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FDIC ModSquad

FDIC ModSquad: Not A Welcome Sight For Investors

 

By Candice Workman Nonas, CEO, Fundamental Credit Capital Partners

 

Mortgage loan servicers who are managing loans in a securitization trust may not be eager or able to jump on the FDIC modification band wagon. Investors and servicers are frustrated because modifications are restricted, loans in the most toxic vintages need to be re-underwritten and principal forgiveness will curtail interest income on the lower payment priority securities. Borrower apathy, inadequate staffing and a broken profit model make loan servicing more expensive and pits the modification option against foreclosure.

ModSquad Master Plan

FDIC is claiming success with the modification plan it is using at IndyMac and recommends that other servicers follow suit:

• Owner occupied loans on balance sheet or in IndyMac securitizations targeted

• $1,000 to servicers to offset modification related fees

• 50 percent loss sharing associated with redefaults

• Use a front-end Housing-To-Income ratio to determine payment affordability; target a 31 percent ratio

• Reduce interest rate to as low as 3 percent

• Extend, if necessary, the amortization and/or term of the loan to 40 years

• Forbear principal if necessary

The FDIC's current plan does not call for principal forgiveness but other voices, congress among them, are pushing to write down loans to market value and allow banks to use TARP money to absorb the losses. For servicers of GSE securitizations or unsecuritized whole loans the FDIC plan may be feasible but Pooling and Servicing Agreements (PSA) of private label securitizations oblige the servicer to act in the best interest of the certificate holders and for some securitized deals the FDIC modification plan does not meet this standard.

 

PSA Limitations

Securitization servicers are legally bound by the terms of the securitization trust and loan resolution decisions are governed by the PSA which restricts the number and nature of modifications. Many PSAs limit the number of loans that can be modified to 5 percent to 15 percent of the “then aggregate number of outstanding mortgage loans.” If there is a wrapped Net Interest Margin (NIMs) security, the prior written consent of the NIM insurer must be obtained. Loans also cannot be modified past the legal final maturity date so the 40 year term option is not going to work for more seasoned deals.

 

Chairwoman Sheila Bair stated in November 2008 that she received approval from the proper investor and guarantor pursuant to IndyMac securitization PSAs, which is no small task. Indymac had a significant presence in the mortgage market; they went from the 19th largest originator in 2000 to the top 10 in 2005 and stayed there until the market collapse. Before falling into FDIC receivership Indymac was originating all types of mortgage products – including HELOCs, Sub Prime and Lot Loans - off of 8 origination shelves. In their March 2008 filing Indymac's servicing portfolio was $185 billion unpaid balance (UPB). While this number may seem large it pales in comparison to Countrywide which had a servicing portfolio of 9 trillion loans representing a $1.5 trillion UPB before it was purchase by Bank of America. Getting the requisite approvals to modify loans on a large scale would prove very difficult for a portfolio of Countrywide's size.

 

Other PSAs state that the servicer has to buy the loan out of the trust before modification and the trust must be made whole, i.e. pay a price “equal to 100 percent of the Stated Principal Balance of that mortgage loan, plus accrued and unpaid interest on the mortgage loan before a loan can be modified.” This stipulation is great for note holders but for the servicer it creates a liquidity and capital problem. First, liquidity is needed to buy the loans out of the trust at par. Then the servicer will need the capital to park these toxic assets somewhere – which requires balance sheet capacity; if not their own they need to use the balance sheet of another institution through a warehouse line of credit or a reverse repurchase agreement. Either way, liquidity and capital are near impossible to come buy in this market especially for mortgage related assets. At this point servicers cannot re-securitize re-performing loans given market illiquidity.

 

Modification Is Not Enough

Servicers have always had the modification tool in their chest and have used it effectively in the past. This raises the question about the services ability, not their willingness, to use this workout option and the 40 percent modification re-default rate raises questions about how the mod is being implemented. Loans from the most toxic vintages -2005, 2006, and 2007, need more than modification, they need a complete re-underwrite. Let's face it, these borrowers purchased homes at an inflated price without really verifying income and they didn't put any money down. Now in order to determine an appropriate payment plan a borrower's ability to pay needs to be properly measured through physical documentation, i.e. 2 years of W2s, 24 month of pay stubs or 1040s. Unfortunately some servicers are still accepting verbal statements of income or using weak ratios like mortgage-to-income (MTI) or housing-to-income (HTI) as recommended by the FDIC, to gauge payment capacity. The ratio is skewed because it assumes that the borrower is going to choose to pay housing over food, healthcare, car insurance, Christmas presents or other debt obligations. If a borrower does not get into an affordable home loan, which means that all debts are considered, then the borrower is going to redefault. Forensic underwriters suggest that the re-defaults are also due to servicing professionals not having the requisite underwriting training or experience to get borrowers into an appropriate loan. Additionally, once or if the borrower financial situation is properly assessed the borrowers deteriorated financial condition makes it difficult to find new loan terms that are affordable and acceptable to the lender.

