Cracking The Loan Modification Myth: Securitized Mortgages Cannot Be Modified

By Author: Scott Podvin
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By December 2010, lenders owned or were foreclosing upon more than three million loans, and 2011 is predicted to be a record breaking year for foreclosures according to Realty Trac, a publisher of the largest database of foreclosures and bank-owned homes in the country.

The question that must be asked of President Obama is why lenders haven’t been more willing, or eager, to make loan modifications. Answering that question thoroughly will include exploring the contours and parameters of the securitization market, including a brief discussion of each of the market participants and their role in the process. Clearly, some major roadblocks to modifications spring directly from the incredible complexity of mortgage securities; any discussion must include problems attributable to securitization.

This article will briefly explore and describe the securitization market, the players and their roles in securitization and some of the most common roadblocks a borrower will face when attempting to have his or her loan modified. In this article, modification will only refer to changes in loan terms consistent with the ...
... model initiated by the Federal Deposit Insurance Corporation (FDIC) in 2008 and incorporated into President Obama’s February 2009 Home Affordable Modification Program (HAMP).

Securitization Market

In the United States, the most common securitization trusts are Fannie Mae and Freddie Mac, both of which are U.S. government-sponsored enterprises (GSE). Some private institutions, such as Real Estate Mortgage Investment Conduits (REMICS) and the Real Estate Investment Trusts (REITs) also securitize mortgages, but these are commonly referred to in the industry as “private-label” mortgage securities.

There is currently about $14.2 trillion in total U.S. mortgage debt outstanding. There are about $8.9 trillion in total U.S. mortgage-related securities. The volume of pooled mortgages stands at about $7.5 trillion. About $5 trillion of that is securitized or guaranteed by the GSEs, the remaining $2.5 trillion are pooled by private label conduits.

Typical Securitization

A typical securitization is composed of approximately $500 million to $1 billion or more of assets. A residential mortgage backed security (RMBS) is secured by a single-family or a two-to-four family home. This means that a pool of RMBS is composed of a minimum of 26,737 and a maximum of 53,475 single family or two-to-four family homes.

Key Players

Securitization involves a number of players.

First, there is the borrower, who wants to buy a home. The borrower can go directly to a mortgage broker, who arranges with a mortgage banker to originate the loan. Alternatively, the borrower can go directly to a mortgage banker, who originates the loan. The mortgage banker, who in many cases acts as the issuer, will securitize the loan with other similar loans.

A particular loan originator, the entity that interfaces with the future homeowner and lends him/her money, often cannot generate sufficient loan volume through its direct branches and personnel. Thus, to supplement its own loan production, an originator often purchases loans from, or indirectly through, a network of mortgage brokers or correspondent lenders.

In this fashion, originators both initiate loans through their own efforts and aggregate loans initially generated by third parties. Traditionally dominated by commercial banks and savings and loans, the loan origination process has grown to include other parties such as non-insured financial institutions. Although federally-insured financial institutions continue to generate the largest volume of loan originations, today, non-bank financial institutions make up a much larger share of the loan origination market.

To initiate the lending process, the originator collects from the borrower the required personal financial and asset valuation information necessary to underwrite the loan. This information varies by loan type, but will typically address the borrower's ability to make the required monthly payments of principal and interest, as well as an assessment of the value of the asset that will serve as collateral for the loan.

Once the loan underwriting process is complete and the loan has been approved, the borrower will execute a note, and either a mortgage or deed of trust, depending upon the jurisdiction in which the collateral is located. In the residential mortgage situation, the originator will then fund the loan with the proceeds being directed by the borrower to the purchase of a residence, retirement of prior debt or cash out to the borrower.

Typically, the source of funds for the originator will predominantly be a loan from a warehouse lender and a small amount of the originator's own funds. Warehouse lenders often advance a very high percentage of the ultimate loan principal amount. The originators' own funds usually represent just a small percent of the loan amount.

