Wednesday, July 22, 2009

Does Securitization Affect Loan Modifications?

Posted on Credit Slips by Adam Levitin:

A few days ago I wrote a long and detailed critique of a Boston Federal Reserve staff study that argued, among other things, that securitization was not a factor in the paucity of loan modifications. The study reached this conclusion based largely on the similar rate of modifications for portfolio and securitized loans. Although the study controls for the effect of the modification in terms of monthly payment, it otherwise assumes all modifications are created equal. But clearly they are not. There is a significant difference in redefault rates for securitized and portfolio loans, and the securitized loan mods perform much worse. This is something the Boston Fed's study cannot explain other than if there is (1) unobserved heterogeneity in the loans or (2) differences in the loan mods.

The nature of unobserved heterogeneity in data is that it can't be observed, so all that can be said of (1) is that it is a possibility. But assuming that there isn't a heterogeneity problem about the unmodified loans, what about the mods? Is there heterogeneity problem in mods that makes comparisons of mod rates a poor measure for evaluating the impact of securitization. It appears that there is.

The Boston Fed study did not control for the effect of the loan modification on the homeowner's equity. It does have controls for LTV and negative equity, but those don't seem to have been applied to the serviced/portfolio distinction, at least in the paper. I'm not sure whether there is sufficient data to do this, but what the study could have controlled for, but did not, was whether the modification involved a reduction in the unpaid principal balance. In this aspect, there is a significant difference between portfolio and securitized loans.

OCC/OTS Mortgage Metrics Data for the first quarter of 2009 indicates that very few loan modifications have involved principal balance reductions. In fact out of 185,186 loan modifications in Q1 2009, only 3,398 (1.8%) involved principal balance reductions. All but 4 of those 3,398 principal balance reductions were on loans held in portfolio. The other 4 are quite likely data recording errors. This means that there is heterogeneity in loan mods between securitized and portfolio loans.

The difficulty in doing principal reduction mods for securitized loans is quite important because to the extent that negative equity is driving foreclosures (and there is significant evidence that it is), principal reduction modifications are the tool for eliminating negative equity (with an shared appreciation clawback or not). The quality of loan modifications matters, and securitization affect the quality.

There is also a major difference in the ability of portfolio lenders and Fannie/Freddie/Ginnie servicers to extend the term of a mortgage that private-label servicers don't have. Not all securitization is the same. Private label servicers can usually stretch out the term of a loan by no more than a year or so because the servicing contracts prohibit the extension of the term beyond the last maturity date of any loan in the pool, and pools are usually of similar vintage and duration loans. Fannie/Freddie/Ginnie loans can be bought out of a pool and modified, making them more like portfolio in this regard. Thus 49.2% of portfolio loan mods, 50.8% of Fannie, 61.2% of Freddie, and 17.2% of Ginnie mods involved term extensions, but only 3.9% of private-label securitization mods.

Quite likely there is other heterogeneity that cannot be as easily discerned. This makes sense--portfolio lenders are much less constrained in modifications than securitization servicers. Attempts to quantify servicers' constraints by looking at contract language are inherently limited, as there are structural and functional constraints that are not apparent from an examination of the face of the servicing agreements. Moreover, securitization servicers are adverse to principal write-downs because that affects their compensation far more than an interest rate reduction. The agency problem just doesn't exist for portfolio loans.

Finally, the study has a very strange observation that there is a moral hazard problem in principal balance reductions, but apparently not for interest rate reductions: "Balance reductions are appealing to both borrowers in danger of default and those who are not." Therefore, borrowers might default to get principal reductions. Sure, that's right, but everyone would also like a lower interest rate too. I don't see why a principal reduction presents a different level of moral hazard from an interest rate reduction. In terms of net present value, principal and interest rate are interchangeable (yes, there's an interest deduction, and a principal reduction changes the ability to refinance, but that's not the distinction at issue). The bigger factor pushing against principal reductions (other than servicer compensation) is an accounting issue. A principal reduction shows up on the balance sheet immediately. A reduction of interest just reduces future income.

The take-away here is that even if the Boston Fed staff is right that securitization doesn't affect the prevalence of loan modifications, it clearly affects the quality of those modifications, and that is every bit as important, not least because the performance of past modifications is the basis for servicers' calculation of the redefault risk that the Boston Fed staff emphasizes as constraining modifications. If servicers do bad mods and have high redefaults, that will make them more adverse to doing mods in the future because they will think that the mods don't work.

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