Scotsman Guide - February 2009 Residential Edition

Loan Modification Continued from Page 19

In a simpler world, when homeowners ran into difficulties making their mortgage payments, they’d contact the bank that made the loan, describe their predicament — e.g., extended illness, job loss or divorce — and negotiate a loan modification. These alterations could include a temporary decrease in interest rate, a lengthening of the loan term, a refinance or sometimes even a reduction in the principal amount owed. Securitization of home loans changed all this.

Today, securitization and its side effects pose exceptional challenges to the full range of mortgage-market participants. This includes everyone from borrowers to brokers and from lenders to the federal government.

Securitization dramatically altered the borrower-lender relationship. Instead of holding mortgages in their own portfolios, many banks and lenders bundled large numbers of loans into pools that were turned into residential mortgage-backed securities (MBSs).

These securities were divided or “tranched” into different payment-priority tiers, each of which carried a different dividend rate and a different credit rating and were in turn resecuritized into collateralized mortgage obligations. These were backed by

“Securitization and its

side effects pose exceptional

challenges to the full range of

mortgage-market participants.

This includes everyone from

borrowers to brokers and

from lenders to the

federal government.”

mortgage-backed securities rather than the underlying mortgages themselves.

Adding another layer of complexity, collateralized mortgage obligations were tranched. Senior tranches, which stood first in line to recover potential losses, received investment-grade ratings from rating agencies. These ratings allowed these tranches to be sold to institutional investors. Noninvestment-grade components of these obligations were securitized again into what are known as CMO2s.

To make matters worse, the whole process could be repeated again. Often, it was.

The direct connection between borrowers and bankers had in effect disappeared. This not only made it difficult for troubled borrowers to know where to begin with loan modification, but it also created a tricky proposition for mortgage brokers looking to help borrowers negotiate these modifications.

Back to servicing

Mortgage brokers who advise their clients on loan modifications can build their reputation and help borrowers escape bad financial situations. To offer good advice, however, brokers must first understand the layers involved in securitization and how those layers affect modification attempts.

For starters, many homeowners send their mortgage payments to servicing agents rather than to the lender that initially extended them credit.

These servicing companies collect monthly payments and distribute them to investors — whoever they might be. Many borrowers don’t know who owns their mortgage or its components, long since stirred into a securitized stew.

Servicing agents carry out their duties pursuant to pooling-and-servicing agreements, which place heavy restrictions on servicing agents’ ability to modify mortgages in their care. These restrictions include limits on the types and the number of modifications permitted. They sometimes forbid modifications altogether. If servicing agents attempt to extend their authority without the consent of the MBS-holders, they risk being sued.

Pooling-and-servicing agreements were created to meet a variety of considerations, which had little to do with borrowers’ underlying needs. Moreover, modifying these agreements can impact the tax status of the underlying trusts holding the MBS interests. Changes also can impact the bankruptcy remoteness of the trust, which protects the trust’s assets from creditors as well as MBS-holders from liability for the trust’s actions.

Even if some of MBS-holders wanted to make loan modifications easier, changes to pooling-and-servicing agreements frequently require approval by two-thirds of the MBS-holders. Convincing two-thirds of the investors to agree to take losses by reducing the value of a loan pool represents a huge undertaking.

Servicing agents also often make more money by foreclosing upon homes than they do by modifying loan conditions. This isn’t to say that servicers lack any incentive to make loan modifications. Write-downs, for example, help them reduce their cash outlays, or advances, on loans they service. But financing these outlays has become more difficult and costly as credit markets have tightened. Servicers also face increasingly severe government regulations related to the upkeep of vacant homes in their control.

Insurers also involved

Mortgages are often secured by private mortgage insurance that the borrower or lender purchases. This insurance is designed to protect MBS investors from losses and can enhance the value of the securities. If a loan is modified, it frequently loses its insurance, which can reduce the loan’s value.

There are also layers of insurance. Mortgage payments made by borrowers in a pool often exceed the dividends paid to MBS investors. This extra amount is called net interest margin, and separate net interest margins themselves were securitized and insured by financial institutions. The insurers of net-inter-est-margin securities took a position similar to an equity-holder in a loan pool.

Modifying a pooling-and-servicing agreement — and therefore, the terms of the underlying mortgages — also requires consent from the net-interest-mar-gin security insurer. These insurers hold positions similar to junior mortgagees, and loan modifications are liable to wipe out their interests. In other words,

Continued on Page 26

Richard H. Zahm is a founder and principal of Second Angel Bancorp. He leads the firm’s investor relations as a manager of Second Angel Commercial Mortgage Fund I LLC, a real estate focused hedge fund. A California attorney, he earned degrees at Colorado College, Stanford Law School and the Graduate