Tuesday, April 15, 2008

Is anyone speaking for the mortgage "lenders"?

(Credit Slips) Katie Porter makes an incredibly important point in her recent post about how securitization structures may be impeding mortgage modifications because the ultimate holders of risk on the mortgages are not the ones involved in the modification decision. Mortgage servicers, who typically hold a small interest (if any) in the loans are the ones making the modification decisions. When servicers do hold positions in the mortgage-backed securities, they are first lost positions, so the servicers likely takes a loss regardless of a modification or foreclosure, meaning that their interests are not aligned with the other MBS holders.

Let me take Katie's post a step further and suggest that the relevant voices on the lending side of the mortgage market have not been heard. The ultimate risk on mortgages is held by mortgage-backed securities holders, private mortgage insurers, and pool-level bond insurers. These parties have been entirely absent from the conversation on modification and bankruptcy reform.

Instead, we have been hearing servicers and originators (such as the Mortgage Bankers Association) speaking for the entire mortgage lending industry. But there is strong evidence that servicers are themselves part of the problem and that some may be faithless agents to the MBS holders they represent.

If Congress is concerned about the impact of foreclosure legislation on the mortgage lending industry, it should make sure that the conversation includes parties who bear the ultimate risk in mortgage loans--the private mortgage insurers and the bond insurers and the major pension plans and mutual funds that hold MBS. For that matter, the state regulators of insurers should also be involved in this as a safety-and-soundness issue. Limiting mortgage loan losses limits the insurers losses.

There seems to be little disagreement that foreclosure would result in a larger loss on a mortgage than a modification. One would think, then, that the market would respond by modifying non-performing mortgages to a level that homeowners could afford. But this hasn't been happening on a large scale. As we think about why this market isn't working, securitization structures should get a lot of attention.

As Katie noted, securitization structures can create impediments to modification. Sometimes it is contractual, such as pooling and servicing agreements (PSAs) that forbid servicers from modifying mortgages or severely constrain the modifications that are allowed. Other times the PSAs create incentive structures that lead servicers to prefer foreclosure to modification.

Going forward, one hopes that the securitization market will fix this--MBS purchasers will recognize the importance of good servicing in portfolio performance and will be willing to pay a premium for MBS with PSAs that give servicers the ability to make necessary modifications and the incentives to do so. I say hopefully because I am not at all convinced that many MBS purchasers understood exactly what they were purchasing. (Maybe signaling works, but maybe not...)

But for existing mortgages, the contractual and incentive impediments created by securitization pooling and servicing agreements remain a problem, and the only clearly Constitutional way to overcome them is via bankruptcy. If mortgage modifications were allowed on all properties in bankruptcy, it would allow a bypass to the obstacle created by modification. Bankruptcy modification is an involuntary workout that should be possible when there are market problems preventing voluntary workouts. This is essentially a parallel to companies with public debt using bankruptcy to restructure the terms of their bonds. Many bond indentures forbid the indenture trustee from modifying the terms of the debt absent unanimous consent of the bondholders, raising a huge structural obstacle to loss-minimizing modifications.

Notably, the loss calculus for MBS holders or PMI insurers or bond insurers should not change depending on whether a workout is voluntary or not--it will still produce a smaller loss than foreclosure. The Bankruptcy Code's best interest test guarantees that, and in the current market especially foreclosure outcomes are brutal.

This, of course, is just my evaluation of the market. But the voices that should be heard from the mortgage industry about this are the MBS holders and the insurers, not the servicers and originators.

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