This week, MortgageOrb talks with Alan M. White, an assistant professor of law at Valparaiso University School of Law in Indiana and author of the Consumer Law & Policy Blog. He was formerly a legal services lawyer in Philadelphia, and he currently serves on the Federal Reserve Board of Governors Consumer Advisory Council. In September, White released Rewriting Contracts, Wholesale Data on Voluntary Mortgage Modifications from 2007 and 2008 Remittance Reports, which takes a look at the success rates of various loan modification efforts.
Q: Your abstract notes that the decision to liquidate properties rather than modify loans can result in increased loss severities. Despite this fact, many modifications offered by servicers do not appear deep enough, and foreclosures are still mounting. What do you see as the reason for this trend?
White: Pooling and servicing contracts really aren't designed to allow servicers the flexibility to maximize investor returns. In addition, servicers are not compensated to work out and restructure loans; they are paid to collect monthly payments or to foreclose. I also suspect that the industry culture still prefers to see foreclosure losses, even at 50% or more of principal, than to see principal reduction agreement losses.
For one thing, the foreclosure losses aren't realized for many months, while a principal modification will show up immediately in the monthly remittance reports. In fact, the issue of how to account for and report the cashflow consequences of principal write-downs is still being worked out, with important consequences for the different investor classes.
The recent Credit Suisse report shows clearly that interest and principal reductions result in much better performance (i.e., lower re-default rates) than modifications that merely capitalize arrears. I think servicers are reluctant to do more modifications in part because of fears about re-default rates, and they are modeling modification cashflows based on historical performance, which is now irrelevant. As the industry starts to look at re-performance and re-default rates in more fine-grained way, perhaps servicers will feel more confident about taking the more aggressive approaches.
Q: How would you rate the job that mortgage industry groups, such as HOPE NOW, are doing in providing data on loan modifications? Is there room for improvement?
White: The modifications data that comes from HOPE NOW is inadequate. They have mostly been concerned with showing an increase in workouts and modifications, and the gross numbers they report have definitely gone up. The problem is that the number of delinquencies and foreclosures is going up faster, and the baseline of servicer efforts back in early 2007 was terribly low.
The modifications and payment plan totals also don't tell us how many homeowners are getting meaningful, permanent restructuring. Some modifications are increasing principal and monthly payments, while others are reducing principal and payments.
Some modifications are temporary, and some are permanent. I have seen some indication that servicers are going to start reporting more complete information on what kind of modifications they are doing, at least to investors.
Having more detailed information on modifications made public will be essential as the next administration tries to develop a strategy to maximize value and minimize foreclosures for the mortgage securities the Treasury ends up buying, as well as for the market as a whole.
Q: Your research included mortgage pools that all had the same trustee. Yet, you found a wide variety of loan modification approaches therein. Why do you think there is such a diversity in approach? Would the industry benefit from more consistency and standardization in this area?
White: Despite the HOPE NOW statements and the American Securitization Forum guidelines for rate freeze modifications, there really are no comprehensive and uniform guidelines for mortgage servicers to respond to the huge wave of foreclosures with aggressive loan restructuring.
Litton has been the most aggressive, and it has the fewest number of investors to answer to (essentially one). The current level of foreclosures, and of loss severities, are unprecedented. Some servicers have been more nimble in adapting than others. Hopefully, the success of the more aggressive servicers will help set new standards for the laggards to follow.
Q: In August, the Federal Deposit Insurance Corp. (FDIC) unveiled a program that aims to "systematically" modify troubled mortgages held by IndyMac. In short, modifications would be designed to achieve sustainable payments at a 38% debt-to-income (DTI) ratio of principal, interest, taxes and insurance. Do you think the FDIC plan has merit?
White: I think the FDIC plan is an excellent starting point. Obviously, servicing standards and practices with respect to modifications are going to have to remain flexible. The IndyMac program will provide some valuable new data on how well an aggressive modification program can perform in meeting both – hopefully, complementary goals – reducing investor losses and reducing foreclosures.
I'm not sure that an exclusive focus on DTI ratios is wise, and it is also very useful to look at residual income as well as individual performance on trial modifications. In addition, the FDIC plan does not seem to take into account the negative equity problem for homeowners who bought homes at the peak of the bubble. Even if their payment is made affordable, a loan modification will be more successful if the principal is reduced to a level where the homeowner can foresee having some equity at some point down the road.
Q: Do you believe servicers' modification efforts properly address the issue of mortgage debt, or do they place too much emphasis on payment stress?
White: I do think that the sole focus of modification efforts so far has been on payment stress. All the economic research on foreclosures shows that loan-to-value ratio, or homeowner equity, is the strongest predictor of default. Unless and until the negative equity issue is resolved by writing down principal, within reason, even homeowners whose payments have been reduced will remain in an untenable situation and face greater likelihood of future defaults.
To look at it another way, a homeowner with some equity is much more likely to hang in there and make payments. Now, it may not be necessary to restore equity immediately, but homeowners need to feel that there is at least some prospect that near-term appreciation will put them back into the black with respect to their home equity.
Recasting arrears has revealed itself to be one of the most commonly used modification techniques, but it can be argued that it only worsens a borrower's position. Principal reduction, on the other hand, is among the least used but most effective modification approaches. Do you anticipate an eventual large-scale shift in approach?
I am optimistic that, in part as a result of the government interventions with the FDIC, Fannie/Freddie and the Treasury [Troubled Asset Relief Program], we will start to see a paradigm shift in servicers' willingness to do meaningful mortgage restructuring for the long term.
Once some good performance benchmarks are established and some experience is gained on how to do principal and interest write-downs intelligently, that knowledge can be applied – and the sooner, the better.