Compared to what? Part 3: Motivating modifications
[Continued from previous Part 1 and Part 2.]
In my ongoing exploration of Joseph R. Mason’s new article, Mortgage Loan Modification: Promises and Pitfalls, we’ve hit the curious fact that loan servicers affiliated with originators have incentives to keep up appearances.
In this, Professor Mason concludes ulterior motives:
One of the key reasons loan modification has grown has been to skew financial reporting of delinquencies, modifying loans to help borrowers make a few payments and then aggressively re-aging the accounts to classify them as ‘current’ instead of ‘delinquent’.
My financial reporting isn’t skewed
The good professor cites no evidence for this conclusion, which is a pity, because it flies in the face of all those scandal-by-anecdote stories you read in newspapers across this great land of ours — yet in general, I believe him. It’s plausible, particularly if one were (say) New Century, a huge subprime lender, on the curling edge of the downturn, trying unsuccessfully to keep things going and to hold off bankruptcy.
Such practices appear to have been a key mechanism in supporting the paper earnings of many failed subprime lenders prior to bankruptcy.
Once a loan has been restructured, it can be reclassified from ‘non-performing’ to ‘performing,’ even if at a lower payment level. That’s a big deal for stock investors and regulators, because, as the professor quotes:
In May, 2007, Bank of America wrote “even in the case of successful workouts … true credit exposure will be masked because worked out loans are considered performing and will no longer be disclosed once they are disseminated into performing loan pools.“
Really, all of us are performing loans
Since reality will not be fooled, a lender who masks the moth-eaten quality of its loan book is deceiving the present at the expense of the future. Such a lender’s principal victims are those who buy its stock (if it’s publicly traded), and those who invest in its securities or derivatives. This element of inter-entity agency risk largely disappears when the loan is serviced by its holder, as in the case of state housing finance agencies. It’s a real problem, however, when the loan servicer is a fee organization and the lender is a distant investor.
[Bank of America quote continues] “The credit ratios going forward should be distorted and are no longer reflecting real credit exposure. For these reasons, going forward, we believe investors should focus on static pool yield changes, instead of credit ratios, as a credit performance indicator of the existing loan portfolios and static securitization tools.”
Yes, investors should pay more attention to their originators, particularly in downturn times, since those originators and loan servicers have a selfish interest in making things look rosy.
Such false cheer doesn’t harm borrowers — probably it helps them. Or does it? What if the bad underwriters were the biggest modifiers, hastily papering over their previous sins so long as to postpone their day of reckoning?
I’m the ultimate regulator, and begone to your false modifications!
In any case, it’s just this side of fraud, isn’t it?
Regulators can already require modified loans to be reported as material considerations under Sarbanes-Oxley, with standardized reporting practices promulgated under FASB Regulation AB.
What are these nefarious modification practices? The professor only indirectly mentions them:
Work by JP Morgan prior to the present market difficulties illustrates that the kinds of flags that can indicate predatory modification are [1] liberal repayment terms with extended amortizations, [2] moving accounts from one workout program to another, [3] multiple re-aging and [4] poor monitoring of performance.
To be sure, rearranging the Titanic’s deck chairs by shuffling bad loans through a series of modifications, each of which fails and is replaced by another one, or hiding the bad loans under the rug of ignorance, are bad things. It seems unfair to lump in with them ‘extended amortization,’ which to an ordinary mortal is simply ‘relief.’
In any case, these questionable practices have been tackled already:
Predatory servicing was a common concern among regulatory officials and servicers in 2003 and 2004.
Following these regulatory actions, many servicers re-evaluated their operations to identify potential exposure to predatory servicing concerns. Servicers [1] implemented 100% call recording, [2] itemized monthly statements, and [3] issued paper notification to borrowers when fees are charged. Servicers [4] added transparency to force-placed insurance programs (hazard insurance that is assigned to mortgaged property when the borrower fails to maintain his or her own coverage) and [5] reduced or eliminated ancillary fees.
These five actions all are solid consumer-protection steps. What’s the professor’s beef today?
From his email to me:
I am not so faithful that the practice is in the past. Even stated re-aging policies for non-banks would be useful.