 

Principal Forgiveness Is Problematic

For loans in securitizations, forgiving loan principal is problematic for some investors because it curtails interest cashflow primarily on subordinate notes. In a sequential pay structure which is a very common deal structure, senior notes have the highest payment priority and the lowest loss priority; the opposite is true for subordinate notes. Mortgage loan principal forgiveness is eventually matched by a security wiritedown that starts from the most junior bond and progresses up the capital structure. Even if a subordinate note holder does not expect to collect a $1 of principal, he will hold the bond and clip the coupon for as long as possible. If the notional value of the certificate is written down for any reason the note holder is collecting less absolute interest on the bond. Subordinate note holders know that eventually the bonds will be written down partially or completely due to the large delinquency pipelines, evaporating excess spread and eroded over collateralization. However, the poor real estate market has made it very difficult for servicers to liquidate homes and push the losses through to the trust and therefore the collection of interest has been prolonged. (See discussion on Servicer Advances below for further explanation.)

 

Broken Servicer Business Model

The business model of the servicer, both captive and third party, has fallen off of the track with the collapse of the securitization secondary market and the lack of liquidity. On a pool of securitized loans a servicers typically collect 20 basis points on prime- and 50 basis points on subprime quality loans. Servicing fees are paid at the “top of the waterfall” or before any other fees or certificate disbursements. A captive servicer is a subsidiary of a parent company that also owns an originator. This arrangement is typical used by banks that are active originators like IndyMac, Chase and Wells Fargo and it was the case for independent subprime originators, now defunct, like New Century, Countywide and Ameriquest. Ocwen Loan Servicing, a subsidiary of Ocwen Financial Corp (OCN: NYSE), provides servicing and sub-servicing for nonaffiliated originators on a fee basis. In some cases, pursuant to the deal documents, if a loan falls into an extreme state of delinquency it will be transferred to a back-up or special servicer at a fee higher than the standard 50 bps.

 

Servicer also collects “servicing compensation” which includes the float or interest earned on cash held in account prior to distribution. Borrowers pay their mortgage on the first of the month and the funds earn interest until certificate holders are paid on the 25th (or the corresponding business day) of the month. If tax and insurance are also collected by the servicer then they are held in escrow until remitted to the municipality and insurance provider. During the refinance boom loans were paid off in full days and even weeks before distributions were made to certificate holders. So servicer made good income on prepayments and escrow accounts.

 

The servicer can also own the NIM certificate related to a securitization trust. When the deal is structured special notes are created and pledged to the NIM. Those notes usually include excess cash flow securities identified as Classes X, C or R. The Class P certificate captures penalties and fees that borrowers pay if principal is paid off in full or in part (as in the case of Negative Amortization loans) before a specified time. Prepay penalties are not designed to take advantage of delinquent, struggling borrowers; in most PSAs they are not applicable to defaulted loans and can be waived in the case of a loan modification. Admittedly some NIMs are still receiving cash but flows are not as robust as originally projected given the extreme slowdown in prepayments and the lack of excess interest due to increased realized losses.

 

Cost Up, Revenue Down and Margins Squeezed

Servicing current loans is very inexpensive because they require little effort to collect on; they are considered low-touch and a paper or email statement is typically sufficient. The margin on servicing new current loans is very high since the servicer is collecting 50 bps and only spending less than 5 bps. Conversely, delinquent loans require multiple phone calls, use of servicing technology and highly skilled, experienced professionals that command a higher salary. Loans that are difficult to collect are referred to as high-touch loans. Of course expenses like labor, postage and fixed operating costs increase every year and that increases the cost of servicing all loans. A servicers' profitability depends on a higher proportion of low cost to high cost loans since the fees collected on new loans offsets the high cost of servicing delinquent loans. For both captive and third party servicers, the securitization market provided a constant flow of low cost, low touch loans. Some subprime servicers like Option One have a graduated fee schedule written into their securitizations where the fee starts at 10 bps to 15 bps and as the deal seasons it is increased to 65 bps. Under normal market conditions the scaled up fee is matched to the progression of delinquency status as loans season. Now that the private label origination market is shut down servicers are sitting on large pools of aging loans that are expensive to service without the offset of new low cost, high margin loans.

