How Tenant Occupancy Is Negatively Affected by MBS Contracts
Contractual conflicts of interest between investors and servicers regarding foreclosure sales may create a disincentive for servicers contemplating whether or not to provide lease-to-purchase options on vacant properties with securitized loans.
How mortgage loan securitizations affect a servicer’s motivation to invest in foreclosure prevention and workout options can be an issue for banks with large foreclosure portfolios, says Dale McPherson, CEO of Field Asset Services, a distressed property management services provider, who has over 33 years of mortgage market experience.
Many servicers of securitized mortgage loans “are not motivated to advance a dime” on foreclosure prevention measures because they cannot recollect advances made to the investor on a delinquent loan unless the property is sold and can even get penalized if they close a foreclosure. Plus, servicers do not get additional income for helping generate a better return for the security holder either. “It is real bad chemistry,” he says, with some not that obvious consequences.
For example, demand for “the tenant management part of the business” saw a significant increase in 2010 and may experience further growth this year McPherson said. The number of occupied properties under management is growing faster than vacant REO properties.
He estimates that due to this “very big shift” about 18% of the REO and foreclosure inventory is tenant occupied—and growing. It is a positive trend that indicates demand for lease-to-purchase options on vacant houses that cannot be sold will further increase. Housing availability has relented, but affordable housing demand is strong because “financing has gone away.” So promoting tenants who can prove themselves creditworthy for one to two years before they purchase or repurchase the property is a win-win solution. But in many cases, McPherson warns lease-to-purchase options will be less accessible unless the aforementioned monetary incentive to lease properties is taken out of the equation.
Other insiders agree that the crisis has made some securitization challenges more clear. Certain systemic problems were not as obvious as they are today, argues David Joseph, partner and co-chair of the structured finance and securitization practice group at Stradley Ronon Stevens & Young, because in the past the delinquency rate among securitized loans was insignificant.
The disincentive argument is a concern, he said, even though it is not present in all MBS contract deals.
The flat mortgage servicing fee structure is an even more fundamental problem for the mortgage-backed securities market that adds to contract-based issues. A differentiated fee structure was not deemed necessary because the number of MBS foreclosures was relatively small. Historically servicers were not compensated for the extra work required to workout a delinquent loan or manage an REO. During the loan origination boom of early 2000 low interest rates allowed for fast refinancing within a few years, so “none of these systemic flaws were exposed.”
Each time a mortgage loan becomes delinquent there is a basic conflict of interest for the servicer of the loan receiving a 50 basis points servicing fee on the balance of the loan for most deals, says Joseph, who has presented both servicers and issuers securitized loans. One of the biggest lessons from the crisis is that workouts can be very costly. In the lease-to-rent context it all depends on how the individual securitization deal documents evaluate servicing advances. In the future the securitization market will use “a more granular compensation for servicers that accounts for all the different stages of a loan’s life cycle.”
Until then existing servicing contracts which may or may not require servicers to make advances on principal, interest and servicing, “unless and until it is determined that they are nonrecoverable” to protect servicers from potential losses from unrecoverable advances.
Servicers who have that contract protection make “a good faith determination” whether liquidation proceeds received in connection with taking the loan to foreclosure and selling the property would be sufficient to recover previous advances.
If that determination is negative servicers can stop advancing on a bad loan and even recover early advances. Sometimes investors call up to complain that the servicer is pulling money out of the deal, he recalled, and in many cases they can because the way the deal was written. (Hence, the disincentive does not apply.)
Some contracts limit the ability to recover advances and nonrecoverable advances from liquidation proceeds to the liquidation of “the related loan.” Meaning if after the servicer advanced $500 on a particular loan it is determined that the loan is not performing, the servicer may have the option to stop advancing, “but wouldn’t get the money back until the loan has been liquidated.” A requirement that does not play well in times when the foreclosure processing timeline has increased to an average of 400 days, according to RealtyTrac’s April data.
The mechanism that determines how that process is executed is deal-specific depending on the language used in the deal. The contract determines whether the collections account is tied to a pool-laid reimbursement structure or a loan-level reimbursement structure. So the question is: Should independent contract requirements continue to be regulated by the free market or regulated by the government?
Joseph says it is unconstitutional to have the government regulate existing securitization contracts because it would be a violation of private contract law. For the same reason when HAMP mandated servicers of securitized loans to do modifications, servicers could not proceed.
Going forward, he adds, an industrywide implementation of the pool-laid reimbursement mechanism, as opposed to a loan-level mechanism would best serve the market and avoid cashflow conflicts of interest. Servicers require back the advances if based on analysis and profit valuations of market values in the area the property is located, potential sales prices and other data it is determined the asset is nonrecoverable. So valuations that are not conducted on the loan level probably offer the best method the industry can use “to isolate the conflict.”
Cost is the main reason third-party servicers prefer to get reimbursements from the general pool because they do not have vest interests in the securitization, do not hold the residual security and are not the sponsor.
Joseph suggests other ways to eliminate this inherent conflict of interest and motivate servicers do not have to be legislative. “Hold them [servicers] accountable to standards, audit their functions and make sure they are reviewing their process and pushing loans through the pipeline and not sitting on them.”
This crisis has shown over and over again, the challenge is to find “a good business solution to every political problem,” not the other way around, McPherson says.