Guest Commentary: Ramsey on Default and Foreclosure Volume

Submitted by Rich Toscano on March 13, 2007 - 9:16am

The prior guest piece by Ramsey (San Diego foreclosure guru and orderer of Chinese restaurant meats with questionable provenance) was a big hit, and Ramsey has kindly agreed to let me publish more of his thoughts...


THOUGHTS ON DEFAULT AND FORECLOSURE VOLUME

For those who have been receiving my weekly SD foreclosure updates, you know I have been somewhat puzzled by the week to week bumpiness.

I finally figured out a number of factors that are most like responsible for what I consider erratic foreclosure data.

Be forewarned that this email is almost entirely MY OPINION or hearsay with no data to substantiate my theories.

(Before continuing, I am linking to two blogs by Tanta: Mortgage Servicing for UberNerds and A Tantamentary on "Messier Mortgages." She is probably the most knowledgeable servicer who is posting on the net that I know of. It is recommended reading if any of you like to have a better understanding of loan servicing and how it impacts the mortgage foreclosure market.)

80/20s

We know that 80/20s are responsible for a high percentage of defaults today. Each defaulting 80/20 borrower most likely started off with two foreclosure actions (NODs) when they originally defaulted. The holders of the 20s soon found out they were pursuing a lost cause and quickly dropped out to avoid incurring more non-recoverable costs.

In the beginning of the cycle, my guess is the NODs, even NOTs, could be double counted. Junior lien holders initiated foreclosure proceedings while keeping current all senior delinquencies such as mortgage payments to the 1st, property tax, and insurance, hoping for recovery in the end.

I suspect the learning curve is quite steep, as junior lien holders realized they were suffering total losses. Junior lien servicers today are probably instructed to do some loss analysis before incurring foreclosure cost and investors are less likely to throw good money after bad.

If this theory is correct, then more NODs will become NOTs and REOs in the near future. Furthermore, the process will be faster, without the 20s getting in the way of the 80s. Unfortunately, I know of no source that could affirm this theory.

Aggressive Work Outs

A friend attended the MBAA National Mortgage Servicing Conference recently and told me about a presentation at the conference. The presenter, a subprime servicer, apparently projected that 80% of their loans will default at recast. To combat this problem, they will go to the extreme of offering the defaulting borrower fixed rate mortgages at the rate prior to recast. The reason this is not widely publicized is obvious. They do not want to encourage widespread defaults.

So how many defaults are cured? Is this a long term fix or just a short term band-aid?

Loan Servicing – Tricks of the Trade

Refer to what Tanta posted and apply it to all the subprime blowups we have been experiencing in the last few weeks.

For example, think about the motivation of a subprime servicer, servicing a portfolio that they had sold or securitized. Would it not be in this servicer’s best interest to make sure there are no first payment defaults to avoid triggering a repurchase? Would it not be in the servicer’s best interest to drag out the other people’s loans while promptly foreclosing on their own loans? Could it be that I am just too cynical?

LOOKING FORWARD

Refinance Volume and Type

I still believe that refinancing is the best indicator going forward. We know there are a mountain of 2/28s, 3/1 and 5/1 hybrids facing recast every day. The most bullish indicator would be high refinance volume compounded by a high fixed-rate mortgage to adjustable-rate-mortgage (FRM/ARM) ratio. On the other hand, low refinance volume would imply that more and more borrowers are stuck with the recast. Refinancing in ARMs would imply that borrowers are buying time.

My cyber friend Calculated Risk offered me this refinance chart using the MBAA data. May be someone has a FRM/ARM chart that we can follow.

Regulators and Legislations

The new and improved guidelines are out.

http://www.federalreserve.gov/boarddocs/press/bcreg/2007/20070302/

We also know both the Senate and the House are finally close to introducing bills that will change the mortgage industry.

http://www.responsiblelending.org/issues/mortgage/policy/page.jsp?itemID=29837365

We know about the 2/28s and the 80/20s, but the most restrictive could be the stated income alt-a loans. What percentage of these alt-a loans are “liar loans”? According to a recent UBS presentation, there were $28.7 Billion alt-a loans originated in 2001 vs $206.1 billion in 2006. I can think of no legitimate reason for this explosive growth. Furthermore, alt-a loans are loaded with the option ARMs and neg-am ARMs.

I can’t wait to watch Bob Pisani explain what an alt-a loan is on CNBC.

Legal Nightmare

I heard demands have already started from borrowers who are looking for relief from the originators. Who is going to take the “blame” for the stated income loans, when everyone from borrower to the ultimate buyer of the loans knew the application contained fraudulent incomes?

