Market Braces for Subprime Modifications

With the use of loan modifications expected to increase to avoid subprime mortgage foreclosures and possibly improve the credit profile ratings of residential mortgage-backed securities, securitization industry insiders issued guidelines and answered frequently asked questions about this loss mitigation tool.

Modified loans in securitizations have been low to date, but they’re likely to become more prevalent as interest rates on many hybrid adjustable-rate mortgages approach reset dates and a slowed housing market slims refinance opportunities, according to a Moody’s Investor Service report. Most servicers have begun exploring the potential for expanding use of modifications to prevent defaults on existing loans.

To provide practical guidance to servicers and establish a common framework for the structure and interpretation of loan modification provisions in securitization governing documents, the American Securitization Forum issued a statement of principles, recommendations and guidelines for the modification of subprime loans in RMBS. The forum believes the statement represents widely-accepted industry views, based upon extensive consultation with forum members and other securitization market participants.

“We hope this guidance will encourage broader and more effective use of loan modifications in appropriate situations,” said George Miller, executive director of the forum, in an announcement.

Wells Fargo, one of the forum members involved in the development of the guidelines, said these “promote more flexible use of modifications in appropriate circumstances to address the difficulties presented by the current market environment.

“We believe they will lead to reduced foreclosures, helping homeowners and communities, while continuing to balance the interests of all involved, including investors,” Wells added.

Unlike repayment or forbearance arrangements, which focus on allowing borrowers to make up past due payments, modifications typically reduce the total obligation for the borrower compared with the original terms of the loan through methods such as lowering the interest rate, converting an ARM to a fixed-rate loan, reducing the principal amount owed, forgiving past due amounts, extending the amortization term and/or loan maturity, and capitalizing past due amounts over the remaining term of the loan, Moody’s FAQ report said. Such methods were amongst the recommended loan modifications in the forum’s statement.

Moody’s expects the most prevalent type of modification to be rate modifications on 2/28 and 3/27 hybrid loans at the initial reset date.

Delinquent borrowers unable to resolve their situation or those who are at the point of “imminent default” are suitable candidates for loan modifications and servicers are likely to offer these when they believe the losses from modifying will be lower than those that they would incur by using other loss mitigation options or from foreclosure.

In determining whether to modify, a servicer considers a borrower’s desire to retain the home and whether the borrower has the financial ability to pay the modified loan terms. To come to this conclusion, a servicer reviews household expenses and compares them to the borrower’s income, and reviews W-2 forms, bank statements and credit bureau reports, Moody’s said.

The forum’s statement suggests loan modifications should be considered on a loan-by-loan basis and opposes any across-the-board approach that would have all modifications structured in a particular manner and any proposals that would provide a universal moratorium or delay period on foreclosures. Modifications should only be made in a manner consistent with securitization governing documents and that serves the best interests of borrowers and investors.

The extent to which a loan can be modified is determined by each securitization’s legal documentation and by accounting and tax rules. While exact provisions in securitization governing documents differ from one transaction to another, most may give servicers a degree of flexibility if the loan is in default or default is “reasonably foreseeable.” While all bondholders are not always equally impacted when a loan is modified, in general, when a servicer has a stake in a securitization, the interests of the servicer should frequently be aligned with those of the bondholders, Moody’s said.

A review by Moody’s of governing documents for subprime securitizations it rated in 2006 found that only 5 percent of the transactions contained specific language prohibiting the servicer to modify loans and roughly 95 percent permitted loan modifications. Of this majority, about 60 percent had contained no restrictions, while the other 35 percent specified modifications could not exceed 5% of the original pool loan balance or of the cumulative number of loans in the transaction. Restrictions limiting flexibility to modify loans are generally not beneficial to bondholders, Moody’s said.

“The credit impact on any given class of bonds within a securitization depends on a great number of factors, including not only on the level of losses that is incurred by the pool, but also by the timing of those losses, by the bond’s position in the securitization’s capital structure and by the impact of loan modifications on the performance triggers in the securitization,” said Moody’s Assistant Vice President and author of the report, Michael Drucker, in a written statement.

For the most part, Moody’s does not anticipate that “the judicious use of loan modifications, in and of itself, would result in rating downgrades.” The ratings agency believes “modifications employed in a judicious fashion are beneficial to the trust and should typically mitigate the extent of downgrades on bonds backed by poorly performing pools, in particular if the modifications are incorporated in any performance tests that are included in the transaction.”

Because modifications have been used sparingly prior to this year, servicers have yet to report these in a standardized manner, thereby reported delinquencies can have different meanings across transactions. A standard set of reporting guidelines that “illuminates the types of modifications being extended at the loan level and the cumulative amounts being granted at the pool level” would enhance the monitoring of transactions, Moody’s said.

The forum’s statement also calls for “standardization of loan modification language in securitization documentation, the development of guidelines to identify and manage potential conflicts of interest in loan modification activities of servicers, and achieving greater clarity and transparency in the manner in which loan modifications are reported to investors and treated for purposes of delinquency, realized loss and other performance trigger mechanisms included in subprime mortgage securitizations.”

Such might help clear conflicts that may arise between market participants.

Paulson & Co. Inc. wrote a letter to the International Swaps and Derivatives Association expressing concern over a Bear Stearns proposal that would amend pay-as-you-go credit default swaps on ABS trade confirmation — complex securities that act as an insurance policy against a drop in subprime securities values.

Bear proposes “to explicitly authorize uneconomic transactions by sellers of credit protection with respect to underlying reference entities, which transactions artificially inflate the value of underlying securities,” Paulson wrote.

But Bear suggests it is focusing on the interest of the borrower, and not hedge funds betting against subprime borrowers.

“Anything we do to keep borrowers in their homes like the EMC Mod Squad has the potential to negatively impact someone who is short the subprime market,” Tom Marano, head of Bear’s mortgage business, responded in an e-mail statement to MortgageDaily.com.

The hedge fund claims Bear’s proposal would enable illegal manipulation of the market.

In a statement introduced to the derivatives association, Bear said a seller of protection may own certain subordinate securities or act as a servicer or have some other rights that allow it to buy certain delinquent loans for the reference entity or exercise “the optional clean-up call.”

A seller may have the ability to “limit losses suffered by the reference entity and therefore may be able to limit amounts payable by the seller of protection to the buyer,” Bear continued. In taking any action with respect to the reference entity, “each party may act solely in its own interests … and neither party will have any duty whatsoever to consider the effects of its action or failure to take action on the other party.”

Marano noted, “The ISDA contract states that all rights and rules of the underlying reference obligation apply. In response to a suggested change that would have modified those rights and obligations, we proposed a clarification of what the rights were in order to ensure participants understood the terms of the underlying documents.

“When market participants said they believed the documentation was already adequate, we withdrew our proposal.”

But Paulson said credit default swaps participants can’t sell credit protection then make transactions that destroy the value of the protection. “If they could do so, no one would buy credit protection in what would be exposed as sham transactions.”

“If the underlying assets lost value and the credit protection buyer had to make larger floating payments to the credit protection seller, the buyer would execute these transactions to reduce their losses on the CDS position,” Paulson added.

Bear’s proposal “scares away credit protection buyers by suggesting that transactions with reference entities can be used to destroy the economic benefits of credit protection,” Paulson said. “It attempts to give legal cover to credit protection sellers entering into such transactions.”