 

When a borrower fails to make a mortgage payment, the servicer advances the delinquent principal and interest due to the trust. The servicer repays itself for advances “off the top of the waterfall” in the next pay period. If the loan falls into foreclosure or REO status additional carrying costs are incurred by the servicer. Taxes, insurance, legal fees, realtor fees and any property maintenance are carrying costs that accrue until loan resolution and are recouped once the property is liquidated. The servicer will continue to make advances until they are deemed unrecoverable in the judgment of the servicer. In a liquid market servicer advances were financed. The pledged repayment was structured into a receivable and used to collateralize Asset Backed Commercial Paper facilities or securitized and sold in the secondary market. Haircuts were typically low but would vary based on the quality of the receivable. Given the unprecedented delinquencies and depressed home values servicer advance receivables cannot be financed because investors are not willing to take exposure to the residential mortgage market. Over the past 3 years mortgages closed fully leveraged typically in the form of a 80 percent first and a 20 percent second lien. The 100 percent cumulative loan to value plus declining home values (which greatly increases the time to liquidation) and accrued carrying costs makes it difficult for a servicer to be reasonable sure that those advances will be fully recovered at liquidation.

 

This is the key to understanding why investors don't want widespread principal write downs as a form of loan modification. Let's say an investor owns the lowest rated bond of a mortgage backed securitization called Class B4 – the rating does not mater – the deal is failing all loss and delinquency triggers and the note holder has no hope of being defeased by a release of overcollateralization. Like all other subordinate investors they're resigned to the fact that they are not going to see $1 of principal paid on their bond. So the Class B4 investor has a note with a notional value of $1,000 and is collecting 6 percent interest on that note. Although the delinquency pipeline is growing, the note holder will collect interest for as long as possible until the class suffers realized losses and is written down to zero. Now enter a modification plan that forgives mortgage principal, and it has a $100 impact on our class B4. Instead of collecting interest on $1,000 the investor is only collecting interest on $900. Widespread modifications that forgive principal speed up the inevitable certificate write down and reduces cashflow to the bond.

 

The Cheaper of Two Choices

Eventually housing and home retention advocates are going to push harder for widespread principal forgiveness. If it works borrower payment velocity will improve, senior notes will amortize and subordinate notes will suffer writedowns. The FDIC fee stipend and loss sharing are nice gestures but securitization servicers are legally bound by the constraints PSA. More importantly, if the costs and losses associated with foreclosure can be completely absorbed by the securitization trust and the modification exposes the servicer to loss, then the servicer is going to choose the most affordable option.

 

Until then servicers managing loans in securitizations have to survive in the face of shrinking margins with no sign of new securitizations in sight. The FDIC feels that the modification plan implemented at IndyMac is working but the high redefault rate and the lack of robust income documentation don't give confidence for long term success or make the program feasible for duplication at other servicers. The $1,000 fee stipend and 50 percent loss sharing are nice gestures but they will not be enough to get major servicers on board.

 

Candice Workman Nonas is a structured finance professional who speaks and writes about residential mortgage issues. Ms. Nonas began her mortgage finance career at Moody's Investor Service where she covered every type of residential mortgage product and small balance commercial loan. After the rating agency, Candice worked for WestLB and Barclays Capital in their respective risk management groups. While at Barclays Ms. Nonas established warehouse lines of credit, reverse repurchase agreements, Asset-Backed Commercial Paper (ABCP) conduits and other credit facilities for subprime mortgage originators and servicers. She developed a process to conduct on site due diligence at the counterparty's origination and servicing base of operations. Ms. Nonas established the criteria used during on-site due diligence visits to evaluate the operations, technology, asset quality and management ability of the prospective counterparty. Ms. Nonas was responsible for negotiating all mortgage counterparty borrowing agreements, ISDA agreements and syndicated loan documents. To monitor the bank's exposure and regulatory capital requirements, she also conducted financial analysis on the borrower counterparties and on Fannie Mae and Freddie Mac. For the banks' mortgage-backed securities and net interest margin securitization shelves, Ms. Nonas was responsible for the credit approval of the subprime mortgage assets included in the trusts. After investment banking, Candice joined the ABS CDO asset management team of Fortis Investments in New York. Fortis manages various structured credit products including high grade and mezzanine ABS CDOs and US and European CLOs. After leaving Fortis, Ms. Nonas founded Fundamental Credit Capital Partners, a hedge fund and funds of funds advisory firm that specializes in distressed asset-backed securities investing.

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Posted on Dec. 4, 2008


Markets Media (press release)
FDIC ModSquad
Markets Media (press release) 
This arrangement is typical used by banks that are active originators like IndyMac, Chase and Wells Fargo and it was the case for independent subprime originators, now defunct, like New Century, Countywide and Ameriquest.

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