Group Warns on Large Scale Modifications

Last week, FDIC Chairman Sheila Bair expressed frustration over the slow pace of modifications on around $450 billion in loans with interest rates expected to reset in 2007 and 2008. She noted the problem is “huge” and a case-by-case approach is inadequate for the millions of loans scheduled for rest.

Bair called for servicers to make teaser start rates permanent for owner-occupied borrowers with current mortgages, adding that these hybrid adjustable-rate mortgages were designed as short-term programs that relied on appreciation.

But in a letter to the chairman, the Consumer Mortgage Coalition explained that while a global solution such as foregoing rate increases on all 2/28 and 3/27 ARMs would seem to be the easiest solution, such a move would violate pooling and servicing agreements.

CMC members generally service the loans they originate as well as mortgages acquired from other lenders — including a number of subprime lenders that has since become insolvent, the group said.

While many servicers are governed by agreements with companies like Fannie Mae and Freddie Mac that can approve modifications on a loan-by-loan basis, private securitizations typically do not have an active manager to which the servicer can go for approvals, according to the letter.

“While this passive structure may appear to give the servicer more discretion, in fact, because of the lack of an active decision-maker from which the servicer could obtain waivers of the usual requirements, no entity exists with the authority to grant waivers,” CMC explained. “As a result, a servicer that violates the terms of the PSA faces potential legal action from the securitization trustee and even from the securities holders themselves.”

The group noted that servicers are obligated to work on behalf of securitization trusts to maximize principal and interest repayments.

“When a servicer agrees with a customer to reduce a loan’s interest rate or principal balance, the servicer is giving away the investors’ money, not its own,” the letter said. “As a result, investors limit the servicer’s discretion to make significant modifications both through the servicing contract and related guidelines.”

The group warned that mortgage-backed securities investors have begun scrutinizing how servicers’ actions are harming their interests because they are not adhering to the PSAs. In addition, servicers acting outside the passivity requirements of FAS 140 could jeopardize the special purpose entity status of the securitization and have a dramatic effect on accounting at numerous major institutions.

Also at issue is the REMIC status of the securitizations under the Tax Code which would be lost if more than five percent of the loans are modified, CMC said. The loss of that tax status would cause extreme losses to investors — who would be subject to double taxation — and likely lead to PSA defaults as well as the loss of ratings agency approvals.

“We believe that the ‘loan by loan’ methods we use are appropriate and allow all the stakeholders — the borrower, the investor and the servicer — to reach the correct outcome under the circumstances, and not create too many modifications or workouts that the borrowers will not be able to maintain,” the trade group said.

Sam Garcia worked in mortgage lending for twenty years prior to becoming publisher of MortgageDaily.com.

e-mail: mtgsam@aol.com