The value of delinquent second liens declines extremely rapidly, with many losing almost all of their full value within 90 days after becoming seriously delinquent (60-plus days). A successful servicer must quickly diagnose the second lien's circumstance and prescribe the most appropriate treatment very early in the delinquency cycle.
The best diagnostics revolve around processes based upon computerized data and analytics; these processes classify the second lien into a specific class of problems, against which is appended a class specific, cashflow maximizing treatment.
As portrayed in the 1984 movie Top Gun, fighter pilots have a "need for speed;" it is how they survive. There are no "slow, old" fighter pilots. The same is true in second-lien servicing: there are no "slow, long-lasting" second-lien servicers; their customers (i.e., asset holders) will lose too much money.
There are now in excess of 30 million second liens, with approximately 10 million being "orphan" seconds (originated separately and often subsequent to the first lien) and the remainder being piggybacks that were originated along with the first lien. However, a portion of the piggybacks were separated from their first lien at the time of securitization, with the second lien posted to a different security and often serviced by a separate servicer.
In the final analysis, many servicers have a huge number of delinquent second liens with no precise knowledge of who originated the first lien, where it is being serviced and what its status truly is. All they know is which second liens in their servicing portfolio are delinquent and to what extent. This is a crucial information deficiency, but one that is not rectified readily by the typical servicer.
Unfortunately, many servicers take 30 or more days to manually accumulate sufficient information to evaluate the circumstance of their second liens. This is very expensive – by the time the servicer accumulates the necessary information, over 30% of the second lien's value has been lost during the info gathering phase.
Moreover, the servicer often absorbs additional time deciding on treatment strategies, which results in further delay. Many servicers do not take constructive treatment action until 50 days after the second lien has gone seriously delinquent, which means that the second lien has lost over 50% its value – a value that will most likely never be recovered, regardless of treatment.
A more appropriate process would be to use computerized processes to aggregate the necessary information within 48 hours, analyze it and post it to the servicing system once the second lien reached a specific delinquency level (e.g., 60 days past due).
The most appropriate process would be one that predicted which second liens were going to become seriously delinquent and post that information to the servicing system, enabling the servicer to take preventive actions as opposed to remedial actions.
Still, remedial actions taken early in the delinquency cycle are preferable to taking such actions very late in the cycle, which is the current practice.
Data, data, data
What does a successful second lien servicer need to know? Such data as the following come in very handy:
- Loan data (especially the first lien). Necessary information includes the current value of the first lien, its value at origination, status (level of delinquency) and servicer, as well as what treatments are in process (e.g., loan modification, short sale, foreclosure/real estate owned).
- Property data. What is the current property value of the property? How does that compare to the value at origination? What is the most likely future value of the property? How much equity is in the property at this time, and how much equity is in the property in the future?
- Borrower data. This involves determining the borrower's level of distress. Is the distress concentrated on the second lien or does it extend to the first lien or other debt types, such as credit cards, auto, etc.?
The capturing of loan, property and borrower data enables the servicer to capitalize on the synergy that exists among these data. The circumstances of a 60-day delinquent second lien can vary widely, as would the handling of each.
Let's evaluate two examples.
In one situation, a 60-day delinquent second lien may be attached to a seriously delinquent first lien. The first lien is being serviced by a very distressed borrower, and the property is in rapid state of depreciation, with no equity that is being serviced by a severely stressed borrower.
In another situation, a 60-day delinquent second may be attached to a current first lien that is being serviced by a non-distressed borrower and attached to a property with limited to no depreciation.
The most appropriate form to receive consumer and property data products is not human readable, but machine readable (i.e., computerized). The machine readable form enables the data to be processed and analyzed by a computer, which gives the servicer the capability to automate the second-lien decision process.
Automation ensures that the process is faster and more efficient. Defaulting to a human readable format, which requires manual analysis, will corrupt the process at the outset and deny a servicer any meaningful improvement in speed or decision quality.
Of course, machine readable consumer and property reports can be tremendously difficult to handle. These are complex, multi-field, variable-length records. Handling them requires custom software that can parse the report, create meaningful attributes and post those attributes to a relational database.
These are non-trivial tasks; a servicer must ensure that it has the necessary resources, expertise and programming talent to transform raw machine readable information into useful, decision-ready data.
Extracting what's important
Parsing a consumer credit report or a property report does not automatically guarantee a servicer a speedier, smarter process. A servicer needs to establish a well thought out process of how to use this information, what data elements are crucial, how can they be extracted and what estimates must be made and why.
