Incentives are being Embedded in Second-best Solutions

This week I release my eagerly-awaited white paper on servicer reporting. The paper is of acute importance to policymakers because it points out the degree to which Administration policy remains wedded to not only a “command and control” approach, but one that is embedding failed industry practices.

The sad fact is that mortgage underwriting moved outside of regulated financial institutions to avoid the burden of oversight. Much of the industry remains outside regulated entities – as does servicing, today – specifically located precisely in the “holes” in regulatory barriers erected for the safety and soundness of consumers and the banking sector. Hence, two points are important: (1) continuing to regulate via institutional type rather than by financial product will continue to facilitate the institutional arbitrage (the regulatory “holes”) that fueled the bubble and placed borrowers at risk, and; (2) subsidizing the firms that were complicit in the institutional arbitrage will increase the presence and importance of those non-regulated institutions, rather than resolve the crisis they caused and the difficulties they present.

It appears that the multitude of press alleging that deregulation was the proximate cause of the crisis forgot that housing is the most regulated area of finance. In fact, government subsidies helped fund overbuilding and pushed homes onto financially unsuitable buyers, boosting homeownership rates far above any sort of reasonable natural rate. The question, therefore, is whether we will be able to resist the temptation to try to fix failed regulation by regulating even more, or whether we will have the courage to allow markets to work for themselves by facilitating honest transparency that investors can use to efficiently allocate capital.

While my present white paper specifically relates to servicing the problem is by no means limited to that sector – the Federal Reserve’s TALF disincentivizes counterparty due diligence  by making the Federal Reserve the center of the tri-party repurchase market. While one can make an argument that the second-best solutions are a necessary expedient in the short-term, my argument is that policymakers risk reducing market efficiency caused by embedding the second-best as the long-term solution. The credit crisis has been going on for two years now and Lehman was six months ago. I therefore find it hard to think of the present policy choices as mere “temporary expedients.”

In the words of Richard Carnell, former Assistant Secretary of the Treasury, regarding the Thrift Crisis, “The benefits of forbearance (and the costs of stringency) are short-term and easily identifiable. The costs of forbearance (and the benefits of stringency) are long-term and less obvious.”  Let’s stop fearing the short-term costs of stringency and put markets back to work, again, for the benefit of the economy.

Below, I provide the introduction to my paper, “Servicer Reporting Can do More for Modification than Government Subsidies.” The full text is attached her and can be downloaded from the Social Science Research Network at http://ssrn.com/abstract=1361331 (just click the button on the abstract page to download).

Servicer Reporting Can do More for Modification than Government Subsidies

Joseph R. Mason

Table of Contents

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I.          Introduction

Recent descriptions of securitization have emphasized the mechanism by which loans are sold on from their originator into a conduit or special-purpose vehicle managed by a trustee. The securities that fund the special-purpose vehicle are issued by investment banks, sold through broker networks, ownership is recorded by registration agents, and credit enhancement is provided by various providers of letters of credit, monoline bond insurance, and internal credit support mechanisms. Throughout the discussion, however, little mention is made of the servicer.

In fact, the servicer holds great sway in the securitization. The servicer both creates and protects investor value by collecting payments, monitoring delinquencies, and motivating borrowers to pay. Recent vintage residential mortgage-backed securities performance is known to be significantly affected by servicer performance. Moody’s Investors Service attributes significant consideration to performance variance that can be attributed to not only origination characteristics and housing market differences across the country, but also variability among how servicers manage “…looming interest rate resets and resulting payment shocks.”[1][1]

Even the Bond Market Association and the American Securitization Forum acknowledge that valuing mortgage-backed securities involves far more than just estimating cash flows based on borrower characteristics, but involves a substantial effort in monitoring servicer effort and pricing in the possibility that the servicer may reduce their efforts or otherwise change the value they bring to the loan. According to those industry sources, servicer track record is a key consideration in valuing mortgage-backed securities today.[2][2]

Servicer quality matters even more when loans become distressed. A defaulted borrower that re-establishes payment on their loan usually does so because of some element of trust between them and the servicer that leads to establishing a payment plan the borrower believes is advantageous to both parties. The servicer may work on the borrower’s behalf as part of that plan, assembling a program combining elements of bankruptcy, selling other assets, or consolidating other loans. If the borrower is still unable to make the payments, the servicer maintains a good relationship with the borrower through the foreclosure process to preserve the value of the home and liquidate the collateral to collect money owed to the investor.[3][3] Hence, the servicer’s workout and liquidation processes crucially affect loan recoveries.

