holdings at the expense of senior bondholders. Hence, there is still little acknowledgement of the need for servicer reporting, not even on par with that required by the GSEs in their third-party arrangements. While there is growing realization that the senior investors that are being exploited are – to a great extent – pension funds, even policymakers that get this still acknowledge that helping “homeowners” right now is far more visible than helping retirees in the future. Besides, the Treasury can always borrow more to fund retirements later.

One last item: it appears that the product restriction elements of the Consumer Product Safety Commission may not have broad support, even among consumer advocates. Many I talked to yesterday advocate rolling consumer protection authority into a single agency to better coordinate existing enforcement, but none seem to advocate the product restriction or certification elements of the proposal. The feeling seems to be that much simpler changes to the degree and timing of disclosure can solve many of the problems in today’s market while respecting consumer choice.

In closing, the text of my prepared oral testimony from yesterday is below. Those remarks are based substantially on my March 2009 paper, Subprime Servicer Reporting Can Do More for Modification than Government Subsidies,” available at http://ssrn.com/abstract=1361331.

Oral Testimony of Joseph R. Mason to the Joint Economic Committee

“Current Trends in Foreclosure and What More Can Be Done To Prevent Them.”

Tuesday July 28, 2009, 10:00 A.M. Cannon House Office Building Room 210

Thank you Madam Chair and Committee Members for inviting me to testify today. I’ve submitted a more detailed paper I’d like to ask to be included as part of the record. What follows is a summary of that work.

Recent history is rife with examples of subprime servicer problems and failures, resplendent with detail on best – and worst – practices. The industry has been through profitable highs and predatory lows, over time reacting to increased competition with greater efficiency.

But intensively customer service-based enterprises such as servicing are hard to evaluate quantitatively, so that proving a servicer’s value is difficult even in the best business environment. Unfortunately, today’s is not the best business environment, so proving servicer value has now become crucial to not only servicer survival, but the survival of the market as a whole.

There are seven key reasons why servicers are facing difficulties with today’s borrowers:

1.         Modification is Expensive;

2.         Arrearages are a Drag on Profits;

3.         Mortgage Servicing Rights Values Decline with Defaults;

4.         Increased Fees are only a Partial Fix;

I wrote about these in Fall 2007, and they are being addressed in recent Administration proposals like HAMP. But as Congressman Cummings mentioned in his opening remarks,

5.         When Servicers are Threatened, Employees (and Expertise) Flee. Reduced servicing staff, particularly with respect to the most talented employees that have other options, will have a demonstrably adverse affect on servicing quality.

…and more importantly…

6.         Servicer Bankruptcy Creates Perverse Dynamics. While most securitization documents stipulate a transfer of servicing if pool performance has deteriorated or if the servicer has violated certain covenants, which are expected to generally precede bankruptcy. The problem is that the paucity of performance data makes it difficult for the trustee or the investors to detect servicer difficulties prior to bankruptcy to make the change.

7.         Default Management is More Art than Science. While modifications can be a useful loss mitigation technique when appropriate policies and procedures are in place, servicers that are unwilling or unable to report the volume, type, and terms of modifications to securitized investors or regulators may be poorly placed to offer meaningful modifications.

The main drawback with current policy is therefore that the industry can use modification to game the system and investors are wary. In other works, some servicers are taking advantage of both borrowers AND investors. There are four major reasons for investor concern.

1.         Aggressive Reaging makes Delinquencies Look Better than they Really Are. Investors know that redefault rates on modified loans are high, so calling the modified loan “current” again immediately is disingenuous at best.

2.         Aggressive Representations and Warranties also Skew Reported Performance. At their best, representations and warranties help stabilize pool performance. At their worst, representations and warranties inappropriately subsidize the deal. In practice, it is difficult to decompose the difference between stabilization and subsidization.

3.         Reaging and Representations and Warranties are used to Keep Deals off their Trigger Points. Residual holders, nay, servicers, however, continue to push for lowering delinquency levels, no matter how artificially, in order to maintain positive residual and interest-only strip valuations that can keep them from insolvency. Aaa-class investors are therefore at the mercy of servicers who are withholding information on fundamental credit performance in lieu of modification.

4.         Private Sector Servicing Reporting does not Capture even the Most Basic Manipulations. Servicers that utilize unlimited modifications or modifications without appropriate controls heighten risk to homeowners and investors.

The State Foreclosure Prevention Working Group’s first Report in February 2008 acknowledged that senior bondholders fear that some servicers, primarily those affiliated with the seller, may have incentives to implement unsustainable repayment plans to depress or defer the recognition of losses in the loan pool in order to allow the release of overcollateralization to the servicer.

Regulators can therefore do a great service to both the industry and borrowers in today’s financial climate by insisting that servicers report adequate information to assess not only the success of major modification initiatives, but also performance overall. The increased investor dependence on third-party servicing that has accompanied securitization necessitates substantial improvements to investor reporting in order to support appropriate administration and, where helpful, modification of consumer loans in both the private and public interest. Without information, even the most highly subsidized modification policies are bound to fail.

† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: [email protected]; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason.

4 Responses to "Mortgage Modification, Full Speed Ahead!"

  1. Anonymous   July 31, 2009 at 4:08 am

    Excellent piece. Sheds light on what’s going on behind the scene on modifications & highlights the difficult relationship between the various stakeholders involved.

  2. Anonymous   July 31, 2009 at 9:06 am

    this article misses a key point that servicers owned by banks who hold the home equity loans are conflicted

  3. Anonymous   August 3, 2009 at 12:01 am

    This stuff all sounds great, however if you are trying to do a loan modification under the Obama modification program and you have your loan with Wells Fargo you can forget it unless you are way behind in payments Wells does not give a hout!

  4. Alex Frank   August 4, 2009 at 4:14 pm

    One question I have is why aren’t we focusing more on getting homeowners into these empty houses? I just heard that there is something like 19 million empty houses in the country. Lets help some people buy homes that can afford it and make it easier for them. I recently bought a home with the help of http://www.MortgageRefinancing.com and they were great. Interest rates are low and houses are cheap so it is an amazing time to do so. I think we need to shift gears.