Perfect Storm in Default: Mortgage Servicing News Febraury

Implications: I agree with the Wall Street Journal article. I had an article in Mortgage Servicing News in the February MBA Servicing Conference Issue title the "Perfect Storm in Defualt." My remarks and commentary are attached below.

The issues raised in the Wall Street Journal article are applified and dimensioned in my article.

Highlights the need for different workout solutions or face a liquidity crisis for mortgages and possibly the whole MBS market.

Highlights the needs for different thinking than exists in the current Pooling and Servicing Agreements.

Points the issues of why we are not only headed to recession but a bad recession.

Analysis: I have a company that works defaulted mortgage loans and tries to prevent foreclosure sales by working the loan out. A number of our customers are subprime companies and facing the many defaults and the huge number of resets.

In the movie the “The Perfect Storm” three storm systems converged to create the storm of the century which had a horrendous impact on the east coast of the United States and Canada. What does it mean when we have 16 major economic indicators pointing to problems with the housing industry and the national economy. It means “The Perfect Storm in Mortgage Default” is not only possible but extremely likely.

1. According to Freddie Mac in the December 13, 2005 American Banker, 65% of defaulted borrowers do not communicate with their lenders.
2. According to the American Banker as reported in the MBA Newslink in November 2006, 12 of 20 lenders were not making 3^rd quarter expectations.
3. There have been many articles about the 1.5 million adjustable (2/28), Interest Only and Negative Amortization loans that will reset over the next year.
4. Many states have reported record increases in foreclosures and again the US as a whole is over 1 million loans in foreclosure.
5. The US savings rate is at or near an all time low according to Bureau of Economic Analysis (BEA). It is below a negative 1%. This is the lowest level of savings since 1933 and the Great Depression.
6. The US Consumer has continued with maximum credit card spending rates: Many retailers reported flat or lower same store sales growth but most with on-line catalogue shopping reported big increases. All of these purchases were by credit card.
7. The use of the equity in homes has grown to an all time high and is continuing to grow. These funds are being used for many purposes including education, offset job loss or reduction in pay, pay credit cards, high energy bills, and making ends meet.
8. In December there was talk of an increase in home sales versus November. What was not asked is the volume on hand, the length of time on the market, and the incentives or reduction in price required to sell the property.
9. In many are there is a spiral of deflating prices caused by a large volume of homes for sale, many of these homes are in default ( or near default) and are trying to be sold as quickly as possible. Thus creating a cycle of lower price to value.
10. Real jobs increases, until December’s report showing an increase in jobs, had been weak for the year. What was not reported with the December increase was the type of jobs that were created; November and December are traditionally big seasonal job months. There are sectors of the economy that are increasing, but are they sustainable and do they offset the losses in the housing and automotive industries and their direct relationships to many ancillary manufactures, metal stamping, wood products, appliances, electronics, rubber and tires, etc.
11. Many of the new jobs as reported by the defaulted borrowers we work with are paying less than the comparable job they held before. The January indices say that payroll was up. A question would be does that include the payroll effect of some large severances (Home Depot), stock options that now must be reported, and bonuses paid on the Wall Street.
12. Mortgage Companies are going out of business, being sold or looking for acquirers particularly in the sub-prime market it is beginning to resemble the exodus of the late 1990’s.
13. Record Fraud levels, The FBI reported in December 2006 that fraud had hit the $1 Billion mark for the year. Unfortunately that number is severely under reported. Fraud has become the new big money game in many locations.
14. Several of the mortgage companies going out of business have reported that loan buy back programs are a major problem because of the non-performing loans. It is clear such agreements with Walls Street investors will continue to have a big impact when you understand the dynamics of origination profit versus the loss on a buyback loan that goes to foreclosure. Origination fees on a $100,000 loan may generate $2,500 on the closing and another $2,500 on the sale but the average loss on that home when going to REO is in excess of $35,000. In other words you have to make seven loans that are good just to break even, and that does not include the commissions paid and processing costs.
15. Energy Costs were a major issue last year, fortunately a milder winter and lower fuel costs should help this year with many families.
16. One of the changes in the credit card billing process provided with the law changes last January was the ability of Card Companies to go to maximum rates if you miss or are late on credit card payments. This allows lower interest rate cards to raise their rates to a maximum amount just when the borrower can least afford it.

