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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
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
This includes everyone from
borrowers to brokers and
from lenders to the
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,
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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
School of Business at the University of Cape Town in South
Africa. He holds a California real estate broker’s license.
Reach him at (916) 863-7300.