REQUIRED READING: In his forthcoming book, ‘Way Too Big To Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System,’ Greenwich Financial Services CEO Bill Frey, one of the first investors to sue over a servicer's perceived loss mitigation failures, describes private investors' loss of confidence as the single biggest problem in the U.S. mortgage market.
Since the private-label residential mortgage-backed securities (RMBS) market came to a standstill in 2008, only two private-label deals containing newly originated loans have come to market, and they were both from the same issuer, Redwood Trust. Ninety-seven percent of RMBS issued last year were federally backed, compared to only 64% in 2007, American Securitization Forum (ASF) Executive Director Tom Deutsch testified earlier this year.
In the early fallout from the housing crash, much of the focus on reinvigorating the private-label market has zeroed in on higher-quality loan originations. But with many investors shifting their attention to default management issues recently, a more timely question may be, what can the servicing industry do to help restore investor confidence?
"The first word that comes to mind is "transparency,'" says Deborah Martin- Dominick, vice president of business development and client management for RoundPoint Mortgage Servicing Corp., a Charlotte, N.C.-based specialty servicer. "Giving investors the ability to look at loan-level data gives them a sense of security in their relationship with their servicer."
RoundPoint appears to be something of an outlier in today's world. The company's proprietary loss mitigation system, which tracks loss mit recommendations and investor approvals, provides loan-level data access to investors. According to Round- Point President Dave Worrall, it is critical to make granular loan details available to investors, who are taking on a much more active asset management role than they have historically.
"You have to have a different model that enables loan-level data access for investors – via their desktops, in their own office," he says. "You also have to allow investors to give you portfolio- and loan-level instruction on the mortgages they've invested in. Servicers nowadays have a few very strong investor partners who are regularly in the shop, giving precise guidance on the level of loss mitigation activities that take place on a loan."
To date, however, a main beef among investors has been their inability to peek into servicers' operations and gain a true understanding of workout decisions on a loan-by-loan basis. Remittance reports offer a view of RMBS performance at the macro level, but they provide little in the way of specifics says, Sue Allon, CEO of Allonhill LLC, a risk management firm.
"Investors are beyond frustrated with having to reverse-engineer the remittance reports and find a way, using outside loan data providers, to back into what the data really means," she says.
Determining how various loss mitigation options, such as short payoffs or principal-reduction modifications, translate into cash recoveries is an expensive and time-consuming process for investors. Much of the repurchase litigation occurring in the market is the direct result of investors' desire to see what is happening with their loans, Allon says.
Loan-level disclosures – both those provided at the time of issuance and those provided on an ongoing basis – were at the heart of the first phase of the ASF's Project RESTART, an endeavor meant to facilitate the return of a private-label market. The Securities and Exchange Commission included the ASF's concepts in its proposed Regulation AB II, which responds to disclosure mandates baked into the Dodd-Frank Act.
Glenn Costello, senior managing director and head of modeling for Kroll Bond Rating Agency, says the ASF's model disclosures are a good starting point for servicers.
"If servicers can hit that format and fill in a lot of that information, that will go a long way toward having that rich data that we'd all like to have," he says.
Along with more in-depth reporting, investors will press for better metrics that can be used to trigger third-party loan file reviews, according to Allon. Such metrics could take the form of predetermined delinquency thresholds, whereby a third-party investigator that is named in the RMBS pooling agreement would be called into action if a certain percentage of loans became nonperforming.
The ASF included similar protocols in its Model RMBS Repurchase Principals document, released in late August. That document refers to "review events" that would prompt independent firms to review loans that were either previously liquidated or became real estate owned, or loans that became delinquent for a period of time specified in advance in pooling contracts.
Regulatory intervention may not be necessary, Allon cautions. She believes that once the RMBS market does get back on its feet, investors will simply balk at deals in which transparency is not promised up front. Investors might demand stronger disclosures elsewhere, according to attorney Isaac Gradman.
"Obviously, a huge issue has been captive-fee arrangements," says Gradman, referring to servicers' affiliate relationships with vendors such as valuation and force-placed insurance providers.