He’s somewhere between suspicious and deeply skeptical about the seeming benevolence of loan servicers offering modifications:
Modification does not always work. Fitch Ratings reports that a good modification program has only a 60-65% success rate. That means that some 35-40% of borrowers re-default on their loans within 12-24 months.
The two out of three who don’t default really appreciate being tossed out with the bathwater of the one in three who does.
I just do not advocate developing a new risky lending technology immediately on top of a failed risky lending technology. Building further uncertainty upon what we don’t know is what got us here in the first place. I would also think that banks would want recordkeeping and best practices guidelines so that they don’t get caught in the trap.
True enough; but what’s the risk to borrowers?
It appears, therefore, that the main purpose of loan modification is to skew financial reporting of delinquencies [Really? – Ed.]. In other words, modifying loans helps borrowers to make a few payments, allowing lenders to aggressively re-age the accounts and classify them as ‘current’ instead of ‘delinquent’. Such practices appear to have been a key mechanism in supporting paper earnings of many failed subprime lenders prior to bankruptcy. Hence, without regulatory oversight or increased transparency, it is hard to imagine that borrowers will benefit from modification in the long run. [Ay, there’s the rub, isn’t it? — Ed.]
That last sentence is the logic leap I can’t make. As I’ve previously posted, loan modification or workout is a customized activity that depends on the lender’s conclusions about two key questions: (1) Why are you behind? and (2) What’s the best way forward?
The path to foreclosure, which gets worse for the lender as it advances
Loan modifications come in many types:
Modification strategies in the most general sense include a wide range of pro-active loss mitigation tool like payment plans and loan modifications. Loan modifications may include “[1] a permanent reduction in rates, [2] extending the term of the loan to reduce monthly payments, [3] deferring prior missed payments and adding them to the principal balance, and [4] reset shock modification where the terms of the loan are adjusted to mitigate the payment shock.”
Take a look at those tools. If you were a borrower, which of them wouldn’t you want to use? And if you were an investing lender, which ones wouldn’t you want your lender to pursue?
Isn’t it worth trying anything once?
Zero equity ownership speculators were not meaningful community members anyway. You can’t ignore that a lot of people are paying their loans in full and on time and will consider a bailout an affront. I do advocate transparency, not a standard workout. Some borrowers just can’t afford their loans. Period. We need to come to terms with this. There is, somewhere, a natural rate of homeownership (like a natural rate of unemployment) that may have been met and even breached. If this is the adjustment, we need to learn not to extend that much credit.
Tough love indeed. Professor Mason approvingly quotes J P Morgan:
“Principal reduction should be the main goal of workout programs, not maximizing income recognition [emphasis added].” Servicing that does not promote principal reduction can therefore be considered predatory.
Some things are just obviously wrong
While income recognition — booking short-term earnings at the expense of ruining long-term collectibility — is clearly contrary to the lender’s and investors’ interests, principal reduction is an option or a tool, not a goal in itself.
Fortunately, an email dialog with Professor Mason clarified that phrase — what he means by principal reduction is not that the lender takes an immediate haircut, but rather that the borrower gets restored to a loan situation where, over time, the amount the borrower owes gradually goes down. Otherwise you get the rising-arrearage problem:
Total nominal loss rises as nominal charges rise
The goal of loan modification is to restore the loan to the optimal achievable performance given the changed circumstances. As we’ve seen, sometimes a principal writedown with the current borrower is the right answer. Sometimes it’s an adjustment in interest rates. Sometimes it’s simply a temporary deferral, with the deferred payments re-amortized.
There are more workouts in heaven and earth than are dreamt of in the good professor’s taxonomy — and the right choice is entirely a matter of facts and circumstances, some of them macro, some micro. As Professor Mason acknowledges:
According to Chris Flannagan, managing director and head of global research at JP Morgan Securities, the whole premise of loan modifications is to allow the servicer to exercise independent discretion and evaluate borrowers individually to determine appropriate options available to them.
What then is the right answer? What does Professor Mason recommend?
When in doubt, slap a valve and a gauge on it
[Concluded tomorrow in Part 4.]
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