The latest Fed reports are throwing more confusion into the economy. The fact that December employment and payroll appeared higher in some reports resulted in a stock market decline on January 4^th and 5^th, because of the fear that the FED will not reduce rates as expected sometime in 2007. The real concern is that they may even raise rates because of inflationary concerns.

Economist Predictions

Soft landings in the housing industry have been noted by many groups this year, with some actually forecasting an upswing in the second half of the year. I sincerely hope they are correct, because if they are not then implications for the national economy are dire. Lets just say that the variables both domestic and international (wars, energy costs, etc.) are considerable.

Back to the Indicators

Over 1,000,000 in Foreclosure

The impact on mortgage companies/Investors with 1 million loans in foreclosure is substantial. The loss to the companies and investors on these loans will be significant. If even 40% of these loans go to REO with a loss rate of 25% (very conservative, average losses in REO are running 35 to 45%) the loss would be on the scale of $20 Billion and that does not include the impact of losses related to the other 60% where short sales, forbearances, modifications and other workout solutions would have a significant impact.

That is like another Katrina, and look at all that has been done to try and minimize that disaster.

The other potential impact of this magnitude of default is the source of funding dollars. If in fact we do take a beating on losses related to these 1 million homes, what will that do to Walls Streets/Investors willingness to continue to be the funding source for new loans? If nothing else, Wall Street is a risk reward enterprise, the cost of funds will go up and so will the cost to borrowers through interest rates. It does not make since for MBS loans to have coupon rate that is higher than the underlying notes rate.

Resets

One and a half million homes are going to reset this year. The prevailing fixed rate is higher than when the loans were originated. Can the borrowers afford to refinance or will they be fighting a losing battle? We are already seeing the impact on stretch buyers for their principal residence, how about the investment buyer who thought they could sell the property for a profit. We are now seeing resort properties sitting for extended periods with big incentives to be sold, what happens as more and more of these face their reset and become cost prohibitive? Naturally, a reduction in price until it is off the owner/investor’s books or it goes to short sale or foreclosure. The end result will be no decrease in the overall foreclosure level for the next year and another potential big loss for investors or mortgage companies, potentially a Third Katrina disaster.

Refinancing Problems:

I am reading now in the MBA Link (January 11, 2007) of an increase in refinance applications of over 17% for the first week of January. It is a certainty that there will continue to be a wave of refinance applications because of the loan resets. It will be interesting to see the percentage of successful refinancing. A hidden issue in the refinancing is the drop in value due to the availability, length of time on market, and other defaulted properties in the area which will curtail the amount a borrower is able to borrow. They may not be able to borrower enough without coming up with cash to close or they will simply have to accept their one year arm rate. That is unless the practice of inflated valuations is continued.

This also impacts the borrower who originally closed in those communities on a fixed rate basis. Many have used equity from those purchases to fund other parts of their lives. If the community drops in value, don’t those loans become less secure? Now we have a potential for loss beyond normal for the home equity market as well.

Summary – The Emperor has No Clothes

Not many of the current mortgage professionals were around during the last major crash in the housing industry. When interest rates were 18%, people were walking away from homes and mailing in keys and the country was going back and forth into a recession.

This time around, we made home ownership easy and affordable. Unfortunately we did it in a manner that lacked discipline and common sense. We relied on automated values that are and were impacted by comps from sales that maybe questionable and are usually overstated, creating a cycle of escalating values based on nothing. We created lending policy that gives folks a loan without the ability to pay the loan when it resets. We stopped looking at the basics of underwriting; time on job, net pay, debt load, references, etc. to looking at equity based on appraisal, potential rental value, rising property values, and credit score.

Up until now it was easy and losses were minimal. The reason being the continual rising market made it possible to dump the bad loan/house with a refinance or sale. That was a time when most foreclosures never went to sale. The industry did its part earlier in the 2000’s by creating the negative amortization and interest only products when the traditional product sales were starting to slow down. The losses did not come, they were deferred, and the new products stimulated even more appreciation and sales. Like most games of musical chairs the music does come to an end and someone has to pay the piper.

What can we as an industry do to prevent or at least minimize the potential for the Perfect Storm in Default?