An attorney and managing member of RMBS consulting firm IMG Enterprises, Gradman previously represented PMI Mortgage Insurance Co. in a lawsuit against WMC Mortgage Corp. The case was one of the first examples of litigation focused on breaches of subprime reps and warranties.
Servicers' relationships with outsourcers have been under the microscope for some time. Last year, Bank of America paid $108 million to settle Federal Trade Commission (FTC) allegations that two Countrywide units overcharged homeowners for fees relating to field services. The FTC alleged that Countrywide deceived delinquent borrowers into paying inflated fees for property inspections and lawn mowing. The services were performed by Countrywide subsidiaries.
Investors worry that these types of arrangements pile on unnecessarily high fees for borrowers that, in turn, can worsen a borrower's standing and increase investors' loss severities.
RoundPoint's Worrall says most servicers have become "network organizations" due to the complexity of regulations that govern certain servicing functions, such as foreclosure processing and real estate tax administration. Although some servicers have captive vendors, these arrangements likely do not result in preferential treatment for certain clients.
"A lot of vendors now are so big that they have very standardized contracts or relationships with servicers so that most servicers have the same pricing – and, ultimately, get the same service – that their peers in the industry would," he says.
That is not to suggest that outsourcers should be let off the hook for noncompliance or otherwise poor performance.
"If you want to continue to build the integrity of the industry overall, there certainly needs to be more focus on the service providers to the servicing industry to increase their quality controls and regulations in tandem with the servicers," Worrall adds.
Investors will need to present a unified front if they hope to standardize servicing practices and costs relating to issues such as outsourcing fees, Gradman adds. Standards lead to the establishment of "customary and reasonable" practices, which investors can then use to compare against their servicers' own practices. But even proving that servicers fail to live up to industry standards can become a difficult task if MBS trustees refuse to get involved.
Trustee trouble
Powerhouse securities litigator David Grais, of New York-based Grais & Ellsworth, has described trustees as "aggressively passive." In his upcoming book, Frey terms the phenomenon "trustee apathy." No matter how you cut it, RMBS investors believe trustees are doing too little to support bondholders.
This past July, the Association of Mortgage Investors (AMI), whose members collectively hold about $300 billion of MBS assets, wrote to the nation's major trustees to voice the association's disapproval. In its letters, the AMI wrote that trustees "can no longer "look the other way' and remain uninvolved" with investors' requests for information, which can be used to support claims that sellers misrepresented loan quality or that servicers have administered securitized loans in a manner that adversely impacts bondholders.
The AMI advised the trustees that it wants to develop best practices around two key items: the enforcement of repurchase requests, and the remedying of servicer defaults, the latter of which would include establishing a process by which investors can replace servicers.
As is true in nearly every other crevice of the securitization market, conflicts of interest can and do arise when investors tap trustees for information on deals. Trustees are sometimes affiliated with, or even the same company as, the master servicer on an RMBS deal, and so an impulse exists for trustees to protect themselves by denying investors access to data.
Furthermore, trustees are not compensated to do much more than act as cashiers that compile and publish trust data and deliver funds to end investors. According to Allon, who says trustees' credibility has been tarnished, market participants have historically inflated the role of trustees. Going forward, RMBS counterparties should scrutinize trustees and hold them accountable for their core job description, but not ask too much of them, she says.
Under the current scheme, trustees are also broadly indemnified by loan originators against investors' repurchase claims, says Gradman. Although trustees' reliance on indemnifications is economically rational, it is also bad social policy that "creates a market in which investors feel the game is rigged against them," he says.
"It's a two-headed monster," Gradman explains. "Ideally, trustees should be doing a lot more, but they're not paid to do more, and they're not technically forced to do more."
He believes that future pooling-and-servicing agreements will require independent trustees that are not beholden to banks.
Steaming over subordinates
Another femur-sized bone of contention for investors is the seeming bastardization of lien priority, embodied by a situation in which a servicer owns the second lien on a property for which it services a securitized first-lien mortgage.
This conflict of interest is most pronounced at the nation's four largest servicers (Bank of America, Wells Fargo, Chase and Citi), which hold more than $400 billion of second-lien mortgages – nearly half of the $1.1 trillion of outstanding mortgages – on their balance sheet.
