Many believe that the only way to improve the high re-default rate on modified loans - said to be more than half in some cases - is to reduce the principal for borrowers.
In recent weeks, the federal government has taken steps that indicate it may now be willing to allow residential mortgage servicers more autonomy in offering mortgage modification options to borrowers. If that's so, we can hope for a significant increase in the success rate for modified loans.
The U.S. government has said it would lend as much money as necessary to Fannie Mae and Freddie Mac to keep them solvent. This virtually unlimited government support for the GSEs may presage changes to the Obama Administration's Home Affordable Modification Program (HAMP), including allowing servicers to reduce borrowers' principal balances.Indeed, FHA also has said it would allow servicers more latitude to assist borrowers who are running into financial problems but have not yet missed a payment. Under the new policy, servicers can offer distressed borrowers forbearance or even a reduction in principal under the FHA-HAMP program; previously, a homeowner had to miss several payments before servicers could consider these options. The FHA-HAMP program will now let servicers reduce the principal amount of an FHA-insured mortgage by up to 30 percent.
Currently, the HAMP program allows the GSEs to forbear, or defer, a portion of principal until the loan is paid off and to waive interest on the deferred amount, but it does not allow for principal reduction. But many believe that the only way to improve the high re-default rate on modified loans - said to be more than half in some cases - is to reduce the principal for borrowers, particularly those with negative equity. Indeed, modifications where servicers have reduced principal have among the lowest re-default rates in the industry.
Many of the largest servicers have already been granting significant principal reductions on loans held in their own portfolios. And these modified loans have performed better than those serviced for the GSEs. The reason: portfolio lenders have more flexibility in offering principal reductions.
According to a report by the OCC and the OTS, portfolio lenders reduced principal for more than 17,000 borrowers in the third quarter of 2009. By contrast, Fannie and Freddie combined did less than 150.
Not only have portfolio lenders reduced principal amounts on more loans than the GSEs have, but the relative performance of these loans is much better at the portfolio lenders. Portfolio lenders had re-default rates of 12 percent after three months and 25 percent after six months, compared with Fannie's re-default rate of 27 percent after three months and 44 percent after six months, according to the OCC-OTS report.Something new needs to be done Clearly, the standard treatments have been tried and they haven't worked. Something new needs to be done. For starters, it may be time to accept a basic truth, that it may be more appropriate for a borrower not to keep their mortgage debt - yes, even under modified conditions. In a large number of cases, short sales may be more appropriate than any other remedy.
Distressed mortgages represent an interesting and exciting opportunity - and a huge one - for servicers of troubled assets in the coming years. Clearly the need for servicing these assets is overwhelming, given the record number of delinquencies and foreclosures. But servicers must be given the ability to use all the options at their disposal if more mortgage modifications are going to work.
The mortgage servicing industry was built for a performing environment, from technology issues to even the way workflow is allocated, where you streamline processes the best you can. But delinquencies and foreclosures have never been as widespread as they are now. Therefore, the current environment has been an overwhelming challenge for the servicing industry.
The sheer volume of modifications on this current level is still very much a new experience for most loan-servicing companies that report people with a wide variety of backgrounds - from rental-car service representatives to former chief executives of small mortgage brokerages that went under - are applying for these jobs. Many of these new collectors, however, "don't understand all the programs, so there is a lot of slippage in that area," says Duwaine Thomas, director servicing management, Fannie Mae, adding: "It's trench warfare out there."
Distressed assets, as a percentage of all the mortgages we service, represent more than half of our business.
Where servicers have fixed revenues, like when servicing GSE loans, cost-savings become more important. It's understandable why they work the way they do given their size, scale and the types of portfolios they have.Focus on the best outcomeHowever, where the issue is "let's explore the best possible workout for this loan," you focus on the best outcome. When you're dealing with severely distressed assets, the approach has to be dramatically different.
For example, the HAMP program would be more successful - for borrowers, investors, servicers, and the government - if servicers were given greater flexibility to reach the goals that the government wants to accomplish.
For instance, the government wants the borrower in a modified mortgage to have a 31 percent debt-to-income (DTI) ratio. There are several ways to get to that 31 percent DTI, including an interest rate reduction, principal forbearance, and principal forgiveness. Right now, servicers must try the other methods first before they can contemplate principal forgiveness. Owners of the loans have been very reluctant to grant forgiveness since it means taking a loss on their investments.
If a 31 percent DTI ratio is the goal, let the industry figure out which of those approaches makes the most sense. Let the servicer choose which combination of those approaches is going to get to that DTI target.
There is also discussion that Fannie and Freddie may be considering hiring servicers to handle either performing or non-performing loans exclusively, possibly including on a "forced placement" basis, where delinquent portfolios are placed with a servicer who has expertise with those types of loans. We've seen a similar situation recently with the placement of the Taylor Bean portfolio with Cenlar.
These servicers of distressed loans would get paid a smaller base fee than servicers of performing loans. But they would stand to benefit from performance bonuses linked to the number of loans that are brought back into performance.
This is recognition of the specialty servicing model BSI is working on, in which there are incentives for servicers for completing successful loan modifications. That's how we work with private investors. We earn a base fee and the rest is all incentive-based. We align our income to the outcomes of our client. We are not motivated to reduce our costs, if it's not the best exit strategy for our clients.
Looking at the loan and borrower situation as it is today, servicing must be done in a cooperative manner. From the servicer's perspective, the borrower who wants to communicate is worth a lot. If the borrower is actively engaged in dialogue with the servicer, there is a way to turn that conversation to something productive rather than simply moving to foreclosure. Therefore, servicers must be given the ability to accommodate borrowers in a way that benefits them as well as the investors.
In the end, the big picture just may be to accept the fact that loan modifications are not The Holy Grail - the only measure of success. Foreclosure alternatives can go beyond just a modification. What's most important is that problem loans be approached in the most cooperative way possible.
Gagan Sharma is president and CEO of BSI Financial Services Inc., Irving, Texas, a leading provider of mortgage subservicing, quality control and business process outsourcing services. He can be reached at: Gagan@bsifinancial.com