What will this brand-new year bring to the mortgage servicing industry? Well, if the tail end of 2008 was any indication, the answer likely includes two components: pressure from the government to modify loans and pressure from investors to abide by servicing agreements.
To discuss service-agreement complexities and modification best practices, MortgageOrb spoke this week with Carol M. Beaumier, vice president of Global Industry Programs and leader of the Financial Crisis Team at Protiviti Inc., a global business consulting and internal audit firm.
Q: Bank of America was recently sued by a group of investors who claim the bank's loan modification program – a result of its settlement with 12 state attorneys general – violates service agreements. How can servicers both accomplish mods on a large scale and avoid litigation?
Beaumier: Dealing with the risks of investor claims can be quite a bit more complicated and challenging than many news reports have suggested.
In the case of relatively straightforward arrangements involving whole loans serviced on behalf of a single investor, managing the process can be as simple as understanding what types of modifications are permitted by the applicable master servicing agreement, and seeking the investor's consent to modify those terms if the servicer believes more flexibility is appropriate.
Fannie Mae and Freddie Mac, for example, have recently taken steps to make this process more efficient by unilaterally modifying their servicer guidelines to permit and encourage more aggressive modification efforts for loans serviced on behalf of the [government-sponsored enterprises].
However, for loans that are serviced as a part of a trust on behalf of the holders of complex securities (and derivatives of such securities), there is no obvious or low-risk solution outside of the relatively limited types of modifications that are generally permitted by the applicable servicing agreements.
Certainly, some investors would be happy to take advantage of any deviation from the servicing agreement to force the servicer to repurchase the loan (or its underlying securities) at face value and thus relieve the investor of an undesirable asset at a very favorable price.
Even in cases where the servicer and individual investors would be interested in negotiating changes to the servicing agreement on a good-faith basis, however, the obstacles to doing so are many. Some of the more significant ones include:
- identifying all of the investors in a particular trust and obtaining consent from a sufficient number of them to alter the servicing agreement,
- realizing more aggressive modifications might be beneficial for some classes of investors but detrimental to others who hold different tranches of securities in the same pool of loans, and
- dealing with the tax consequences of modifications to the servicing agreement (or of modifications to the loans themselves).
To minimize the risks, modification programs must objectively result in a higher expected return to investors than taking the loans to foreclosure. In this scenario, it would be difficult for most investors to demonstrate that they have suffered financial harm as a result of such modification.
To support and evidence their efforts, servicers should document specific, detailed standards for consideration of loan modifications – including, especially, the components of and assumptions inherent to the expected value test – and apply these standards to their portfolios systematically to demonstrate that all potentially eligible loans were evaluated properly and consistently.
Q: In light of President-elect Obama and Fed Chairman Ben Bernanke requesting more help for troubled homeowners, do you believe more TARP funds will eventually flow toward foreclosure-prevention efforts? Has the government miscalculated its allocation of the money, or was providing banks with more capital a wise first step?
Beaumier: Key members of Congress have made clear their views that release of the remaining TARP funds will require direct, measurable efforts to help consumers avoid foreclosure, so whether TARP funds will be used directly for this purpose, or whether those who benefit from the release of the funds will be required to use the funds for that purpose, we expect that the future of TARP and more tangible foreclosure prevention efforts will proceed hand in hand.
What seems clear to us now is that the problems facing the financial services industry were more severe than was recognized when the initial plan of purchasing distressed assets was proposed. Treasury Secretary Paulson and other responsible parties would appear to deserve credit for showing enough flexibility to redeploy the funds in a manner that they felt would provide the most benefit based on the information available to them at the time, even if that doesn't turn out to have been the optimal approach in hindsight.
Although the initial belief was that the purchase of distressed assets would clean up banks' balance sheets and provide for greater availability of credit, we think it is reasonable to expect that the capital injection phase of TARP will eventually be viewed as a necessary, interim step to stabilize the system generally and provide an orderly, relatively low-cost means to wind down troubled banks (e.g., takeovers of some large, troubled banks by TARP recipients) before a broader recovery effort can eventually take place. In the end, however, history will be the judge of whether this was a wise first step.
Q: What are your thoughts on FDIC Chairwoman Sheila Bair's proposal to the government to consider a systematic modification approach that includes an affordability standard (rewriting loans to reflect a 31% debt-to-income ratio)? Do you believe it will be accepted and, further, will be successful?
