Loss Mitigation In The Subprime Era

Readers of these monthly alerts know that they are designed to be short, to the point, highlighting an important concept relating to mortgage lending and servicing, usually spurred by a recent case on the subject.

This alert, though, will be different.  Settling many foreclosure actions can now be a different and more arduous process because of the world created by the subprime crisis.  The topic was the focus of a more lengthy piece we wrote for Servicing Management last fall.  Those of our readers who may not have seen the issue, or who are not on our mailing list, might not be aware of what a consensus pleasingly tells us is a very important piece.

People in the lending and servicing industry have found this quite informative so, if it could be instructive for you, the full text follows.

The seemingly omnipresent subprime debacle has been analyzed in all branches of the media to a degree that knowledge of it goes well beyond the mortgage industry and the financial community, extending now to anyone who reads or watches any news programs.  That noted, we need not cover old ground at length.  But how the nature of the subprime crisis impacts the foreclosure process and the ability to mitigate losses is a subject less explored, an arena of meaning and concern.

Traditionally, loans were most often thought of as being made based upon the ability of a borrower to repay according to the terms of the note and mortgage.  Notably, compliance was not evaluated based upon an initial interest rate exclusively.  And the terms of loans were more straightforward, most often plain vanilla if you will.

The confluence of many forces, however, led the world of mortgage lending away from the usual, the standard and the time honored.  Socially, those with credit normally insufficient to obtain a mortgage loan were being viewed differently.  The idea was to help those who might be disadvantaged in some fashion to pursue the American dream; certainly understandable.  Then, of course, there were profits to be made in closing more transactions.

In addition, there was a basic change in the mortgage lending business from portfolio lenders maintaining control of their loans to the securitization of loans.  Among the many mortgage configurations which varied from the standard were those providing layered teaser rates, interest only loans, negative amortization provisions, floating rate loans and low-documentation or no-documentation transactions.  Among the approximately six hundred billion dollars of subprime mortgages originated in the year 2006, some 75% of those were funded by the securitization process.  (Why this is particularly meaningful to loss mitigation will be discussed.)

That 75% figure also creates some concern when observing that such percentage of securitized subprime mortgages vintage 2004 and 2005 with a hybrid loan structure have a fixed rate for two or three years, then adjusting to a variable rate for the balance of twenty-seven or twenty-eight years.  Because, though, the spread between the initial rate and the fully indexed rate usually varies from 300 to 600 basis points, a substantial number of borrowers are or will imminently be faced with increased interest rates which they may not be able to afford.

All the publicity previously mentioned has ripened into a storm of events forming the subprime meltdown.  In the resultant credit crunch, here are some of the events occurring which then impact upon borrowers’ ability to rescue themselves:

• property values are falling;
• prospective purchasers of properties are finding it far more difficult to obtain mortgage financing which in turn contributes to plummeting prices;
• mortgage companies which might have been in the market to loan money have filed for bankruptcy;
• increasing vigilance by loan purchasers has caused them to require the originators to buy back loans which have breached the sales agreement (such as an initial payment default) so that originators’ funds are increasingly tied up in loans they did not intend to hold;
• rating agencies are downgrading mortgage pools, thereby discouraging liquidity and reinvestment;
• the value of subprime mortgages in securitized pools is often unquantifiable, further depressing the market for the securities.

THE FORECLOSURE PROCESS

Obviously there were always some percentage of borrowers in default or in foreclosure.  Whatever the economic circumstances of the world might have been, either the foreclosure followed its course and proceeded to conclusion, that is a foreclosure sale or, through loss mitigation efforts or otherwise, the borrower was able to rescue himself by ultimately reinstating or satisfying the mortgage.  In good times or normal times, a higher percentage of cases would be settled.  In difficult times, more foreclosure actions would proceed to a sale.  Today, we predict that far more foreclosures will not be susceptible to settlement because of the conditions imposed by the subprime dilemma.  An examination of some of the threatened settlement routes should highlight the point.

