So, in case you haven’t heard, there’s a tentative settlement leaked in the situation with foreclosures and mortgage servicing. Before we get to it it will be helpful to recap what’s broken with servicing. There are many things to discuss, but two recent stories help explain the situation.
The first is the way servicing devastates investor value. I highly recommend this article by Jeff Horwitz: A Servicer’s Alleged Conflict Raises Doubts About ‘Skin in the Game’ Reforms. It begins:
Carrington Capital Management, a former subprime securitization specialist, salvaged an impressive amount of money from its low-ranked residential mortgage-backed securities, thanks to the unusual strategies of its servicing affiliate.
By stockpiling foreclosed homes and declaring borrowers current — sometimes unilaterally — Carrington received payments that would otherwise have protected other investors from future losses. In a single deal that American Banker analyzed, Carrington’s actions likely netted its investment fund more than $20 million.
“They appear to have managed their book for their own personal benefit in a way that screws the investors,” said Laurie Goodman, an Amherst Securities analyst who flagged Carrington’s modification practices in research notes.
Laurie Goodman makes the debate about whether or not public sector employees are overpaid irrelevant, because whatever she is paid we should multiple it by 25 and put her in a senior regulatory role.
I’d recommend reading the whole thing, but here’s how it works. Carrington owns the servicers and it owns the the riskiest tranches of the mortgage loan bonds it services. It has a conflict between servicing loans well – renegotiating bad debt, making sure payments are processed correctly, and for foreclosures that are necessary to be carried out to be done in a value maximizing way – and its own botom line.
How do they harm investor value to their own benefit in practice? First they bounce around mortgages in order to protect the weakest claims to debt payments, which hurts the senior most claimants:
The senior investors would clearly prefer the liquidation,” Goodman said, because unoccupied homes lose value over time and rental income is unlikely to offset the damage. While Rose’s bet that loss severities would decrease with time was largely wrong, Goodman said, the strategy “worked to the benefit of the CE holder and the junior investors.”
Loss severities from 2005 NC3 and other Carrington deals suggest Goodman is correct that the delay was harmful to the trust as a whole. In 2007 the average monthly loss severity on REO sold was 32%. In 2008, that rose to 50%. And in 2009 and 2010, losses exceeded 70%. While Carrington notes that its current severities compare well to other subprime losses, Goodman and investors argue that Carrington passed up a chance to get rid of collateral at points when its loss severities were lower.
Mortgages servicers employed by the largest banks have extensive second and junior debt exposures which mimic these weak and junior claims. These conflicts encourage Carrington to make bad-faith modifications, that decrease payments while actually driving up principal:
Carrington had become an ardent practitioner of capitalization modifications, in which it tacked whatever missed payments a borrower had incurred on to the top of a loan’s unpaid principal and declared the loan to again be current. Reviled by many borrower advocates for saddling a struggling borrower with a higher principal and potentially higher payments than the ones he or she failed to make previously, the modifications nonetheless buy both parties a little time.
Carrington bought a lot of it. A delinquent borrower would be given a mod, perhaps make a few payments, and then often fall back into delinquency. Then Carrington would sometimes give that borrower another mod, perhaps coupled with a rate reduction, repeating the process. In some instances, it appears to have applied three modifications over three years, allowing the loans to negatively amortize.
Carrington’s focus on capitalization mods was one of several practices that drew a lawsuit from then-Ohio Attorney General Richard Cordray, whose office alleged in a 2009 complaint that many Carrington modifications did not amount to a “good faith” effort to help borrowers stay in their home over the long term.
Cordray is currently in charge of enforcement at the CFPB, and I couldn’t be happier about that. Here’s the most fascinating step, that comes with a chart that tells you all you need to know about servicing:
Called a “stepdown,” it obligates the trust to release tens of millions of dollars in excess principal to investors — assuming that the deal is healthy enough to do so.
The deal wasn’t. In March of 2008, 2005-NC3 needed a delinquency rate of less than 24% to allow for a principal payout, but the deal was near 32% despite Carrington’s modifications. Six months went by, each worse than the last. Carrington’s CE tranche again stopped paying out.
Then, in September, Carrington initiated a high volume of modifications, throwing the remittance data’s failing statistics into reverse. After averaging under $6 million of capital modifications per month all year, Carrington reworked $18 million of loans in October, according to Core Logic data compiled by Goodman’s Amherst securities. In November, it surpassed $26 million. And in December, it peaked at $36 million. (Other types of modifications also grew.)
That did it. Remittance reports show that delinquencies, which were over 34% in September, dipped to 25.6% in December, squeezing by the current trigger of 26%. 2005-NC3’s overcollateralization fell from $53 million to $31 million, rendering the deal — at least on paper — significantly overcollateralized. Between principal and increased interest payments, Carrington’s CE position pocketed $18 million over the next five months.
Ironically, during that period, senior investors received nothing. Money owed to the CE class was consuming every dollar that was then available.
As a smart financial type drawing up the mortgage-backed security contract, you will probably put in a trigger that says if the mortgages in your bond aren’t doing well then you can’t make payments to the weakest claimants. No matter how screwy things get, no matter how many things you didn’t appreciate happen in practice, there’s a tripwire that checks for the mortgage bond falling apart that is checked in December 2008 which will block payments and start wind-down.
Now let’s say you are Carrington, who wants some payouts. December 2008 is when the trigger is due – if deliquencies are over 24% it’ll be harder to pull money out of the deal, away from investors.
So what do you do? You do a massive wave of modifications, bad-faith modifications, to get the delinquency rate down just enough so you don’t set off the December 2008 tripwire designed to protect investors. Baltimore City Police, step aside and let the financial sector show you how to juke a statistic:
Once again, as a servicer you need to make sure that delinquencies are below the trigger rate in December 2008 to pull money out of the deal. And for the next six months you get to make cash while senior investors make nothing.
There’s a part of me that sees this and it makes me really want to get in on the deal. If you are also feeling this, make sure to read about this woman being chewed up and spit out by Carrington servicing division from David Dayen’s HAMP Failure series. That’s what this broken servicing pricing system looks like when it is preying on people’s lives.
Between people and investors, between borrowers and lenders, both sides are getting screwed in this deal. Is it any wonder why the calls for servicer reforms are so loud?