By comparison, only $41 billion, or 3.7%, of second mortgages are held in private-label securities, according to the AMI. Investors claim the banks are holding the loans at artificially high levels – between 85% and 95% on par, Gradman says. In contrast, securitized delinquent firsts are valued at 40% to 60% on par.
This dichotomy is due to the perhaps surprisingly high percentage of borrowers who remain current on their second loan after going delinquent on their first. Analysts with Amherst Securities Group have found a "significant minority" of borrowers exhibits this payment behavior. Approximately 78% of borrowers who are delinquent on their first loan stay current on their home equity line of credit (HELOC), while 59% of borrowers with closed-end seconds remain current, their research showed.
The analysts concluded that the disparity is due to credit availability. The liquidity provided by HELOCs is an incentive for borrowers to stay current. Closed-end seconds, meanwhile, carry more affordable loan installments than do first-lien loans, making it easier for mortgagors to continue paying. Such subordinate-lien conflicts, in turn, encourage the mega-shops to employ loss mitigation strategies that private-label RMBS investors find troubling.
"The biggest hit to investor confidence is that it's become apparent that certain servicers have conflicts of interest, and when those conflicts arise, servicers are choosing to service in the interest of their own balance sheets rather than bondholders' best interests," says Gradman.
Allon says her firm has seen numerous short sale deals wrecked by second-lienor stubbornness. She says the second-lien issue will "absolutely" have to be addressed before investors can return to the market with confidence. She believes investors will demand that future securitization documents emphasize disclosure around secondlien activities and require servicers to write off subordinate loans in scenarios where it results in a prudent loan workout.
Resolving investors' second-lien concerns, however, is a process that does not necessarily have to be driven by the private market. In recent congressional testimony, Laurie Goodman, a senior managing director at Amherst Securities, proposed three options that could be enacted by legislative or regulatory means.
Under the first proposal, first lienors would have to approve a second lien. If the investor denies the second lien but the borrower opts for it anyway, the investor would be able to invoke a due-on-sale clause, which would result in the immediate payoff of the first lien. This approach would require amending the Garn.-St. German Depository Institutions Act of 1982, which prevents senior-lien holders from invoking the due-on-sale clause, Goodman said.
Alternatively, Congress could pass legislation prohibiting a second lien on a property where the combined loan-to-value ratio (CLTV)Â exceeds a designated level (e.g., 80%) at the time of origination. The third regulatory-minded option proposed by Goodman would create a rule that simply forbids a lender from servicing both a first- and second-lien loan while owning only the second.
Federal regulators attempted to address the second-lien issue as part of their qualified residential mortgage (QRM) rulemaking. The QRM designation refers to "low risk" loans destined for securitization, and it exempts lenders from having to retain 5% of the credit risk of such loans.
As originally proposed, the QRM definition – which, at the time of this writing, had not been finalized – would not apply to a first-lien loan where the borrower also obtains a piggyback loan. In comments to the regulators, the ASF voiced concern that the QRM definition does nothing to stop a borrower from taking out a second loan immediately after the first.
"Ultimately, a mechanism should be employed that prevents QRM borrowers from either taking out a second lien or taking out a second lien that would raise the CLTV above a certain threshold," the ASF said in its comments.
"Investors, in principle, are not in favor of restricting credit, especially for high-quality borrowers. However, the fact that a QRM pool results in zero risk retention with no future second-lien restrictions is concerning and is potentially the best example of why the QRM concept is difficult to employ in a securitization framework," the group added.
Lien-priority conflicts of interest have been identified for years now, and a resolution has been slow coming. Add in investors' demands for better reporting and disclosures – not to mention the ill-defined role of trustees – and it is clear that investors and servicers have their work cut out for them.
"I do think that servicers are pitted right now against investors, and vice versa," Allon says. "But I think that investors will make it their job to realign their interests with servicers, and if servicers want to be on those transactions, they will agree to the terms."
Allon says the industry is "truly in our infancy in terms of refining things."
Adds Worrall: "I think it will be a long time before investors have a laissez-faire approach to investing in mortgages."
