Affordable Housing Institute : US

[Continued from yesterday's Part 1.]  

Yesterday’s post introduced and teased Joseph R. Mason’s new article, Mortgage Loan Modification: Promises and Pitfalls, exploring how loans in the subprime mess can be successfully recapitalized — or not.  

Nothing to worry about

 

As I’ve posted six months ago, today’s lending business is intermediated — there are many intermediaries in the money store between the original borrower and the ultimate capital provider:

 

Loan servicer.  The person or division within a lending institution that actually receives and processes monthly loan repayments, and sends them on to the investing lender.

 

“We keep your loans shiny and well buffed.”

 

Because they are recurring, routine, and numerical, servicing has become spectacularly automated.  Servicers have grown to enormous financial scale, even as they maintain ever smaller numbers of staff per loan.

 

It’s all in my head

 

Asset manager.  Normally one level higher up within the same entity that provides loan servicing, the asset manager is always a person (or collection of people) who address any loans that aren’t running perfectly smoothly.

 

Looks good so far

 

Asset managers are problem solvers, and because problems vary, solutions are always customized.  Like many other skills, asset management looks easy when done well.  As a result, it’s a term that everybody uses and very, very few people actually understand, much less know how to do it.

 

Workout specialist.  When the problems overwhelm the asset manager, loans need restructuring.  Workouts are their own entire discipline, calling for precise judgment, cool nerves, and skilled action.

 

“Get in, get out, move fast, solve problems.”

 

If all these players confuse you, you could just opt for safety:

 

“Neither a borrower nor a lender be”

 

Professor Mason explains it thus:

 

There are three classes of mortgage servicers: master servicers, primary servicers, and special servicers.  Master servicers oversee all the servicing processes and work directly for the trust that manages the loans on behalf of investors.  Primary servicers manage the routine tasks on the bottom row of Figure 3 and sometimes the tasks related to delinquency and foreclosure on the top row.  Special servicers specialize in delinquency and foreclosure-related tasks.  Many transactions have all three types of servicers present, while others may only have one or two.

 

From the borrower’s perspective, the person who processes your check is a primary servicer; if your check doesn’t arrive, or the amount’s too little, the master servicer hands you over to a special servicer, which may be a new individual in the same company or a different entity altogether.  [Full disclosure: my for-profit company does special service asset management on large complex multifamily loans. -- Ed.]  As he summarizes it in a helpful chart:

 

Who does what to whom?

 

Very significant for Professor Mason’s argument is that the loan servicers have complex motivations, because their companies are not just servicing but also originating new loans, which is their main source of profit:

 

While most servicers claim that a well-managed loan modification program can save money over servicing through what has been illustrated above as an extremely costly delinquency and foreclosure process, loan modification is a relatively new function [Not! – Ed.] and, like the subprime mortgages that necessitate it, is untested in an economic downturn [Not! Ed.].

 

Loan modification isn’t a new function, it’s a bread and butter activity that always occurs whenever any asset class goes backwards.  We had bouts of this in 1990-92 (an OCC-driven credit crunch inspired by FIRREA that gave a recovering industry another bout of financial disease), 1982-84, and 1974-77.  Loan modification is an inevitable part of the recovery cycle that follows a recession or asset price crunch.

 

 

What’s new is this class of borrowers in this post-securitization environment. 

 

Servicing is a mechanical business: it’s routine, it’s quantitative, and it benefits enormously from digitization.  Not surprisingly, it scales beautifully, with large servicers much more profitable, and generally delivering better service.  As a result, servicing of healthy loans is profitable.  Indeed, it’s very profitable, so profitable that mortgage servicing rights (MSRs) — contract rights, that is — are themselves considered an asset:

 

The total value of a mortgage servicing enterprise is the sum of the value of its contracts.  The value of those contracts, called mortgage servicing rights (MSRs) is the present value of the series of uncertain direct service fee payments.  The reason the fees are uncertain is that they rely crucially on how many mortgages remain with the servicer after prepayments and defaults. 

 

How many prepayments?  How many defaults?

 

Got that?  The value of an MSR book is based on how many loans you service, and for how long.  As a servicer, you can lose loans either because they are paid off, or because they default and get foreclosed.  Servicers don’t control either of these events:

 

Since prepayments and defaults are not well understood, MSRs are difficult to value with any degree of certainty and the valuations that result can be very volatile to actual conditions realized in the servicing pool.  Residual first-loss investment stake violations rely crucially on the same conjectures about prepayment speeds and default rates, and are therefore similarly difficult to value.

 

When loans are securitized, the residual piece the originator retains (called the B piece, to contrast with the A piece, which is sold to investors) is exposed for the first loss.  If the pool of loans goes bad, the B piece loses most if not all of its value before the A piece is hurt.  As Mycroft Holmes put it:

 

“That is a principle of securitization; each time the banker slices offer a lower tranche — as a concession to the Bourse, we have adopted their term — the remaining junior security is on the one hand higher yield, and on the other, a distilled or more concentrated residue of risk.” 

 

We’re concentrating the risk

 

Originators — like Countrywide, whose business has been battered and whose CEO, Angelo Mozilo, has been criticized recently for selling his stock in bulk — use the existence of these contracts to substitute for cash on their balance sheets.  It’s in their interest, therefore, to value those loan servicing contracts up.

 

The usual suspects?

 

It should not be surprising, therefore, that the vast majority of bank failures since 1992 have involved substantial issues of MSR [mortgage servicing rights] and residual valuations. 

 

Have you gentlemen been fiddling with your residual valuations?

 

Nonetheless, many of the mortgage servicers listed in Figure A1 derive a great deal of their value from equity incentives and MSRs.  WaMu’s MSRs amount to 23% of their capital, IndyMac’s amount to 90% of their capital, and Countrywide’s amount to 115% of their capital.  

 

I hadn’t known this — and it’s truly remarkable.  To stay in business, banks and non-bank lenders have to maintain capital reserves, so they have money to cover the vicissitudes of payment and receipt.  You’d think capital means cash, but Professor Mason’s analysis says that the lenders are counting a contract right — an anticipated set of future payments — as capital.  In Countrywide’s case, what they are counting is more than the firm’s book value.

 

Holy book value, Batman!

 

Clearly, having MSRs worth more than the value of capital creates a high risk that valuation difficulties can wipe out a firm’s underlying capital with the stroke of a pen.

 

There’s an understatement!

 

That’s an understatement too

 

Now the worm of doubt should be creeping into your brain.  The loan servicer and lender have motivations to keep up appearances.

 

Neither my loan servicer nor I are crooks

 

[Continued tomorrow in Part 3.]

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