Securitization and Modification
Foreclosures are very expensive for lenders. On average, the costs alone of a foreclosure have been estimated to cost over $58,000. And lenders are thought to lose 40-50% of their investment. In short, for lenders (not to mention for homeowners, their families, and communities) foreclosure is a rotten deal.
So why aren't lender's reaching more consensual deals with distressed homeowners? Why do we need to permit homeowners to use the bankruptcy system to bring lenders to the negotiating table?
Part of the answer lies in securitization, which separates the ownership of the mortgage loan from the servicing of the loan. The servicers are often compensated based on the outstanding principal of the loans, which reduces their incentive to write-down the loans. Securitization also divides the ownership of the loan into various slices, called tranches, some of which get paid before the others. These tranches have conflicting interests regarding modification, and any servicer that modifies a loan risks being sued by the tranches that find themselves out of the money. In short, securitization makes workouts difficult. Unfortunately, nothing in the Paulson plan is legally binding or changes the incentive structures inherent in securitization.
The market is actually impeding lenders from coming to the negotiating table and achieving the efficient outcome by working out loans consensually. This means that the only way lenders can be brought to the bargaining table is through bankruptcy, if debtors are permitted to modify their mortgages, as H.R. 3609 proposes. Rather than interfering with contracts, mortgage modification is actually a case where bankruptcy encourages efficient outcomes by avoiding foreclosures.
O. Max Gardner III
Shelby NC
www.maxgardnerlaw.com
I have to disagree with the writer that the investment grade (AAA bonds) investors lose money when the Servicers sale REO property after a foreclosure. I do not dispute that the average "book losses" could be as high as $58,000 per property. However, the writer fails to take into account the available insurance claims that protect the upper tranches.
Why do you think the two biggest issuers of Private Mortgage Insurance (Radian and MGIC) are in such dire financial straits? They are having to pay the AAA investors for the first 20% of each REO loss.
And, each securitized trust has various forms of pool insurance that covers losses not covered by Radian or MGIC. Just look at the financial problems of MBIA, one of these bond insurers. And, then we have all of the credit default swaps, etc. The bottom line is that the Servicers actually make more money from a defaulted mortgage or a mortgage involved in a Chapter 13 bankruptcy case than from a performing mortgage product.
The problem with the AAA bond investors is not that they are not getting underpaid but that they are getting paid too soon. They invested their money for 5 years at a fixed return and they really don't want all of the cash at one time. Why? They have to figure out where to invest it now.
Since many of these bonds have been rescuritized in Collateral Debt Obligations, and then in Credit Squared Obligations, the problem right now is that there is simply no market for any of these bonds and nobody really knows the current market value. Some of the single A and BBB pieces have a market value of 10% of the face amount and many have 0 value. We are also seeing 30% reductions in the market value of some of the AA bonds.
As the values have dropped, the credit grantors who took these bonds as collateral for loans have issued margin calls and these calls have created the need for massive cash to cover the same. The Federal Reserve Bank and the Foreign Banks have recently provided this unprecendeted infusion of additional money into the market to cover the margin calls but also to add liquidity to the markets so that these bonds will start trading again. When the two big Bear Hedge Funds failed back in June, many investment banks and other grantors of credit started a complete revaluation of these bonds from computer driven to market driven models. This is when things started to rewind in fast forward.
All of these Single A and diffent B bonds have been used to leverage additional loans and then re-leveraged again and again. As noted, the value of all of these bonds was based on sophisticated and highly complex computer models. The bonds were marked to model as they say. When the two Bear Hedge funds failed in June, all of the sudden the computer models were discarded and the investors started looking at the "market" value. The market value has dropped like a rock since June.
As the market values have dropped, this has triggered margin calls and guarantee calls that have forced most of the Banks and Investment entities to recognized these SIV's and SPV's as assets along with their respective liabilities. The leverage on most of these deals was at least 10 to 1, with many deals much higher. So, for example, $1 trillion dollar in mortgage bonds secured by $1.1 trillion in residential mortgages were used to eventually borrow $10 trillion dollars. This is the magic of resecuritization and collateral debt obligations. Maybe a better word would be the black magic.
December 20, 2007 4:11 PM | Reply | Permalink
Max:
It's nice to see you commenting on here. I am no longer in the bankruptcy practice, but I am trying to keep up with the latest information as best as I can.
Anyway, I think you might be interested in seeing an even bigger picture than the bankruptcy market. A good blog, IMHO, is Sudden Debt. Sudden Debt discusses not just the effects of consumer debt, but national and market debt as well. So its focus is larger than the individual consumer debt that bankruptcy lawyers focus on.
Here is one pertinent post and discussion to this topic: Here There Be Monsters.
Satellite Sky Blog
Find the Truth. Do Justice.
December 23, 2007 5:58 AM | Reply | Permalink
Securitization also divides the ownership of the loan into various slices, called tranches, some of which get paid before the others. Adam Levitin
I hope Adam will revisit to confirm the correctness of this statement, because it seems, on its face, to be wrong.