But even more vexing to valuation models, distressed loans offer far different cash flow patterns than non-distressed loans. Newly originated loans typically experience losses beginning six to twelve months after origination, after which they increase sharply and then tail off to a very low level by roughly twenty-four months. The loss pattern in distressed loans, in contrast, varies with collection patterns and the servicer’s aggressiveness. Distressed loans also prepay slower than newly originated loans, as distressed borrowers generally have fewer remaining opportunities for career advancement and less access to new sources of credit due to their severely impaired credit record, no matter how interest rates move.[4][4]

Furthermore, a servicer is usually not just a passive third party in a residential mortgage-backed security deal. Rather, the servicer is usually also an investor, typically owning a junior first-loss residual stake in the securitization. As a residual holder, the servicer naturally favors high levels of loan modifications, since without modified loan cash flows to the servicers’ investments may be cut off until the senior bonds are fully repaid. While modification may be prudent, therefore, it is hard for investors to tell if the servicer is really acting in investors’ best interest. Loan modifications make it hard for investors to estimate cash flows, so investors need to be fully appraised of servicer modification policies.

Investors must consider a variety of other conditions that are affected by the quality of the servicer. For example, investors have to model not only defaults, but also modified loan redefaults to estimate pool cash flows. Servicers, however, vary considerably in how they report modified loans and their subsequent performance. Some report extensively, but many report virtually nothing at all. Last, and perhaps most importantly, servicing delinquent loans in general and modification in particular are expensive, usually outstripping direct servicing fee income. Hence, investors are critically concerned with servicer financial conditions, which dictate the level of effort servicers will be able to devote to crucially adding value to even non-delinquent loan pools moving forward.[5][5]

Given current market conditions, servicers are likely to play an increasingly important role in mortgage pool value than in previous market environments. The problem, however, is that servicing is a lightly-regulated and highly variable segment of the mortgage industry that has experienced more than a few difficulties. According to Elizabeth McCaul, former Superintendant of Banks for the State of New York, some areas of weakness in the servicing industry in recent years leading up the present crisis included:

…a lack of focus on the strength of the originator/servicer, and improper analysis of the substitution of good loans for bad. We have seen re-aging policies not being properly analyzed. In fact, investment in this area has been largely driven by mathematical formulations without enough qualitative analysis of operations and financial strength. For example, we have conducted reviews of portfolios and seen residuals on balance sheets that do not reflect enough financial strength to continue operations effectively. If the shop is closed, the Trustee comes in, the re-aging practices (and other practices) are halted… delinquencies roll in, and the rest, as you know, is history.[6][6]

The rest of this paper enumerates the concerns introduced above. Servicing is, in general, not very well understood by regulators or investors even though it is a crucial aspect that affects the value of all consumer loan securitizations. This central role also means that servicing is critical to securitization market stability. Sadly, servicer accountability and reporting (to both investors and regulators) is woefully inadequate. There is rarely sufficient information to evaluate a servicer, and when it does exist it is not consistently or widely distributed. Hence, regulators can do a great service to both the industry and borrowers in today’s financial climate by insisting that servicers report adequate information to assess not only the success of major modification initiatives, but also overall servicer performance. The increased investor dependence on third-party servicing that has accompanied securitization necessitates substantial improvements to investor reporting. These improvements can support appropriate administration and, where helpful, modification of consumer loans in both the private and public interest.

For the rest, please open the attachment or download the paper from the Social Science Research Network at http://ssrn.com/abstract=1361331 (just click the button on the abstract page to download).


† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: joseph.r.mason@gmail.com; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason.
† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: joseph.r.mason@gmail.com; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved.
[1][1].     Moody’s, “US Subprime Mortgage Market Update,” July 24, 2007, at 2.
[2][2].     The Bond Market Association and The American Securitization Forum, “An Analysis and Description of Pricing and Information Sources in the Securitized and Structured Finance Markets,” October 2006, at 3.
[3][3].     Fitch, “Scratch & Dent: This Is Not Your Father’s MBS,” Dec. 13, 2005 [hereinafter Scratch and Dent], at 8.
[4][4].     Id. at 7.
[5][5].     Nomura, “Sub-prime Mortgage Loan Servicing and Loss Mitigation,” Securitization & Real Estate Update, May 18, 2007 [hereinafter Nomura Servicing and Mitigation], at 2 (informal notes from: American Securitization Forum Seminar, “Subprime Mortgage Loss Mitigation Strategies – What’s Working”, May 16, 2007).
[6][6].     Elizabeth McCaul, “What’s Ahead for the US Residential Mortgage Market, Speech at ASF 2007 conference, Feb. 2, 2007, available at www.SIFMA.org.