The first and foremost preventive measure is to recognize that we have a problem. If you talk to servicing insiders they will tell you they are very nervous. Many will tell you the volume of resets of “2/28” business alone scares them and they have no idea what to expect from the “interest only” and “negative-am” loans. In addition they will tell you that they are starting to get signals from their investors to push more short sales, modifications, repayment plans, and workouts in bankruptcy, Deeds in Lieu (DIL) and pre-foreclosure sales.

Yet, I can tell you on many of the short sales that we present on behalf of borrowers to various lenders, the lender is looking at values from last year and saying that is way to low and we can not accept it. Departments that manage short sales and Deed in Lieu need to be working with the best local information they can. They need to be looking at MLS information for average time on market, value, sales versus asking prices, etc. Instead many just say our investor will not accept that amount. I can guarantee you that the investor will really not accept the amount when it is finally sold out of REO 4 or 5 months from now for considerably less than you were offered now. These become trigger point breakers for securities.

On modifications, it would be great if companies would start to use step modifications like some do with FHA and reduce interest for a period of time, one to two years, then return the rate to normal. This gets the borrower caught up and allows for many more workouts. But seeing that will probably not happen, then eliminate the other main reason modifications do not take place: requiring all fees and costs upfront. If the borrower had $4,000 upfront, do you think they would let their mortgage get behind? Take the fees and costs and put them on a 12 month repayment plan along with modifying the mortgage. Do a combined budget for surplus income based on both amounts.

The standard repayment plan is for a 12 month period. Why? The borrower’s alternative is to file Chapter 13 and spread the deficiency up to 60 months. For someone who is tight at 12 months or can not qualify for a 12 month plan, do you think they will decide to just let it go or do you think they will file bankruptcy? Why not set up a 24 month repayment plan if necessary with someone who was out of work and is now back in a verifiable position? Yes it is more troublesome to track but it is something that can be tracked and managed through the systems available today.

If you are not working out accounts in bankruptcy you are surrendering your accounts to someone else’s control, the borrower and the trustee.

We complete workouts on bankrupt loans for our lenders all of the time. They are actually the easiest to workout because you know you can make contact with the attorney representing the borrower. The BK 7 discharge non-owner occupied is an invitation for a DIL. The working Chapter 13 is perfect for a modification that can secure your position in the funds through the trustee. Most lenders do not approach working out bankrupt accounts because of the difficulty and fear of legal transgression. That is why you have specialist do it, and not just ignore it.

The Deed in Lieu is a powerful workout weapon. Get the house back, minimize the carrying cost through advances and liquidate the property. Avoid or minimize the issues of property neglect. But do not require the borrower to provide you three boxes of data to consider it. Proof that they are out of work is enough. A review of the credit bureau showing them behind on everything suffices to say they will be hard pressed to pay you back. Certainly do not ask a Bankrupt Borrower to provide budget, tax- returns, pay stubs, etc. before considering a DIL. It is unnecessary and the information will never be used. They are BK , there is no deficiency so get along with things and take the house back. Yes, you have to check lien position and you may want to check value and code violation issues, but you do not need all that other information.

The final solution is the pre-foreclosure sale. This should be one of simplest, but it has become truly time consuming unless a full payoff is achieved. Again, many lenders want everything about the borrower, and many also are using last year valuations to compare to today’s offers. It cracks me up that investors will spend a fortune on BPO’s to buy a portfolio and then 12 to 18 months later will not take into account what they have learned about the borrower and the property and get a new value and make a decision. It’s too big of a loss… as if it is going to get better five to 12 months from now after we have foreclosed, evicted, marketed, and neglected the property and sold it as “bank owned”. Get a good comparable value and sell it when you can.

All of these solutions are predicated on talking with the borrower. Remember the first indicator from Freddie Mac; 65% of defaulted borrowers do not talk to their lender. Hire a specialist to make contact when you can not. In our case the attorneys make contact either pre-foreclosure or after the referral and they pursue the borrower for a workout while they continue with the foreclosure.

You have to ask yourself, do I want to take on the full force of the foreclosures in the storm, or do I want to try and minimize the pain by working out as many loans as possible? One way or the other, the music is coming to a stop.