Beaumier: Except for the loss-sharing component (which requires that the government and the loan holder split the costs associated with a modified loan that subsequently redefaults), many of the largest banks and servicing companies are already carrying out or are in the process of launching loan modification programs that are broadly similar to what Chairman Bair has proposed.
There continues to be widespread criticism of the loss-sharing component on the grounds that it improperly rewards investors who made or purchased inappropriate loans. However, we think continued bad news regarding the scope of the foreclosure problem, coupled with the change of administration, make this provision – or one similar to it – more likely to be accepted going forward.
There is no easy solution for solving the housing crisis, and any plan that helps some borrowers by eliminating preventable foreclosures is a step in the right direction. However, we believe that proponents of large-scale modification programs often overestimate the likely benefits of the programs and that Chairman Bair's proposal is subject to many of the same limitations. A few of the many such limitations include:
1.) Lack of borrower participation. Even if a modification is objectively in their best interest, our experience working with our clients and other industry data suggest that typically only 15% to 20% of potentially eligible borrowers respond to modification offers.
2.) Recidivism rates. A recent paper published by the banking regulatory agencies themselves suggests that more than 50% of modified loans redefault within six months. Chairman Bair suggested that this is due to the terms of the modifications themselves (i.e., that the modifications did not provide a sufficient benefit to the borrowers).
However, our experience has led us to believe that, although this may be true in some cases, the majority of redefaults occur for the same reason(s) as the original default – a loss of job, medical event or other issue unrelated to the loan terms, per se. Moreover, increasing the benefits provided to borrowers as a result of the modification (e.g., by further reducing the interest rate) will necessarily make it less likely that a proposed modification would pass the required expected value test.
3.) No provision to permanently write down (or directly share the cost of writing down) principal. Our experience suggests that a very large percentage of loans that are delinquent and potential candidates for modification have principal balances well in excess of the current value of the property.
Even if a loan modification could be offered in these cases, many such borrowers are either uninterested in the modification or are very likely to redefault, because they have little tangible incentive to repay their loan unless the principal balance is reduced by a sufficient amount to give them at least the hope of regaining equity in the property.
For their part, loan holders are, thus far, almost universally unwilling to write down principal and "lock in" their loss, while giving the borrower the potential to benefit from the reduction when housing prices recover. The Bair proposal explicitly reduces the loss-sharing contribution for [loan-to-value ratios (LTVs)] in excess of 100%, and eliminates it altogether for LTVs above 150%.
Q: Numerous states have proposed foreclosure moratoria, and it's rumored that Congress is also considering going the moratorium route. Do you see this as a positive move or a detrimental one?
Beaumier: A moratorium as a stand-alone solution generally delays the inevitable at best, and at worst, removes the urgency for a borrower and a servicer to find a solution to the delinquency, and increases losses for all parties involved so long as housing prices continue to decline.
Proposals such as that set forth by the state of California – which takes a carrot-and-stick approach by exempting from the moratorium provision servicers who have a good-faith, systematic loan modification program in place – are much more likely to be effective in our view.
Q: According to several reports, the Treasury's TARP-funded capital injections have not been sufficiently tracked. If large-scale modification programs become the norm, how can the servicing community prevent a similar lack of oversight? Will loan mods en masse demand a different kind of monitoring than what servicers may be used to?
Beaumier: The HOPE NOW coalition has started to take helpful steps in this regard by tracking the specific terms of modifications and other solutions offered, and it is hoped that this data can eventually be mapped back to loan repayment performance to provide empirical data as to what types of solutions work and don't work.
The data gathered by the [Office of the Comptroller of the Currency], as referenced above, could provide a similar benefit. In working with our clients on these matters, we've captured the terms of the loans pre- and post-modification, as well as the borrowers' circumstances that led to delinquencies, and used this data to perform statistical analyses to recommend changes to underwriting criteria with the objective of reducing redefault rates on future modification.
As more such data becomes available for larger numbers of loans on an industry-wide basis, such analyses can become more sophisticated.
More generally, all servicers offering such programs will want to perform regular monitoring procedures and/or internal audits to ensure adherence to the servicer's modification guidelines.
Aside from the importance of this consideration for purposes of protection from possible investor claims, we expect that consumer groups, regulators and the plaintiff's bar will eventually seek to compare the terms of modifications offered to various classes of borrowers for purposes of determining whether discrimination against a protected class might have occurred.
Setting forth detailed, objective criteria for considering loan modification opportunities, and applying these criteria consistently, will be helpful in mitigating these types of Fair Lending risks as well.
