«Barriers to Federal Home Mortgage Modification Efforts During the Financial Crisis Patricia A. McCoy August 2010 MF10-6 Paper originally presented at ...»
Servicers who hold the B piece may favor loan workouts over foreclosure to avoid losses to the residual tranche. At the same time, they are likely to resist interest rate reductions that would eat into their excess interest payments.59 To summarize, servicers’ compensation structure is consistent with patterns seen in HAMP. Most aspects of servicer compensation make servicers favor foreclosure over loss mitigation. To the extent that servicers do loan modifications, the fixed monthly servicing fee helps explain why servicers prefer interest rate reductions over principal reductions.
Furthermore, servicers who own the B piece may resist interest rate reductions as well.
The Cost Structure Of Servicers The cost structure of servicers also helps explain the low levels of permanent loan modifications seen to date. Under the standard PSA, servicers do not get added compensation for the higher costs associated with loss mitigation. This makes foreclosure relatively more 58 Tanta (2007); Thompson (2009), at 17. This component of compensation is also subject to abuse. Disreputable servicers have incentives to manufacture late fees by not posting on-time payments until after the due date or delaying initiating collection until late fees can be assessed. Servicers may also seize the opportunity to assess junk fees at exorbitant rates for out-of-pocket expenses that are non-existent or trivial in amount. Thompson (2009), at 17.
59 Thompson (2009), at 3-4, 7-8, 20.
17 attractive. Similarly, servicers’ contractual obligation to advance interest and sometimes principal payments on delinquent loans tilts them toward foreclosure.
Expenses Associated With Loss Mitigation From a servicer’s perspective, loss mitigation is expensive when compared to foreclosure. Workouts require personal dealings with individual borrowers, each of whom is in a unique situation. Similarly, servicers who pursue loss mitigation still incur many of the costs associated with foreclosure because they typically pursue foreclosure simultaneously while loss mitigation is underway. This two-track process is encouraged by the credit rating agencies, which condition servicers’ ratings on not delaying foreclosure on distressed loans.60 The March 2010 revisions to HAMP grappled with this issue by prohibiting foreclosure proceedings against HAMP-eligible borrowers during loan modification negotiations.
The monthly servicing fee structure fails to reward servicers for the higher costs associated with loss mitigation. That is because the servicing fee remains fixed even if overhead and labor costs go up. Further, under PSAs, servicers cannot recoup overhead or labor costs at payoff or foreclosure.61 For this reason, servicers have little incentive to incur added overhead or labor costs with no prospect of added compensation. Since overhead and labor are usually substantially higher for workouts than for foreclosures, this tilts servicers in favor of foreclosure.
Servicers who are under financial stress – as many are these days -- will invest even less in a fully staffed loss mitigation operation in order to cut costs.
The practical effect is a noticeable underinvestment in loss mitigation activities. Most servicers lacked the staff or expertise to handle the flood of loan workout requests during the financial crisis. Borrowers and housing counselors reported persistent difficulties in getting servicers to answer phone calls and stories about servicers who lost documents submitted by borrowers abound.62 Too few servicers automated their systems to streamline loan modifications.63 In sum, the fixed-fee structure of servicers, combined with the high cost of loss mitigation, resulted in a business model that was not prepared to accommodate an unprecedented level of delinquent loans and workout requests.
60 Cordell et al. (2008), at 15; Thompson (2009), at 15.
61 At payoff or foreclosure, a servicer can recover all principal and interest payments advanced and out-of-pocket costs such as legal fees, title searches, and appraisals, that are associated with foreclosure or loan workouts. In contrast, PSAs do not pay servicers for overhead and labor, except out of the fixed monthly servicing fee. Kiff and Klyuev (2009), at 11.