PAYOFF VIA SALE

Not so long ago, rapidly increasing property values often assured that a borrower in some trouble could sell the property and thereby satisfy the mortgage.  The increase in value created the equity cushion that made paying off the mortgage possible.  Inherent, though, in the subprime scenario are two problems: one, many loans required little or no borrower investment so that there never was any equity; two, the decline in property values with the concomitant reduced ability of new purchasers to obtain financing to facilitate the purchase.  (How much of property declines result from the tightening mortgage standards is a statistic we leave to others.)  The net result in any event is that the ability to satisfy the mortgage through a sale of the property becomes far more uncommon.

PAYOFF VIA REFINANCE

This is obvious.  Credit is less available and when it is offered, the standards are much stricter.  The defaulting borrower who was able to get the mortgage loan now in default is no longer a candidate.  Even if he was, the value of the property may no longer support the quantum of the loan needed.  So refinance is less often a remedy.

DEED-IN-LIEU OF FORECLOSURE

This common settlement device is employed when the borrower elects not to contest a case, knowing too that there is no equity to be garnered by a sale of the property.  Therefore, the borrower in essence capitulates and says to the lender “here is the property; there is no need for you to proceed through a foreclosure and get title at the end.  You will have it now”.  But if the property is worth considerably less than the mortgage debt, which can often be the case under current circumstances, the lender or servicer may have a compelling need to pursue the borrower for his or her personal liability, i.e., the deficiency.  Borrowers, however, will not so often give a deed-in-lieu of foreclosure without a promise that the deficiency will not be sought.  Then too, the borrower in distress may have obtained subordinate financing or suffered judgments or other liens which attach to the property.  When distress gives rise to such encumbrances, taking a deed-in-lieu of foreclosure becomes impossible because the title conveyed to the lender is burdened by all those subsequent interests which would have been extinguished by a foreclosure – but are not cutoff by mere delivery of a deed-in-lieu of foreclosure.  As a consequence, subprime events may render the deed-in-lieu far less utilitarian than it once was.

CHAPTER 13

As servicers well recognize, the structure of a Chapter 13 filing is that the borrower must promptly resume remitting the regular mortgage installments, combined with the obligation to then to amortize all arrears in a plan not to exceed five years’ duration.  For a borrower who has suffered a typical temporary mishap, such as illness, loss of employment or marital strife, the Chapter 13 may well offer pleasing rescue which benefits both borrower and lender.

But if the reason for the default is an interest rate resetting at a higher percentage, the reason for the default may very well be that the borrower simply cannot afford the payment.  That portends an absolute inability to meet the Chapter 13 requirement of resuming payment of regular mortgage installments.  In such a scenario – commonplace as a result of subprime issues – the Chapter 13 path will also be less ameliorative than it used to be.

FORBEARANCE AGREEMENT

This is likely the most common approach to settling the mortgage foreclosure action.  The servicer agrees to refrain from prosecuting the foreclosure action for a certain period of time, during which payments are made, eventually to aggregate a sum sufficient to reinstate the mortgage.  Whether this is done over four months or six months – or a year or more – the concept is generally the same.

As it might be with the Chapter 13, however, the borrower may be unable to meet any forbearance agreement requirements for the same reason that it can no longer make the mortgage payments if the interest rate has increased to a point beyond the borrower’s means.

MORTGAGE MODIFICATION

Examination of the Chapter 13 and the forbearance agreement approaches suggests that nowadays the only path which may provide salvation is a modification of the mortgage.  This might be accomplished by extending the term and reducing the payments, or reducing the interest rate or modifying it for some period of time then adding a balloon payment at the conclusion.   (There are of course a host of variations on this theme.)  Indeed, it would seem that under the circumstances presented by the subprime crisis, modification of the mortgage may very often be the only way for many properties to be saved.  That leads then to the overriding question: does the servicer have the authority to modify the mortgage?  The answer is a convoluted one and does not bode so well for hard-pressed borrowers.