Frequently, the warehouse financing arrangement is accomplished through a repurchase agreement, often referred to as a “repo,” whereby title to the loan is held by the warehouse financier and the originator has the right to repurchase the loan for the amount advanced by the repurchase agreement counterparty, plus an interest charge.

As a first step in effecting the securitization, the loans created or purchased by the originator are sold to a Depositor pursuant to a Loan Purchase and Sale Agreement. In this role, the originator is referred to as the Loan Seller.

The Depositor is an entity established for this sole purpose, but has no creditors. The Depositor is essentially a middle man who is in between the Originator and what will ultimately be the securitization entity. Simultaneously, the Depositor sells the loans to another special-purpose, bankruptcy remote entity (SPE), which will eventually serve as the securitization vehicle.

Although other corporate forms are possible, the SPE is usually a trust which has been set up specifically to hold the residential mortgages and loans to be securitized. This SPE becomes the Issuer of the securitization—the Issuer “issues” the securities that will be purchased by the investors. In order to buy the assets from the Originator, the Issuer sells certificates - the proceeds of which are used by the trust to fund the purchase by the trust of the underlying loans.

Since the 1986 Tax Reform Act, most mortgage securitization trusts are designed to qualify under the Section 860D of the Internal Revenue Code as a REMIC. The principal advantage of a REMIC is that the entity is disregarded for federal income tax purposes; thereby, avoiding double taxation. However, to qualify for this tax advantage, REMICs may only hold qualified mortgages and permitted investments, including, for example, single family or multifamily mortgages and are subject to significant number of other restrictions.

The certificates sold by the securitization trusts are often of multiple classes, with each class having different rights with respect to interest rates, principal repayment and other repayment priority upon losses being recognized on the underlying assets held by the trust.

Each class of certificates is often referred to as a “tranche,” which means a thin slice in French and refers to the particular slice of the cash flow and risk that will be received by the holder of that class of certificate. The certificates can be publicly registered securities or sold in a private transaction. Most registered certificates are also rated by one or more of the rating agencies.

The Participants—the Sponsors/Guarantors

The issuer of securities is typically a trust and is established solely for the purpose of holding title to the mortgage and note, but has no employees. Therefore, the structure of the securitization calls for the formation of another entity commonly referred to as the Sponsor.

Sponsors are charged with the responsibility to accumulate and pool the loans, engage counsel and investment bankers to execute the securitization and create the trust so that certificates can be issued.

Historically, the largest Sponsors of RMBS were GSEs, including FHLMC and FNMA. These sponsoring entities purchase from originators only loans which conform to the GSE-published underwriting standards and whose principal amount does not exceed annually determined ceilings. As such, these loans are deemed to be and often referred to as “conforming mortgages.”

FNMA and FHLMC together accounted for 40% of the RMBS that were issued in 2006, whereas GNMA accounted for 4%. The remaining 56% of RMBS issued in 2006 are “private-label” MBS. Sponsors of these securitizations typically are investment banks, mortgage companies and other financial institutions, both federally insured and uninsured. Loans in these residential mortgage-backed securitizations typically do not conform to the GSE underwriting requirements or exceed their lending ceiling, in which case they are known as “jumbo loans.”

The mortgages that serve as collateral for these issuances include prime mortgages, which are usually considered loans made to borrowers with better credit and usually meaningful equity in their homes, and also often include Alt-A loans and subprime loans.

In the private label market, the Sponsor of the securitization is frequently the same organization as the Originator, particularly if the Originator’s wing-span is large enough to enable it to generate substantial volume of loan originations on a regular and consistent basis. Nonetheless, it is also commonplace for the Sponsor to be a third party accumulator of loans in the secondary whole loan market who then creates a trust that issues the securities under its name.