CONCLUSION

Status quo is not an option. Live by the bubble, die by the bubble. To keep the bubble inflated, the market needs to recreate similar conditions as before, which were rapidly declining interest rates, favorable underwriting terms, and the resulting home price appreciation.

Regulations, legislation, and most importantly, market conditions are going to un-layer the layered risk. Low FICO, no downpayment (100% LTVs), stated income for W2 borrowers, and stated income with no tax returns for self-employed are all going to be gone.

The following is a projection of “subprime” foreclosures for 2006. Any projections for 2007 (don’t forget to add alt-a)?

http://www.responsiblelending.org/issues/mortgage/foreclosure_rates.html

CRL Projected Foreclosure Rates for 2006 Subprime Mortgage Loans

(category: )

Submitted by CAwireman on March 13, 2007 - 11:56am.

Watch out for meats with questionable provenance.

Thanks Rich and Ramsey.

I'd be interested to see a prediction of Foreclosures in SD by Zipcode. Or at least a percentage of ARM loans by zip.

If anyone should happen upon such a report, please post it.

Submitted by davelj on March 13, 2007 - 12:46pm.

Hold the phone...

"The presenter, a subprime servicer, apparently projected that 80% of their loans will default at recast. To combat this problem, they will go to the extreme of offering the defaulting borrower fixed rate mortgages at the rate prior to recast. The reason this is not widely publicized is obvious. They do not want to encourage widespread defaults."

If this is true, we have truly reached the land of absurd. OK, let's say I'm a lender with this mortgage on my books. The only reason I originated this thing was to make it to the (higher) re-set. I can't make money lending at 3%-5% because my cost of funds is somewhere between 4% and 6%, depending on whether or not I'm a depository or a mortgage bank, and that doesn't include operating costs. So, I'm going to lose a boatload of money - continuously - if I don't re-set the loan.

Now, let's say I'm a MBS holder. If these loans don't re-set, the value of my bond is going to crater something awful. Again, I bought the thing assuming that there was going to be a re-set (upwards) at some point in the near future and now you're telling me I have to live with a 3%-5% coupon less servicing less losses? When I can buy a short-term treasury yielding 5.25%? I don't think so.

I don't think that the ultimate lenders - or MBS holders - are going to go for this "let's just give them a fixed rate loan at the current rate" stuff. I don't see how they can. It's too much pain for too long a period of time. My guess is that they would rather just foreclose, suffer the dire consequences and move on.

Although I'm sure the servicers would LOVE this "amnesty" solution - it makes their jobs a hell of a lot easier. But it sounds like wishful thinking to me.

But I could be wrong.

Submitted by barnaby33 on March 13, 2007 - 1:23pm.

I also feel like there would be alot of legal hurdles to get through. Can a lender really just not re-cast the loan if its in the contract? Doesn't the loan have to be re-financed into a new one to get those favorable terms.

Leaving aside Davel's incredulity, it seems like quite a jump to get to that kind of solution, legally speaking.

Josh

Submitted by rockclimber on March 13, 2007 - 1:50pm.

Just looking at the numbers, it would make sense to keep collecting 4.5% (interest only) rather than foreclose IF you think you can only collect 86% of the original loan amount (e.g. the value of the property has dropped minus foreclosure expenses) assuming you can return 5.25% in T-bills as someone mentioned.

Am I thinking clearly?

Submitted by DaCounselor on March 13, 2007 - 2:57pm.

"The only reason I originated this thing was to make it to the (higher) re-set."
_________________

Actually, at the point of origination it's usually all about scoring the origination fees. If you're going to sell the loan to be packaged and sold again on Wall Street, whether it recasts or not doesn't confront you.

_________________

"Now, let's say I'm a MBS holder. If these loans don't re-set, the value of my bond is going to crater something awful."
_________________

There is inherent risk in purchasing a MBS, particularly where a recast is part of the deal. The standard prepayment factor is always there. And with a recast, if interest rates drop, the margin at recast may still not result in a higher yield. There are no guarantees. What is going to cause the value of the security to drop like a stone is a downgrade, which will require many institutional holders to sell if the MBS is downgraded below their required minimum threshold. MBS holders don't want to own property - they just want the cash flow to keep coming in.
________________

"I don't think that the ultimate lenders - or MBS holders - are going to go for this "let's just give them a fixed rate loan at the current rate" stuff."
________________

It is well-established in the lending industry that they simply do not want to own property. Foreclosure costs are staggering. I think we are going to see a tremendous amount of loss mitigation going on. But, of course, I could be wrong as well. Won't be the first time.