MODIFICATION, THE ROLE OF FANNIE MAE AND FREDDIE MAC

Approximately fifteen years ago when last there was serious turmoil in the housing market, most mortgage pooling and selling was done by the GSE’s, Fannie Mae and Freddie Mac.  They were rather readily capable of modifying loans even though they were in a pool.

As to Freddie Mac, its documentation reserves that right to itself.  Fannie Mae’s trust documents, on the other hand, give it the right to buy a mortgage out of the pool after it is delinquent for four months.  In that way, Fannie Mae can return to itself the ability to modify a mortgage which otherwise would be difficult or impossible if it remained securitized.

THE SECURITIZATION ISSUE

This is a particular concern which do not involve the GSE’s.  As servicers understand, when an originating lender sells the mortgage, it no longer has the power to restructure a loan.  That authority goes to a servicer who in turn, however, can only do what the securitization documents may allow.  In that regard, both the servicer and the trustee of the securitized mortgages must act in the best interests of the investors in the securitized loans.  The goal is maximum recovery on a defaulted loan on a present-value basis.  If that end is reached by a modification, then there is room for all parties to agree.  But if foreclosure will yield the greatest return, the servicer may be bound to that path even if it will be hurtful to the borrower.

RESTRAINTS ON MODIFICATION

REMIC REQUIREMENTS

Assuming that a loan modification will be beneficial, there are a number of restraints upon the servicers ability to proceed in that fashion.  Securitized loans are typically established as Real Estate Mortgage Investment Conduits (REMICs).  To obtain the tax advantages of such a structure, the loans securitized in a REMIC most often must be addressed as a static pool – that is, they cannot be modified.

While that is a clear general proposition, many documents will nonetheless provide that after a loan has been delinquent for a certain period, modifications may be available in accordance with REMIC statutes.  But then the servicer might be required to support its intentions with an appropriate legal opinion.  It is thus apparent why the REMIC construct can cloud the ability to modify.

THE ROLE OF THE POOLING AND SERVICING AGREEMENT

It is the pooling and servicing agreement (PSA) which sets the parameters about how each securitization functions and how rules may be varied.  How a servicer might modify a loan would be the subject of a PSA and these rules can be very lengthy and restrictive.  Any attempt to modify a PSA may be exceptionally difficult and could require the consent of a significant percentage of all investors in the pool.  Whether the PSA is flexible or strict in this regard depends upon the particular language which can be quite precise or vague.  These things vary and one questioning whether the servicer has the right to modify would need to examine the PSA with some considerable care.

OUTSIDE CONTROL

And yet there can be further constraints upon the servicer.  For example, some securitizations might require approval of the rating agency and the bond insurer before loan modifications exceed 5% of the total transaction.  Likewise, the servicer might be constrained to obtain prior written consent of credit enhancement providers or guarantors for any modification or amendment of a mortgage that causes more than 5% of the original pool of loans to have been modified or amended.

CONCLUSION

The ubiquitous subprime mess is wrecking the proverbial havoc with credit and thus mortgage lending.  That in turn, or somehow as part of the process, is effecting property values and – for the reasons noted – is interfering with the ability to settle mortgage foreclosure actions in traditional ways.  To the extent this is so – and we posit that it is – a much greater role is elicited for mortgage modifications.  The problem with that becomes the ability of servicers to even pursue such a remedy.  Sometimes they can and sometimes they cannot and it is not so easy to evaluate when the modification is available.  So in the end, the loss mitigation process in this day of subprime difficulties is far less certain or amenable.

Mr. Bergman, author of the four-volume treatise, Bergman on New York Mortgage Foreclosures, LexisNexis Matthew Bender (rev. 2017), is a partner with Berkman, Henoch, Peterson, Peddy & Fenchel, P.C. in Garden City, New York. He is also a member of the USFN, The American College of Real Estate Lawyers, The American College of Mortgage Attorneys, an adviser to the New York Times on foreclosure issues and writes a regular servicing column for the New York Law Journal. He is AV rated by Martindale-Hubbell, his biography appears in Who’s Who In American Law and he has been for years listed in Best Lawyers In America and New York Super Lawyers.