62 Cordell et al. (2008), at 9.
63 Cordell et al. (2008), at 23.
18 HAMP tackles this problem by paying servicers bonuses for loan modifications that are approved. This likely explains the seemingly impressive shift in HAMP away from capitalizing arrears toward interest rate reductions. The question is whether this shift is as significant as it seems, in view of the fact that most modifications where it appeared were temporary, not permanent, in nature.
Until recently, HAMP’s main effect was to subsidize temporary loan modifications without much permanent relief. In part, this may have been due to unrealistic loan documentation requirements, which have now been changed. More likely, servicers found temporary modifications cheaper to process because HAMP did not require them to reunderwrite the file until the permanent modification stage. Accounting considerations likely also played a role, as I later discuss. Recent changes to HAMP by the Treasury Department have started resulting in more permanent loan modifications, but more needs to be done.
The Cost of Advancing Payments The cost of advancing delinquent payments and financing those advances is another major factor in servicers’ cost calculus. Under the typical private-label PSA, servicers must advance interest payments (and sometimes principal) for delinquent loans to investors for the time period specified in the PSA. Some PSAs require advances until a loan becomes 90 days delinquent; others require advances until the home is liquidated after foreclosure. In addition to making advances, servicers must pay property taxes and insurance on all delinquent loans until the loans are paid off or the properties are sold.
The advance payment requirement often inclines servicers toward foreclosure. That is because servicers can recoup all advance payments from the sale proceeds of foreclosure, which encourages them to make haste. While servicers can also recover their advances in loan modifications, unlike foreclosure, the speed of recovery in loan modifications is uncertain and often slow. To the extent that servicers agree to loan modifications, they are likely to condition those modifications on quick repayment of all advances.64 That may boost the borrower’s monthly payments, at least temporarily.
The advance payment requirement entails another major cost consideration. Servicers must finance the advances that they pay and this debt service can be substantial. Moreover,
64 Tanta (2007); Thompson (2009), at 23-26.
19 unlike advances themselves, servicers cannot recover the cost of financing those advances from the proceeds of foreclosure. Consequently, servicers have an interest in terminating advance payments as quickly as possible. In states where the foreclosure process is fast (generally nonjudicial foreclosure states), this will cut in favor of foreclosure. In states where foreclosure proceedings are slow (judicial foreclosure states), servicers are more likely to pursue quick workouts to restore the loan to current status and stop making advances. Unless those workouts reduce the interest rate or principal, however, they are not likely to succeed over the long haul.65 Accounting Treatment The choice of workout techniques also has consequences for the accounting treatment of loans and the need to take write-downs. Current accounting rules make servicers resistant to principal and interest reductions. These rules also make servicers more amenable to temporary modifications than permanent ones.
FAS 15 is the central consideration in this regard. Under that provision, permanent modifications of principal or interest require immediate write-downs. To the extent the servicer owns the residual tranche, it will likely absorb all or part of that loss. In contrast, temporary modifications do not trigger the need for write-downs. Thus, FAS 15 encourages temporary loan modifications over permanent ones and short-term payment plans with dubious success rates over modifications that permanently reduce principal or interest.66 FAS 15 is another likely reason why temporary modifications have risen sharply under HAMP while permanent modifications have lagged. That is because permanent modifications condition the acceptance of HAMP payments on a stiff added cost, in the form of write-downs.
65 Thompson (2009), at 26. Piskorski et al. (2009) found that servicers of delinquent securitized loans proceeded to foreclosure more often in states with fast foreclosure tracks than in states with slow foreclosure procedures, relative to servicers of delinquent loans held in portfolio. Id. at 16-17.
66 Thompson (2009), at 12-14, 22. A short-term payment plan suspends terms or full monthly payment requirements for a brief period to allow the borrower to make up missed payments. After the period expires, the payment schedule reverts to the original terms of the mortgage.
In addition, permanent concessions to allay a borrower’s financial difficulties must be treated as troubled debt restructurings under FAS 15 in order to preserve the bankruptcy-remote status of a securitized trust. Among other things, troubled debt restructurings require establishing loan loss reserves under FAS 114.