Submitted by davelj on March 13, 2007 - 4:07pm.

DaCounselor,

I wrote, "OK, let's say I'm a lender with this mortgage ON MY BOOKS." If the mortgage is going to be sold then you're right, take the points and move on. But if you're a lender that's going to HOLD the mortgage ("for investment" as opposed to "for sale"), as I was alluding to, then you damn well care about that mortgage making it to the re-set rate.

Regarding MBS, you wrote, "What is going to cause the value of the security to drop like a stone is a downgrade." Well, yes, of course... But what's going to cause this downgrade? Exactly!! Just the sort of loss mitigation BS (the "let's just give them a fixed rate loan at the current rate" stuff) that the servicer is suggesting.

The ultimate lenders (that is, the companies with this sh*t on their books) and the MBS holders face a faustian bargain: They can let the loans keep paying at reduced rates (as the servicer above suggests) and die a death of a thousand cuts (earning far less on the loans than the cost of carrying them in the case of the lenders, or holding deeply discounted paper in the case of the MBS holders) or they can blow these turds out via foreclosure. Both are painful, make no mistake. From a macro standpoint, it's a classic prisoner's dilemma: Do I try to work with my borrowers and let them pay this reduced rate in concert with other lenders doing the same in order to avoid collapsing the housing market via foreclosures, or do I try to foreclose before everyone else and get my money out more quickly than everyone else and potentially suffer reduced relative losses. I think we all know what the ultimate choice is likely to be - take the pain now and try to beat everyone else to the exit... even thought it'll be a macro nightmare.

I mean look at how well all the lenders are working together to "save" NEW and LEND... it's dog eat dog - nothing more, nothing less.

Submitted by bob2007 on March 13, 2007 - 4:07pm.

I don't know the technical details of how changing the terms of a contract would be handled, but I do think that businesses will always choose the money path. In other words, if the most cost effective way to handle the situation is to adjust the terms of the rate increase to a lesser amount, that would be preferable to foreclosing just because a contract says so.

There could be options such as allowing the initial low rate to continue for one or a few years, then re-evaluate. Its all about the money. Foreclosing on thousands of borrowers seems like the last resort, even though stupidity put them there.

Submitted by no_such_reality on March 13, 2007 - 4:13pm.

borrower fixed rate mortgages at the rate prior to recast

I suspect a key word was left off, which happens to get convoluted by mortgage brokers regularly.

Per another mortgage broker blog, some of them refer to ARMs as short term fixed rate mortgages.

I can easily see a lender recasting a dubious defaulting loan into another ARM hoping the marginally lower rate or teaser will carry the mortgagee through.

Submitted by DaCounselor on March 13, 2007 - 4:21pm.

My prediction is that lenders/servicers will make a substantial effort (in line with what Rich's foreclosure expert Ramsey reports) in loss mitigation and re-work deals to avoid mass foreclosures - ie, they will not rush to foreclose and try to beat other lenders/servicers out the door. It should be fairly easy to track what happens in the land of loss mitigation in the coming months and years. We'll see how it plays out.

Submitted by Bugs on March 13, 2007 - 9:04pm.

Loss mitigation is only a aolution to the extent a lender thinks the market actually will turn around sometime soon. I think some of these lenders have figured out they have no choice but to try and mitigate because they can't afford the loss.

I think the lenders might want to try and mitigate but they have more pressing problems than the contract stipulations in those ARMs. The appraisal still has to support the "V" in LTV; and increasingly that's not happening.

These lenders are caught in a vise that's just as unrelenting as what their borrowers are facing. They're stuck between the borrowers who couldn't afford their loans in the first place and the declining equity levels that prevent them from being able to justify an underwriting decision to recast, regardless of terms. The more of these borrowers go down the bigger the "margin" becomes; the bigger the margin, the more action occurs in the market. The more action there is the greater the loss resulting in even fewer borrowers who can recast.

This is how the market regains its equilibrium. By the time this is all over a lot of people are going to wish the upswing had stopped in 2003 when it was supposed to.

Submitted by davelj on March 13, 2007 - 11:20pm.

The obvious answer is that there's going to be some combination of "loss mitigation" (i.e., rate relief) and foreclosures. I think that ultimately foreclosures will rule the day, but I could be wrong. But when analyzing this issue one must take a look at where the mortgages actually reside and what the motivations of the various constituents are. So, where are these turds? In order of magnitude they are:

1. Inside of MBS and CDOs, which are in turn held by just about every financial institution on earth
2. Held on the balance sheets of investment banks and large commercial banks (these were mostly meant for sale or securitization but now that's been put on hold so these guys are stuck with the production for the time being)
3. Held on the balance sheets of "specialty lenders" (like NEW, LEND, etc.)
4. Held on the balance sheets of Savings & Loans (like Countrywide, Downey, etc.)
5. Other places

I'd bet that 90% of the production of the last several years is in buckets 1-4.