Certificate Holders

Investors who place funds in an MBS transaction receive a pass-through certificate, which evidences their ownership interest in a pool of mortgage loans. The pass-through certificate entitles the investor to a particular interest in the cash flows from an entire pool of mortgage loans as opposed to specific loans in the pool. Thus, investors in a MBS transaction are referred to as certificate holders.

Securities from already existing RMBS are now frequently bundled into new investment vehicles, called Collateralized Debt Obligations (CDO), which are in turn segmented or sliced and diced into their own series of senior and subordinated investment certificates. Further, bundling of certificates from such CDOs, often intermixed with participations in primary MBS certificates, are referred to as “CDO-squared” transactions.

The Investment Bankers

Sponsors invariably obtain assistance from investment banks, which help the Sponsors structure securitizations to facilitate investor interest and sales. Investment banks in this process are intermediaries between Issuers and Investors, which assist the Issuers in structuring the securitization transaction, interacting with the rating agencies and credit enhancers, as well as selling the resulting securities to their investor base.

The Servicers

The securitization trust usually owns hundreds or thousands of loans, each of which needs to be serviced monthly. This servicing responsibility is handled by a Master Servicer, which is responsible for management of the loan portfolio owned by the trust, including establishing policies and procedures for servicing, monitoring performance and handling cash collections.

The Master Servicer provides monthly reporting to the trustee on the loan pool performance and remits cash to the trustee for distribution to the bondholders.

The duties of the Master Servicer are set forth in detail in a pooling and servicing agreement (PSA) to which the Master Servicer, the Trustee and the Depositor are parties. In some situations, the Master Servicer will engage a sub-servicer to carry out the day-to-day servicing functions with the Master Servicer remaining liable to perform the duties if the sub-servicer does not.

Master Servicers typically receive a monthly fee for their services denominated as a percentage of the principal amount of loans they service or on a per loan basis. They also often receive additional fees for extraordinary services. When a sub-servicer is retained by a Master Servicer, some, or all, of the periodic servicing fee will be paid to the sub-servicer.

A Special Servicer is typically retained to handle defaulted loans or loans that after securitization are identified as having special defects or deficiencies. The servicing of a loan is transferred from the Master Servicer to the Special Servicer upon the occurrence of various identified events, usually including a loan default remaining uncured for a period of time, often 30 to 60 days.

The Special Servicer has particular expertise in the collection of delinquent credits and supervising foreclosure and real estate sale processes. If a loan transferred to a Special Servicer has its defaults cured, after a period of time, the servicing of that loan is transferred back to the Master Servicer.

The Rating Agencies

The Sponsor, on behalf of the Issuer, will invariably engage one or more credit rating agencies (for e.g., Moody’s, Fitch, and Standard & Poor's) to rate or grade each tranche of certificates that are proposed to be sold by the trust to certificate holders.

The rating agencies will also provide ratings to each class of bonds that are to be created by the securitization. In transactions where credit enhancement is required, the rating agencies also decide the levels of subordination required to permit the bonds to obtain the desired rating. In evaluating such deals, rating agencies determine the subordination levels required to support particular ratings.

Trustee and Fiscal Agent

A neutral third party is appointed to act as Trustee for the securitization trust. The Trustee's responsibilities include overseeing the distribution of cash in accordance with trust requirements, as well as to ensure that the terms and conditions of the PSA or trust indenture are complied with. There is also typically a Fiscal Agent (which may or may not be the Trustee), normally a bank, which is appointed as the certificate holders' agent under the trust. Typically the Fiscal Agent's main role is to act as paying agent but it has none of the fiduciary responsibilities of the Trustee.

Internal Conflicts Disincentivize Loan Modifications

Given the complexities of mortgage securities, it is not surprising that one of the least understood impediments to doing modifications is the inherent conflicts created by these instruments among the different classes of ownership. Let’s examine just two of the many potential conflicts that might be present.

First, imagine that a group of mortgages is divided into three sub-groups: the top 20%, the next 20% and the bottom 60% (safest). Those three sub-groups would be sliced and diced and sold off to investors.