In 2007, the Securities and Exchange Commission laid to rest another question surrounding the accounting treatment of modified loans. Under FAS 140, a securitized pool limited to assets that are “passive in nature” receives two benefits. The loan pool is protected from claims by creditor against the underwriter or sponsor of the loan pool. In addition, the transferor of the assets does not need to hold capital against those loans. Previously, there had been concern that modifying loans before they became delinquent would disqualify a loan pool from favorable treatment under FAS 140. In a letter dated July 24, 2007, however, then Securities and Exchange Commission Chairman Christopher Cox wrote Congressman Barney Frank, the Chairman of the House Banking Committee, assuring him that modifications before delinquency would comply with FAS 140 so long as default was “reasonably foreseeable.” Rappeport (2007).
20 Servicers that are subject to minimum capital requirements can be expected to shun those writedowns vigorously in order to preserve capital.
Junior Mortgages Another major sticking point may consist of the presence of junior mortgages.
Modifications of first-lien loans become significantly harder to negotiate when there are junior liens on the home. Under existing legal rules, if a first mortgage undergoes significant modification, it risks losing its senior status and turning the junior lien holder into the senior lien holder.67 For this reason, first lien holders generally require junior lien holders to sign an agreement to continue to subordinate their claims before agreeing to modify a first mortgage.
Often this is impossible because the junior lien holders cannot be found. Even when they can be located, junior lien holders are often reluctant to agree or demand several thousand dollars in payments in order to re-subordinate their claims.68 This hurdle is a high one. The Treasury Department has estimated that up to half of all distressed mortgages are backed by junior liens.69 About one-third of subprime 2/28 hybrid ARMs originated in 2005 and 2006 were accompanied by piggyback junior mortgages. Other subprime loans are encumbered with junior home equity lines of credit.70 Currently, HAMP offers a second lien modification program, but servicers do not have to participate in it and uptake has been extremely slow to date. As of March 2010, only three servicers had signed agreements to participate in the second lien program.71 The March 2010 revisions to HAMP seek to encourage higher participation by increasing the subsidies to release junior liens. Whether those subsidies – pegged at 6 cents on the dollar – will be enough remains to be seen.
Contractual Limitations in PSAs for Private-Label Securitizations In addition to possible hurdles posed by revenue, cost, accounting, and lien status considerations, there has been much discussion of the role that PSAs may play in limiting 67 Randolph (2010). A first lienholder may forfeit senior status for increasing the interest rate but not for decreasing it. Increasing the principal balance will also often lead to forfeiture. Extending or shortening the payment schedule will usually not jeopardize senior status. Id.
68 Cordell et al. (2008), at 26-27.
69 Office of the Special Inspector General for the Troubled Asset Relief Program (2010), at 16.
70 Cordell et al. (2008), at 25.
71 Office of the Special Inspector General for the Troubled Asset Relief Program (2010), at 16.
21 servicers’ discretion to modify loans. When a non-conforming loan is securitized, the servicer’s ability to negotiate a workout is subject to the constraints in the PSA for the loan pool. The majority of PSAs permit material loan modifications to some degree in the event of default, imminent default, or reasonably foreseeable default.72 Most PSAs give servicers broad discretion to negotiate forbearance that temporarily extends delinquent payments but does not require a change of loan terms, so long as the servicer timely forwards the missed payments to investors.73 This language may be another reason why temporary loan modifications have predominated HAMP’s outcomes to date.
While PSAs are usually stricter about permanent loan modifications, they vary widely from deal to deal.74 A small percentage of PSAs – roughly 10% -- prohibit any material loan modifications.75 The remaining PSAs do permit material loan modifications, but only when they are in the best interest of investors.76 In such cases, the servicer’s precise latitude to negotiate a loan modification will depend on the PSA. Many PSAs permit modification of all loans.