The problem with Group 1 is that you've got a tradeable asset that most people would rather just trade out of and take the hit based on the valuation, assuming sufficient liquidity to do so. Getting a bunch of MBS/CDO holders together to guide the servicer through "loss mitigation" is a major stretch. My bet is that these securities (the ones with a lot of subprime exposure) will trade to BELOW a value reflecting a "reasonable" foreclosure scenario and a handful of huge companies with a lot of capital and access to expertise - investment banks, hedge funds, private equity, etc. - will buy them with an eye toward rapid foreclosures and quick high IRRs. These securities will also probably be re-sliced and re-diced in order to strip out the good apples in order to generate some additional fees.

It's hard to say what Group 2 will lean toward. The non-depositories may lean toward loss mitigation, but the regulators are going to be all over the depositories to get this crap off their books regardless of the losses involved. Bank regulators generally look at these situations and say, "Write it off and raise some capital - we don't give a rat's ass about your yield problems or the value of your common equity... unless the write-offs are going to sink your ship and cost the FDIC money."

Group 3 is obviously toast. Most of their mortgages will ultimately be held (with servicing controlled) by their warehouse lenders (investment banks, large commercial banks, etc.). I think these guys are looking at the portfolios and just discounting them right off the bat. Their attitude is, "Hey, so long as I get my money, I don't give a sh*t about the common equity, the TPS holders, OR the sub-debt holders. I just want my senior secured debt to come out whole." They'll blow out the properties so long as they think they'll come out whole and they can take pretty big hits. At most of these companies, the sum of equity, TPS and sub and senior debt (that is, all the funding junior to their secured warehouse lines) would allow these holders of the mortgages to discount them by 30%+ and still come out whole. And if they're rational they'll hit the bids in foreclosure until they think they're going to lose principal.

Finally, you get to the S&Ls, who actually hold this crap on their balance sheets as part of their business. Of all the parties involved, these guys would probably be most attracted to loss mitigation because they may not have the capital to take the hits. But, again, you run into the regulators, whose attitude is going to be, "You'd like to do what? Let this borrower just keep paying his 3.5% teaser rate for a few more years? While you just lose more and more money? No. No. I don't think so. My idea is for you to raise some capital and get this stuff off your books ASAP. Yeah, I'm really sorry about your common and TPS holders, but I don't care about them. I care about how much you're going to cost the FDIC if you keep bleeding. Let's nip this in the bud and write this stuff off and move on."

So, my point is that while loss mitigation might seem like a good idea to certain participants, if you look at where this paper resides and what the motivations and constraints of the various parties are, I think you'll find that the answer to most of these problems is going to be a simple one: foreclosure. And it won't be pretty. But, having said all that... only time will tell.

Submitted by DaCounselor on March 14, 2007 - 1:27pm.

I'm certainly no expert on the intracacies of MBS's, but I would be surprised to learn that security holders have any say in whether a loan workout is going to happen. I would imagine that the pooling/servicing agreement speaks directly to the servicers' authority to enter into a workout in a default situation. Security holders face all types of risk that they have no control over. Maybe somebody on this board knows whether the typical pooling/servicing agreement grants the servicer authority for loan workouts.

Anyway, I'm sure we will hear many stories from the front lines regarding the nature and extent of loan workouts. All I have really heard so far is that servicers will continue, as always, to work with borrowers who have a fighting chance to stay in their homes (this from my broker) and of course what Rich's friend, the foreclosure expert Ramsey, reports in the above statement - that at least one outfit is going to offer fixed rate loan workouts at the pre-recast rate in order to avoid foreclosing.

Submitted by sdcellar on March 14, 2007 - 5:21pm.

Also, when we're saying recast to the teaser/intro rate, what must really be implied is that they'll consider letting the borrower make reduced payments based on the teaser rate, but now the loan would start negatively amortizing.

They wouldn't extend their worst borrowers another dicounted rate, would they?

Submitted by davelj on March 15, 2007 - 6:47am.

DaCounselor,

You're right in that MBS holders have very limited say in how a pool of loans are serviced. That's why I wrote it would be a "major stretch..." The only thing the MBS holders can do is petition whomever handled the insurance wrap (and thus negotiated and assigned the servicing contract) on the securitization to change servicers if they feel the servicer isn't abiding strictly by the agreement and indentures. (And this is a long drawn-out legal process.) Ultimately, the servicer is bound by the servicing agreement, as you suggest, which is why I think foreclosures will abound.

