Loan Modifications and the Mortgage Market 10 comments
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I've been thinking a lot about loan modifications, which is basically when a bank voluntarily agrees to alter the terms of a loan. I'm talking about a mortgage loan, in an attempt to avoid foreclosure.
No one has covered this issue better than Calculated Risk (for example: here but CR and Tanta have done many posts on the subject). CR and others have spilled a fair amount of virtual ink on the problem that most mortgage loans which have been securitized either cannot be modified, there are severe limitations on modifications, or there is no single party motivated to choose modification.
This leads us to an unfortunate reality. In 2007, given that such a large percentage of loans are held in securitized form, loan modifications are harder than ever to achieve. And yet, given that rate resets are a big part of the subprime problem, it's likely that loan mods would be more successful in limiting lender losses than in times past.
Other sites have done a fine job in covering this issue from the consumer's perspective. But my writing is all about the cold hearted capitalists, and after all, bond holders are de facto lenders here. So I'm going to give some thoughts about loan modifications from the perspective of a CDO/ABS holder.
In the olden days, back when men were real men, women were real women, and banks were real banks, the negotiation of a loan modification could theoretically be held between all interested parties: the borrower and the lender could actually meet together and hammer something out. If the borrower fell hopelessly behind, the bank could decide whether foreclosure or the modification would result in the minimal loss to the bank.
The securitization business thrives on homogenization. So when it came to the issue of loan modifications, investors wanted strict rules about what could and could not be done. Remember that ABS and RMBS (and later CDOs) were built on complex mathematical models about default and recovery. If a servicer was too aggressive about making mods, then that would mess up the nice neat models. You know, quants get very cranky when you mess with their models...
Loan modifications were often not successful in avoiding eventual foreclosure. But in an investor pool with both senior and junior note holders, the timing of payments becomes a huge issue. Say a loan was modified such that the borrower stayed current for another 8 months but then fell back into arrears and was eventually foreclosed upon. If that loan was in an investor pool, then some of the payments made during the 8 months of modified payments likely went to junior note holders.
Senior note holders had a legitimate gripe: had the loan simply been foreclosed upon, payments would have flowed to the senior note holders first, likely leaving nothing for junior note holders. In effect, the loan mod benefited junior note holders at the expense of senior note holders. This is particularly true in pools where there is any kind of trigger. Increased foreclosures may trip the trigger, which usually causes more cash to flow to senior note holders, where as loan mods may prevent a trigger, keeping the junior classes around for longer, soaking up cash.
This view was reiterated on a recent dealer conference call. The traders were advocating senior tranches of subprime pools from the worst originators. The argument went that pools with larger early payment defaults would cause the payment triggers to be tipped. This results in all cash flow being paid sequentially, with the most senior tranches getting all payments until completely paid off. Given that these kinds of bonds are trading at deep discounts and that the structure had substantial subordination to begin with, there is an opportunity for strong returns.
On the other hand, deals with fewer initial defaults and did not breech the trigger levels would continue to pay pro rata (proportionately to senior and subordinate tranches alike). However, despite relatively low initial defaults, odds are good that defaults will keep rising. Any cash paid out to junior tranches just leaves less for senior tranches down the road. If you are going to get to a high level of defaults anyway, the trader reasoned, why not do so where your tranche is getting all the cash flow?
OK so back to loan mods. Investors objecting to loan mods really need to think this through, regardless of where you are on the capital structure. Say I own the senior most piece (originally rated Aaa) of a 2006 vintage subprime RMBS currently trading at $95. We know its trading at $95 because of default fears. Note that a $5 loss indicates about 125bps in spread widening. So for reference sake, let's say that the pool originally had a coupon of 5.5%, but at a dollar price of $95 would have a yield to average life of 6.75%.
Another way to think of the 125bps of spread widening is that if the same security was created today and priced at par, the coupon would have to be 125bps higher, or 6.75%. Or put another way, investors would pay $95 for a bond with a coupon 125bps lower, yet no default risk. Make sense? So if the senior bond holders were given the option of eliminating default risk in exchange for reducing their coupon by something less than 125bps, they'd likely accept.
Well subprime pool holders, this is your lucky day, because through the magic of loan mods, just such an exchange is possible. Say that half of a pool of MBS is going to reset in 2008 at levels 400bps above the teaser rate, and that these borrower will struggle to make. If these loans were all modified such that the reset was merely 200bps higher, then the net coupon on the deal will only be impaired by 100bps. And since the senior tranche is, say, 90% of the deal total, its coupon is only 90bps impaired!
I know the comments will be filled with two primary objections. First is moral hazard, but frankly we have two bad actors in this case. The borrower who probably should have known better, and the investor who really should have known better. Well, the originator too, but he's probably out of business anyway. The borrower is being given a little of a free pass, but the investor isn't seeing his loss taken away, merely reduced. I don't think investors in Aaa securities are going to have their losses reduced from 5% to 3.5% and consider themselves bailed out. A 3.5% credit loss in a Aaa security is still awful. I also don't think the borrower will walk away from this experience saying "What a great choice that ARM was..." If you see your interest rate go from 5% to 7%, I think that's plenty painful for borrowers to reconsider the ARM idea, the fact that it might have gone to 9% is besides the point. So I'm not buying the moral hazard issue.
Second is the fact that many modified loans wind up defaulting anyway, as stated earlier. This time is different, though. Because the borrower who got in trouble entirely because of a rate reset isn't the same as the classic delinquent borrower who merely can't keep a job or handle credit cards. Remember that all these subprime deals were priced assuming a certain level of defaults: a level consistent with the "classic" reasons for delinquency. If we could do enough loan mods to make the "classic" reason for default the most common reasons, then we'd have a better chance of containing the subprime contagion.
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This article has 10 comments:
www.mizna.com/loanmodi...
Click on the joint economic committee report. Hope that helps.
(loanmod.com) helped me complete a loan mod with my current lender. Of all the companies I researched to help me avoid foreclosure, MIZNA was the most credible and even had various articles written about it in large newspapers. One tip I would give other struggling homeowners looking to modify their loan is that if a loan mod company does not have a mailing address on their contact information page, then I would not do business with them. There are so many scams going on out there that borrowers should be vigilant and not trust every company that has a website. You want to make sure you're working with real people who care. MIZNA definitely cares about homeowners and they did wonders for me. Check them out at loanmod.com .
There's the Hope company which will help
Also www.loanmodassistant.c.../ is a system for people in a hardship or foreclosure that teach the user to do their mod for $199.99
Loan mod "companies" typically charge thousands to do a mod. Sometimes they just take your money.