Mortgage restructuring
Group therapy


Nov 29th 2007 | NEW YORK From The Economist print edition

As defaults soar, America seeks to modify mortgages en masse

THE statistics are chilling. As many as 2m adjustable-rate subprime mortgages, worth $350 billion, are due to reset to higher interest rates in America over the next 18 months. Resets on Alt-A (or near-prime) loans will continue to climb until late 2010. House prices are tumbling (see article). What can be done to avoid a bloodbath of defaults?

Enter the Gubernator. Galvanised by the fact that a quarter of all resets will come in his state, Arnold Schwarzenegger, California's governor, has struck an innovative deal with four big loan servicers. This will see the companies extend by several years the period for which thousands of borrowers can stay at the initial “teaser” rate. Crucially, the four have agreed to “fast-track” their procedures to make it easier to include whole swathes of struggling but not hopeless borrowers.

Washington is throwing its weight behind this kind of mass loan modification. Bank supervisors have urged servicers—who collect mortgage payments and pass them on to investors—to work out new deals with borrowers. The Federal Reserve's Randall Kroszner has encouraged the industry to explore efforts to help large groups of borrowers. Henry Paulson, the treasury secretary, has come round to the same view after concluding that servicers lack the resources to deal with case-by-case modifications. “We are going through uncharted territory,” he says.

The boldest suggestion has come from Sheila Bair, chairman of the Federal Deposit Insurance Corporation, a guarantor and supervisor. The crisis is so grave, she argues, that most borrowers who are facing resets but still paying their dues should be given the chance by servicers to switch into fixed-rate loans at the starter rate for the full 30 years.

Some are hoping that the Californian experiment, which builds on Ms Bair's proposal, will provide a template for a nationwide scheme—if the economics work. They may well. Foreclosure is expensive, typically eating up 20-25% of the loan balance, says Joseph Mason of Drexel University. Modification means smaller cash flows but also fewer defaults. Handling each case separately can be costly, too. Loan servicing is about transaction-processing, not customer service, points out Guy Cecala of Inside Mortgage Finance, a newsletter. Analysing borrowers case by case requires beefing up work-out departments. Mass modification is less labour-intensive and thus, for an industry with wafer-thin margins, more appealing.

In September Moody's, a credit-rating agency, estimated that the case-by-case approach had barely made a dent in the problem, with only 1% of adjustable-rate subprime loans recast. But it will take time for firms to sort the loans in their portfolios into different risk buckets as a first step towards modifying them en masse, says Bill Rinehart of Ocwen, a servicer in Florida.

The trick is to root out both the basket-cases and also those who don't need help. The best way to achieve this, reckons Mr Paulson, is through an industry-wide approach that sets out “relatively few, simple criteria” on who deserves a break.

Hence the strong Treasury backing for Hope Now, a wide-ranging alliance of consumer groups, servicers and investor groups, including the American Securitisation Forum (ASF). It has two main goals. The first is to reach borrowers who elude servicers acting on their own. Up to half of those struggling to pay ignore calls and letters, assuming that the reason for contact is to foreclose rather than negotiate.

More importantly, the alliance is working on principles governing who qualifies for loan alteration. Mr Paulson expects these to be unveiled before the end of the year. Unlike the Californian plan, they will extend to the one-third of subprime borrowers who took out fixed-rate mortgages. That will please those who see no reason why help should be offered only to those who took out unconventional loans.

Perhaps the biggest task will be to steer through complex securitisations. The ASF has moved swiftly to reinterpret the labyrinthine “pooling and servicing agreements” that govern the process in a way that makes systematic modification easier, says Steve Bailey of Countrywide, America's largest mortgage lender.

But whereas investors agree that in most cases everyone is better off if a loan is recast rather than falling into delinquency, they argue that standardisation should go no further than counselling techniques and databases. Technical issues still need to be ironed out, too. The Internal Revenue Service, for instance, has yet to issue guidance on the tax treatment of mass modification. And servicers worry about possible lawsuits from investors. They also fret about costs. Expenses they incur from foreclosures are reimbursed by the securitisation trust, whereas those from modifications are not. (The Office of Thrift Supervision, a regulator, has proposed a payment of $500 to servicers for each loan they modify.) Nor is it clear that the overall costs of modification are always lower than those of foreclosure. In a recent paper*, Mr Mason points out that modified loans experience a 35-40% re-default rate over the following two years—though the data were thin and preliminary.

Tony Sanders of Arizona State University points to another worry. If Alt-A defaults are indeed the next credit meltdown, then extending teaser rates might simply postpone the pain for a few years. “We do not know enough about subprime and Alt-A default tendencies to undertake such a monumental and potentially unfair reallocation of payments,” he says.

Claims of unfairness are likely to crop up a lot in coming months. The one certainty about mass modification is that it will benefit some who do not need help and others for whom assistance is just a postponement of the inevitable. However, more and more market-watchers think that is a price worth paying if it helps avert an avalanche of defaults.