Loan fix requires investors to yield


The success of the Bush administration’s plan to stem home foreclosures will hinge in large part on whether the investors who own sub-prime mortgages will play along and accept lower interest payments to keep people in their houses.

That may be asking a lot -- and not just because of many investors’ visceral negative reaction to government strong-arming on the issue of home-loan modifications.

Thanks to the alchemy of modern finance, investors who put up funds for the same “pool” of thousands of sub-prime mortgages can face very different levels of risk, depending on the section of the pool they own.


Those whose sections would be well-protected from loss, even if loan defaults soared, may have little incentive to agree to changes in the terms of the underlying mortgages. That could invite a torrent of investor lawsuits challenging moves to ease loan terms.

Wall Street has other concerns as well, and they aren’t completely paranoid. One is that, if the economy were to worsen in 2008, lenders and investors could face pressure to provide similar relief to financially strapped consumers with other debt, such as conventional mortgages and even auto loans.

“It could filter up,” said Andrew Chow, who helps manage a portfolio of $14 billion in bonds, including securities backed by mortgage loans, at SCM Advisors in San Francisco.

There also is a fear that many struggling sub-prime borrowers who would be initially helped by the Bush plan’s interest rate freeze could default even before the freeze period is up. Investors might well prefer to just cut those people off now.

Some analysts said the risk of borrowers returning for more forbearance could be intensified by a provision in the program that calls for fast-tracking hundreds of thousands of loans for a rate freeze, as opposed to undertaking a detailed and time-consuming study of the borrowers’ finances.

“To decide if a modification is beneficial,” analysts at brokerage Deutsche Bank Securities wrote in a note to clients Friday, a mortgage servicer needs to assess the borrower “with the same degree of care as a new borrower walking through the door.”

Determining eligibility for a rate freeze based on just a few criteria, as the Bush plan proposes, “is to repeat the same type of underwriting shortcuts that got us here,” the analysts wrote, referring to the no-questions-asked frenzy of 2005 and 2006 that gave home loans to almost anyone who could fog a mirror.

But the administration and its financial industry allies said the crumbling housing market dictated the need for speed in addressing the problem many borrowers are facing in holding on to their homes.

“The standard loan-by-loan evaluation process that is current industry practice would not be able to handle the volume of work that will be required,” Treasury Secretary Henry M. Paulson Jr. said Thursday in announcing the program.

An estimated 1.8 million homeowners with adjustable-rate sub-prime loans will face interest rate resets between the end of this month and July 2010. In many cases the rates would rise to double-digit levels from a current range of 6% to 9%.

Under the deal worked out with major loan servicers -- with input from some investors -- the servicers would seek to quickly agree to a five-year freeze on loan rates at current levels for borrowers who are up to date on their loans and meet certain criteria.

The administration estimated that about 600,000 homeowners with sub-prime loans could qualify for a rate freeze.

Paulson stressed that the program would be voluntary, not mandatory, for lenders and investors. But he spoke of an “investor community on board and . . . a clear beneficiary of this approach.”

In theory, the lenders and investors would face heavy losses if loan-rate resets pushed more borrowers into default and then foreclosure. With foreclosure rates already at the highest level in at least 35 years, and with home prices falling in many regions of the country, more foreclosures could ensure that the seized homes couldn’t be sold for enough to cover their loans.

If that’s the case, it might be better for investors to forgo the higher interest rates they had expected to earn once the loan rates reset and instead be content to continue getting paid at current rates.

That’s the theory. In practice, however, it’s not so cut and dried.

In the last decade, the lending industry became dependent on securitization to fund mortgages and many other forms of consumer debt. That meant loans were bundled and sold to investors via bonds. The interest and principal on the loans are passed through to the bondholders.

In recent years, many bonds backed by sub-prime loans were used to fashion complex investment pools known as collateralized debt obligations, or CDOs.

With a CDO, an investor essentially picks his level of return and risk. At the top of a CDO are investors who own slices, or tranches, that pay relatively modest returns but are meant to be ironclad against loss, even if a massive number of loans in the pool go bad.

At the bottom are investors whose tranches pay high returns but could face wipeout if too many homeowners fall into default.

Therein lies the problem in getting investors in a pool of mortgages to agree to change the terms of the underlying loans.

Modification is “clearly going to favor the guy at the bottom” of the pool, said Jeffrey Gundlach, chief investment officer at Los Angeles-based TCW Group Inc., which manages more than $50 billion in CDOs for investors.

“The guy at the bottom is starving for modification,” Gundlach said. On the other hand, investors at the top of the pool, who know they have little risk of loss from a wave of foreclosures, could be hurt by modifications that could lead to reduced interest earnings for the pool overall.

The administration’s plan thus could pit some investors against the loan servicers who deal directly with borrowers and are under political pressure to save as many struggling homeowners as they can.

The American Securitization Forum, a trade association that includes servicers, lenders and investors, worked to craft the rate-freeze plan with the White House. On Thursday, the group put out a lengthy document asserting that servicers have the legal right to pursue modifications that are “in the best interests of investors.”

But this is the kind of stuff governed by detailed contracts between investors and loan servicers. And in general, Gundlach said, “if you’re going to modify more than 5% of the loans [in a pool], you’re in blatant breach of contract.”

As for the idea that the servicers would get permission from every pool investor, good luck. Specific pools can have hundreds of investors, many of them foreign. The logistics of achieving some kind of consensus are daunting at best.

Josh Rosner, a managing director of financial consulting firm Graham Fisher & Co. in New York, figures that a rash of legal challenges to loan modifications is inevitable. “I think that’s exactly where we’re going to be” in 2008, he said.

Well-intentioned though the rescue plan may be, Rosner said, to some investors it will amount to confiscation of their assets with the assent of Uncle Sam.

Then again, some on Wall Street believe that what a rate freeze would do to lenders, and investors, would simply be to keep them from fleecing borrowers with what are arguably ridiculously high loan reset rates.

Edward Yardeni, a veteran economist who heads Yardeni Research in New York, may echo many Americans’ views when he asserts, perhaps only partly tongue-in-cheek, that lenders who made sub-prime loans under the terms targeted by the rescue plan “should be charged with usury, arrested and thrown into lenders prison.”

That might be one way to solve the foreclosure problem.