While there are many kinds of data and estimates that a service could make regarding first lien, the second lien, the property and the borrower, I have found the following estimates very valuable:
- What is the status of first lien? In particular, if it is delinquent, how seriously delinquent is it? Is it in foreclosure?
- Who is servicing the first lien? How willing are they to cooperate with the second-lien servicer?
- How much equity is currently in the property? How much equity will be present in 90 to 180 days?
- How likely is this borrower to be cooperative if there is equity? If there is none?
A faster, smarter process
The most crucial treatment decision revolves around determining if there is any equity in the property, which leads to an accurate estimate of the current dollar value of the second lien. In these times, it is rare if there is equity, and even if there is some, the likelihood of recouping a significant portion of the original second-lien balance is remote.
Nonetheless, if there is equity, a second-lien servicer has options. For example, if the second lien is a home equity line of credit (HELOC), capping the line of credit and restricting further draw downs is essential.
If the second is a fully drawn down HELOC or a fixed amount, placing a cap on the line of credit is obviously not an option. In either case, the second lien can be treated like a collateralized obligation, and some coordination with the first-lien servicer may prove worthwhile. It is quite typical for a seriously delinquent second lien to be partnered with a very troubled first lien. If there is equity in the property, there is an opportunity for both first- and second lien holders to maximize their value.
However, creating a mutually beneficial outcome requires the second-lien servicer to contact the first-lien servicer. Here is where a speedy, informed second-lien servicer can make a difference.
When contacting the first-lien servicer, it is crucial to determine if the servicer has authorized a short sale, and if so, how much discount has been awarded. A speedy, well-informed second-lien servicer has an opportunity to influence the short sale price so as to preserve some of the second-lien value. While this is not always possible, swift contacting of the first-lien servicer can pay dividends and is the optimum strategy.
If there is no equity in the property, the second-lien servicer is forced to treat the second as an unsecured, non-collateralized obligation. This situation is very similar to the one faced by credit card companies as they pursue seriously delinquent loans and post charge off credit card debt.
Here, the servicer has fewer options. The servicer can either pursue a call-intensive borrower contact and negotiation process or a legal one, wherein the servicer sues the borrower.
The economics of the former process are not attractive. A huge percentage (more than 50%) of the borrowers must be skip traced before contact can be accomplished. This is an expensive, labor- and information-intensive process that must be funded in advance of any true knowledge of the borrower's willingness or ability to pay a defaulted second lien.
If or when the borrower is contactable, skilled agents are needed to execute a compelling talk off. This is one of the most difficult persuasion, or selling, situations.
Please imagine the following: An agent is trying to convince a cost-sensitive, cash-constrained prospect (the borrower) to purchase something of questionable value (a "better looking" credit report – the borrower's report most likely looks like WW III by this time) for a relatively high price (at least more than the borrower can readily afford).
Despite these challenges, approximately 5% to 7% of the charged off second-lien balances are recovered by the primary collector – a feat just a few inches short of miraculous.
In some situations, it is possible to file suit. There are borrower issues and legal issues.
Regarding borrower issues, the second-lien servicer must determine how responsive this borrower will be to a judgment. Surprising, only a small percentage of randomly filed judgments are ever collected. However, a judgment against the right kind of borrower (i.e., someone with something to lose) is much more successful. The best second-lien servicers can make this investment determination.
However, there are also complex legal issues that are fact-specific to each borrower. Not every state will allow a servicer to sue a defaulted borrower. Some states do not consistently hold the borrower liable. When this occurs, suing the borrower is verboten. If a suit cannot be filed – and because the property has no value – this type of second lien must be handled like a typical unsecured, defaulted credit card debt.
In those states where suits are allowed and the borrower seems like a good prospect for same, a suit on note processes is quite successful. In these situations, the outbound calling operation typical of unsecured debt highlighted above is transformed into an inbound call made by a much more motivated borrower. The success rate here is often three or four times that of the preceding process, where typically 5%-7% of the outstanding balances are recovered.
The market's trend of depreciating housing price indices will likely continue, with little abatement through the rest of the year and into 2009. There are still too many foreclosures on the market, and inventory is well above absorption rates. This means that more and more second liens will lose value, requiring servicers to become even more informed and faster acting than they are today.
Thomas Showalter is senior vice president of product and analytics with First American Subordinate Lien Outsourcing. He can be reached at (817) 699-3365.