Investors (that is, holders of the various tranches) in MBSs, CDOs, or CDO^2s don't own the underlying debt but rather own varying claims on the portfolio's stream of payments. Presumably, the portfolio comprised of the underlying obligations is owned by a trustee or other fiduciary taking its instructions from the establishing instrument. If that instrument permits modifications upon the occurrence of certain conditions,* then, the trustee can modify the terms of the underlying debt obligations when those conditions occur.
* The condition might be as simply stated as circumstances such that a traditional institutional mortgagee would act to modify.
December 20, 2007 6:58 PM | Reply | Permalink
I find it hard to believe that lenders lose money on a foreclosure. They have made hundreds of thousands of dollars on a typical mortgage over the years. It is very profitable for them. They simply mitigate their future loss of expect profit by foreclosing.
These claims of losses come from accounting procedures that paint that picture.
Jim Anderson
The Truth About Credit
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Ministry WebsiteDecember 22, 2007 11:15 AM | Reply | Permalink
In the past, when nearly all foreclosures were the result of life disasters (long term job loss, medical probles etc), you might e right: the borrowers they forelosed on had often been paying for years. Today that isn't true. A great many mortgages going bad today are not very seasoned at all, and the lender has not gotten back much beyond a small fraction of the original debt.
December 22, 2007 4:51 PM | Reply | Permalink
Jim,
While I don't know about all of the various insurance products referenced above, I do find it hard to believe that lenders don't lose money in the event of foreclosure in most cases. The reason is that I would suspect that few foreclosed loans have been paying for a long time, since older loans tend to involve lower monthly payments and be on homes where the owner can sell to retrieve his/her equity.
On newer loans, there probably isn't any equity in the house so the owner can't sell or refinance if they fall behind. And if a $200,000.00 loan is foreclosed 2-3 years in, and the house ultimately sells for $150k-175k (a fairly likely scenario where I am) there is likely a loss for the lender even before taking into account the costs of the realtors, lawyer doing the foreclosure etc. I'm not suggesting that we feel sorry for the lenders, but I am suggesting that it is irrational for them not to negotiate.
Pete
December 24, 2007 4:04 AM | Reply | Permalink
Okay, there may be more of these newer loans. But if you do the math, using the numbers you mentioned, they still don't lose much. The interest paid on the $200K loan for three years is likely enough to make up the difference from the sale with your numbers (assuming the lender cannot collect the shortage). When you look at the bad debt expense as a result, it is pretty small compared to the size of the loan, and that mainly comes from the collection costs.
Don't forget that the lender has likely tacked on late fees, penalties, etc to the balance of the loan, and in many cases it isn't a purchase money loan (its been refinanced) and they can go after the shortage after the auction. They earn high interest and fees on the balance while they go through the process of suing, and they tack the costs of suing and collecting on the balance if they can get away with it. In the end, if they win their suit (98% of the time), they probably don't lose anything. This is because they will continue to garnish wages, sweep accounts, and use whatever collection techniques necessary to paydown the balance until it is paid.
If there is a bankruptcy, it is likely to fall out of bankruptcy these days (probably 90% or more chance), due to the unreasonable requirements, and they then will still be able to continue to garnish wages, seize assets, sweep accounts, etc.
With the higher interest rates they charge, it certainly more than makes up for any losses. That is why they aren't willing to negotiate write downs. They are better off if they don't.
Jim Anderson
The Truth About Credit
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Ministry WebsiteDecember 24, 2007 8:19 AM | Reply | Permalink
Ellen is technically correct that the holder of a MBS does not "own" a loan. But this is largely a distinction without a difference. The loan is owned not by the trustee, but by the securitization trust. The trustee merely manages the trust. The situation historically prevented loan modification because of the REMIC tax rules and FAS 140; if the trustee were too active in managing the trust assets, which many believed would be the case with modification, then the trust would lose its pass-thru tax status and the accounting rules might require the trust assets to be on the originator-trustee's balance sheet . My understanding is that these limitations no longer prevent modification, however.
As Ellen notes, the MBS holder is entitled to a share of the stream of income from the loan. But once the income stream has been divided from a loan, there really isn't much else to it, so for all practical purposes the holders of MBS "own" the securitized loans.
Max is correct that the ultimate credit market problem is that no one knows what valuation model to use for MBS (or ABS) anymore. And as a result, no one knows who is in the money and who is holding losses. The effect of this is to inject tremendous caution into the market.
Max is also right to note that some (but hardly all) MBS investors are protected by various derivative products and insurance. But the baseline assumption has to be that other than originators' EPD (early payment default) liability (for loans that default within the first two or three months), the losses are borne by the MBS holders. And most importantly, the insurance payees are the MBS holders, not the servicer. Insurance payouts to the MBS holders do not make whole the trust's principal, so servicer's whose income is related to the trust's principal are incentivized against writing down the trust's principal.