I spoke with a friend of mine yesterday who's the head of securitizations for the subprime unit of one of the large investment banks and he said, in so many words, that the servicers' hands are pretty much tied - it's fairly clear what they can and can't do per the servicing agreement and he predicted foreclosures out the ying yang (his quote: "Rate resets, Trump Jr. can't pay, 90 days' delinquent, NOD, foreclosure - it ain't magic"). When I mentioned the quote from the conference Rich's friend Ramsey attended he suggested that that was probably coming from a captive servicer, not the servicer for MBS. A captive servicer - for example, Countrywide's captive servicer - can work with borrowers on those loans that its servicing for its parent at the discretion of its parent (which makes sense), but it doesn't have this leeway for loans that it's servicing that are part of MBS, as their actions are bound strictly by the servicing agreement in these instances. (Most large captive servicers also service loans for other entities, including MBS.) Also, due to the structure of the industry, this option will be available in only a relatively small percentage of cases. Most of these subprime mortgages, after all, have been securitized and are wrapped up in MBS and CDOs.

But the problem, again, with the captive servicers of depositories, specifically, is that they will run into problems with regulators if they try to allow borrowers to keep paying a rate below the recast rate. I don't think the regulators will allow this to happen as discussed previously.

Just a little clarification on the issue for what its worth.

Submitted by SpyBoy on March 21, 2007 - 2:16pm.

Greetings,

My first post.

Relevant comments from the recent Mortgage Bankers Association's 2007 Servicing Conference in San Diego, from the Default Super Session.

Stephen Staid, Senior V. P. of Default Administration of Litton Loan Serviving stated ( paraphrased ):

"LIBOR ARM's are the Typhoid Mary of the business";

"A stunning 85% of borrowers are 90+ days delinquent on 2/28 Hybrid ARM's within six months of the payment adjustment";

( I guess that means the first missed payment occured within the first 3 months after the adjustment )

"We are fixing loans that are current, trying to forestall an inevitable fall into deliquency";

( "fixing loans", hum, like "modifications" of ARM's to fixed rate loans ? And how about the homeowners pays no refinance fees ? ! BTW; I personally have never seen a pooling and servicing agreement, and I have reviewed many, that permits a modification, or any loss mitigation activity on any loan that was not deliquent. Many require at least 3 month deliquentcy. Of course, any contract can be modified to accomadate the circumstances, including pooling and servicing agreements, and there usually clauses in such contracts that permit changes. )

"Litton loses about $ 50,000 per default";

Juhn Will, Default Manager from Sun Trust Mortgage ( an A-Paper lender ) stated:

"We lose $ 31,000 per case";

"Even spending $ 15,000 to save $ 31,000 is worth it";

"We have to be on steroids now".

Laurie Ann Maggio, Acting Director of HUD's Single Family Asset Management Program, stated:

"In fiscal 2006 HUD spent $ 152,000,000 on loss mitigation to avoid potential losses of $ 2,000,000,000" ( yep, 2 billion ).

I heard recently that the going price on the secondary market for 2nd leins is .15-.25 cents on the dollar, and that 3rds can even be sold.

Williams & Williams, an company that conducts actions on REO/Foreclosure properties, has a newly implemented Assisted Sales Auction Program, where houses are auctioned pre-foreclosure, by agreement with borrowers, lenders, etc. I checked the properties for sale section of the site yesterday and saw quite a bit with opening bids in the
$ 5000.00 - 10,000 range. Granted, not the top shelf properties and not in the to die for locations, but thats cheep.

I have also seen situations where lenders/servicers properties are allowing the foreclosure attorneys to buy the foreclosure sale/sheriffs sale for the amount of attorneys fees due. I'm talking as little as $ 1,500 !

And finally, in the 03/14/07 Wall Street Journal there was an article "Foreclosure Rise Brings Business To One Investor", aboput the investment strategies/activities of one guy making it work for him and his crew. Very interesting. You can do a Google search for "james odell barnes" to find it.

Thank You,
SpyBoy

Submitted by SpyBoy on March 21, 2007 - 10:41pm.

Greetings,

A mistake ( typo ) on my previous post.

"I heard recently that the going price on the secondary market for 2nd leins is .15-.25 cents on the dollar, and that 3rds can even be sold"
SHOULD BE
" ...and that 3rds CANT even be sold"

Obviously a significant error. Hope that clears it up.

Thank You.
SpyBoy

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