If a loan goes into default, the three sub-groups have sharply different perspectives of a proper response to default. The 60% group thinks, “We have plenty of equity cushion; let’s just foreclose and get our money.” On the other hand, the top 20% group thinks, “We’ll be wiped out in a foreclosure; let’s lower the rate, and/or extend the term hoping to get something back.” Of course the 60% group sees no advantage in making any concessions, so without a contractual provision for modification, there is likely no practical alternative to foreclosure (remember that the two 20% groups got higher returns for the higher risk).

Many RMBS are subject to a PSA, under which servicers collect payments and remit the net proceeds to the investor pools. Often, the PSA provides that in the event of default, servicers will be paid extra for the additional work. They normally require servicers to advance any missed payment to the pool to be repaid upon recovery. While some have suggested the former provision encourages foreclosures (for the extra fees), in reality it is the latter provision that is the problem.

The PSA typically requires servicers to maximize returns to the pools in defaults. If modifications yield the highest returns, servicers should modify. However, the PSA may actually prevent or eliminate the possibility of a loan modification, or even worse, the PSA may require that the request for loan modification be sent to the firing squad for investor approval. This may be the death knell of the request, as the requisite number of investor votes will be impossible to obtain due to ownership fragmentation. Furthermore, even if the PSA permits or encourages a loan modification, the PSA may be unclear as to what funds can be used to repay the servicer for any money that the servicer advances or may require that servicers receive shares of each modification payment. In the latter case, it will take years before servicers are fully repaid, so servicers will predictably not find borrowers to be qualified for modifications.

Second, insurance can greatly impact the possibility of obtaining modifications, including mortgage insurance (typically required for loans over 80% of value) and Credit default swaps. Unfortunately, if the agreements do not treat modifications as defaults, lenders must forego modifications and foreclose to collect on insurance or credit default swaps. Insurers, stung by massive losses on many loans of questionable quality, are increasingly declining to pay claims, asserting that loans failed to meet the standards required for coverage.

Finally, the FDIC/HAMP model to determine qualification for a modification is relatively simple. “Housing expense” is reduced to 31% using rate, term and/or principal, as prescribed. Then the net present value (NPV) of the modified mortgage compared to the foreclosure value is calculated using a standardized program. If NPV favors modification, i.e. if the lender will make more money modifying than foreclosing, the modification is supposed to be granted.

Some factors entered into the program must be estimated, e.g. resale price, times to foreclose/resell, likelihood of re-default, etc. As such, the servicer or sub servicer can skew the results by including deliberately false estimates of costs and/or values. Furthermore, calculating modification income can be tricky, as it need not follow underwriting standards exactly. Given the high probability that one or more factors used may be unreasonable or deliberately skewed, denials of modifications should trigger close scrutiny of the input factors to determine if denials were truly warranted.

Conclusion

Unfortunately, for reasons summarized above and for internal policy reasons that lenders may not be disclosing, lenders have not embraced the modification concept. The foreclosure frenzy has now and will continue to overwhelm and overburden the administration of justice to the extent that final judgments will continue to get robo-stamped, despite the plethora of examples of robo-signed documents being used to effectuate the foreclosure.

Until the U.S. government subsidizes bank write-downs so that the principal outstanding balances of delinquent loans are in line with current market values, there will only be a slow, grinding progress toward resolution of the mortgage crisis and that progress could stall or reverse in a still-fragile economy where unemployment remains at record levels. As such, we can only hope that lenders will finally begin to appreciate the long-term benefits to them and the nation of speeding up resolution of this foreclosure crisis.

Scott Podvin is an experienced and savvy attorney determined to protect homeowners from mortgage foreclosure actions. As a founding partner of Florida Homestead Law Group, Scott Podvin focuses his practice in the areas of mortgage foreclosure defense, civil litigation, complex commercial litigation, real estate law and business law.