As for the Jim-Pete debate, it might help to clarify who is the "lender." The originator may not lose much on a single foreclosure--indeed, if it pads its fees for services, it might come out just fine. But the holders of the fulcrum tranche in an MBS (the ultimate lender) certainly take a loss.
December 26, 2007 5:48 PM | Reply | Permalink
While you may consider the concept of legal ownership to be a "distinction without a difference," the law doesn't agree.
Your "lenders" -- that is, purchasers of tranches in Real Estate Mortgage Investment Conduits (REMICs) -- have no legal relationship with the mortgagors. Were those "lenders" to sit down with the mortgagors they'd have nothing to talk about.
It is the servicers acting under the applicable Pooling and Servicing Agreements who must step up to the plate and act to minimize the pools' losses by modifying the terms of the mortgages which are under stress. These servicers may be caught in a conflict of interest situation for other reasons, but it seems unlikely that their incomes will suffer upon modification. The face value of the mortgages wouldn't be altered and the stream of income would not be less -- indeed, it might be greater -- than it would be in the absence of modification.
The larger problem is the one you mention, now -- that no one knows for sure how the IRS will tax these trusts if modifications make them appear to be active rather than passive trusts or whether FASB may require off-balance sheet SIVs to be brought back onto the banks' financial statements if the banks, as servicers, appear to be the real parties-in-interest when they modify the pools.
If the servicers are experiencing a conflict of interest, it appears to arise from the fact that the trust property is pooled but the beneficiaries are not. The beneficiaries (owners of differing tranches) will be affected differently by modifications. How can a single trustee/servicer represent all these different beneficiaries when their interests are potentially adversarial?
December 26, 2007 8:02 PM | Reply | Permalink
Re: Insurance payouts to the MBS holders do not make whole the trust's principal, so servicer's whose income is related to the trust's principal are incentivized against writing down the trust's principal.
Given a choice between having the loan end up as a charge off (the principal is effectively written down to $0) and writing down some minor fraction of it, thereby preserving most of the income stream, shouldn't the servicer choose the latter? I work in the industry. Charge-offs, REOs and the like do not even stay with their original servicer but are sent to special servicing companies to manage, so the original loan servicer loses everything on that deal. And by the way I have not noticed servicers being adverse to bargaining in these matterss when they have a green light to do so. I have seen deals negotiated on mortgages as far as six months into default. Nothing is inherently impossible here.
Re: The originator may not lose much on a single foreclosure--indeed, if it pads its fees for services, it might come out just fine.
New Century, American Home Mortgage, First Magnus and quite a few others have closed their doors because their default rates were too high and they were required to buy back too many of their defaulting mortgages, or, in some cases, got a bad rep for default-prone loans so that the big banks shied away from their product, cutting off their funding and leaving them with a portfolio of bad loans.
One thing I do agree with Ellen about: some tax clarifications (and leniency) are necessary. This should be doable. Some tax changes are already in the pipeline absolving borrowers of taxes owed on "debt amnesties" due to short sales, renegotiated loans, etc., in fact the IRS has already begun to apply a very liberal definition of "insolvency" to effect this before Congress acts. There should be no trouble with geting the trusts off the hook in these instances too.
December 27, 2007 7:39 PM | Reply | Permalink
Failures of banks are not a direct result of a lack of income, but rather poor financial management, believe it or not. Bank salaries for executives are far too high, as well as real estate costs. The industry was built on the margin between the rate it pays the Federal Reserve Bank and depositors, or whoever else it borrows money from, and what it charges on loans. The margins are thin on mortgages (but high volume), and they are sky high on credit cards. Mortgage loans contribute to the volume of portfolios at banks and are typically not the "sweet spot" in the banking business. They do more to contribute to bank growth and size. So, with banks getting more generous with qualification standards has helped them build their portfolios, but they have failed to correctly assess the risk. In a real sense, they rarely lose a lot of money in actuality, taking into account all they get when suing for balances (default fees and etc.), it just doesn't come right away in the form of cash. The banks fail because their portfolio quality deteriorates and stockholders bail, that combined with uneccessary overhead (high salaries, commissions, and real estate costs) kill the business.
In the early '80s Citibank almost went under until they were saved by a Supreme Court decision that opened the door to exporting interest rates across state lines, which gave birth to the high interest rates on credit cards. Credit cards kept Citibank for going under. Citibank was one of the largest banks at the time, though not the largest. I think it indicates that our banking system is in trouble. One of the problems being that the business model carries way too much overhead for the way it derives its income, and the varying interest rates of the market. They have tried to compensate with service fees, late fees, loan fees, and fees for breathing. They don't lose money on loans, they just can't cover their overhead when defaults rise because they have already spent the income they expected to get, and already booked.
Everybody is forgetting the increased risk with increased borrowing. They need to quantify risk better, and be prepared for it. The insurance industry has done this well. Every other business could learn something from them.
Jim Anderson
The Truth About Credit
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Ministry WebsiteDecember 30, 2007 10:28 PM | Reply | Permalink