Mortgage Modifications are Harder than they Appear
From the Wall Street Journal we have the following grim statistics.
12 million homeowners currently have negative equity. Current projections have this growing to 20 million homeowners by the time we reach the housing bottom (from housing futures markets). This is out of 50 million homeowners who have mortgages (24 million own their home free and clear).
So there are a lot of homeowners interested in getting their mortgage modified in some way (reduced interest rate, short sale, principal forgiveness, etc). I am not going to address whether helping out these homeowners is the right thing to do, but rather why modifying these mortgages will be incredibly difficult.
Traditional Mortgage Scenario
With a single mortgage holder and home owner, the conversation on whether to accept a loan modification, say a short sale, was fairly simple. If the foreclosure process would likely net out less than the short sale and the mortgage holder (e.g., bank) was convinced the homeowner can’t pay the current mortgage, the bank would accept the short sale.
As an aside, notice that there are two conditions for accepting a short sale. Besides the mortgage being underwater, the person also has to have shown they cannot pay the current mortgage. This is typically demonstrated by missing payments which means trashing the borrower’s credit score. For someone who is already subprime this may not be a big deal, but prime borrowers should understand the full consequences before embarking down this road.
Mortgage + Home Equity Line of Credit (HELOC) Scenario
Additonal complicattions arise when you add a HELOC into the mix. Now two lending institutions must approve the short sale for it to occur. If the home’s value has dropped below the value of the primary mortgage, the HELOC owner’s default behavior would be to veto a short sale because, as the second lein holder, it would receive nothing. If the short sale is sufficiently better than foreclosing for the primary mortgage owner, then the primary mortgage owner may sweeten the deal to the HELOC by offering some payment to allow the short sale to go through. But clearly having the second mortgage makes getting a modification more difficult.
The purpose of securitizing a mortgage is so that they will appeal and can be sold to investors. This in turn allows the bank to turn around and lend more money. Investors, however, don’t want to deal with indviduals, their stories and late payments. In the previous two scenarios the mortgage servicer and owner (investor) were the same entity. When securitizing a mortgage those two roles get separated and a pool of similar mortgages is created which helps average out sporatic payments and other issues. To protect the investor, strict rules about what modifications and under what circumstances they can be made are written in the security contract. So modifications to securitized mortgages become a matter controled by contract law. The servicer has much less discretion than in the case when the servicer and owner of the loan are the same.
Securitizing mortgages was all well and good, but the creators of these securities discovered that investors generally didn’t want to buy mortgage pools with poor credit ratings (e.g., sub-prime credit ratings). The CDO provided the solution.
The CDO would create a pool of sub-prime securitized mortgages and divide them in tranches (e.g., slices or sub groups). For the purpose of illustration let’s say 10 tranches. This is like dividing the mortgages up into a first morgage, a second mortgage, a third and so on down to the 10th position mortgage. The first mortgage gets their money back before any of the others making it MUCH safer than the 10th position mortgage. So those first few tranches would get a high credit rating because most of the losses would be borne by the bottom tranches.
Remember the problem the HELOC (i.e., 2nd mortgage) owner had with making a modification in the simple case above. This problem has now been expanded 10 fold. Instead of a single “investor” owning the mortgage there are now 10 with different non aligned objectives. The first place tranche is secure that they will get their money back so has no desire to reduce the interest rate. In fact, the trustee in charge of the trache has a fiduciary duty to fight against a modification that reduces the interest rate. Meanwhile those in the lower tranches desparately want to avoid pushing the borrower into foreclosure and would much rather make an intereest rate modification rather than lose their principal from foreclosure.
Of course, if magic works once, why not try it again. No one wanted to buy those lower rated tranches of the CDOs, so they collected those together in a pool and sliced them up into tranches. And through the magic of faulty statitistics were able to get the higher tranches high credit ratings again.
This means we have added even more interested parties to the outcome of each mortgage. And each of these interested parties again have different objectives since they make/lose money under different circumstances.
Credit Default Swaps (CDS)
These are derivatives that act like insurance contracts on a credit obligations. An owner of a number of mortgage backed securities might decide to buy credit default swaps on some of them to reduce their risk (instead of simply selling the mortgage backed securities). You can think of this like buying a put option instead of selling the stock to reduce your downside exposure.
Just like put options, these CDSs are bought and sold all the time. And if any modifications are made on the mortgages that are covered by a CDS that go outside their contractual limits, you now have another party who may be harmed and have an interest in sueing the servicer for overstepping their bounds.
Many interested parties are all pulling in different directions and willing to sue if the servicer starts making modifications that are outside the guidelines written into the security. So the servicer is generally constrained by what the contract allows them to do and they have to make sure they dot their i’s and cross their t’s, which does not lead towards fast processing. The government can provide some liability cover here for the servicers and work on the loans owned by Fannie and Freddie, and perform some arm twisting, but they have to walk a fine line and try not to impinge on contract law too heavily.
I expect the net result to be that the government’s efforts will slow down the rate of foreclosures which will keep housing prices from dropping farther and faster than they would otherwise, but ultimately there are too many people in too much house and those houses will eventually have to come back on the market. So slowing down foreclosures means that the housing problem will likely last longer than people expect. It wouldn’t surprise me if it was at least 7 years (from market top) before major metropolitan areas broke new highs in housing prices.