laurie goodman 5.11 hill testimony

8/4/2019 Laurie Goodman 5.11 Hill Testimony

1/11

May 11, 2011 Laurie Goodman / [email protected] / 212.593.6026

This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

1 May 11, 2011

5/12/2011 Testimony of Laurie Goodman, Amherst Securities Group

to the

Subcommittee on Housing, Transportation and Community Development

of the

Senate Committee on Banking, Housing and Urban Affairs

TopicNational Mortgage Servicing Standards and Conflicts of InterestIamhonoredtotestifytoday.MynameisLaurieGoodmanandIamaSeniorManagingDirectorat

AmherstSecuritiesGroup,aleadingbroker/dealerspecializinginthetradingofresidentialmortgage

backedsecurities.Iaminchargeofthestrategyandbusinessdevelopmenteffortsforthefirm.We

performextensive,dataintensiveresearchaspartofoureffortstokeepourselvesandcustomersabreast

oftrendsintheresidentialmortgagebackedsecuritiesmarket.Iwouldliketosharesomeofourthoughts

withyoutoday.

Afewquicknumberswillserveasbackground.Thereis$10.6trillionworthof14familymortgages

outstandingintheUnitedStates.Ofthose,onehalf,or$5.4trillion,isinAgencyMBS(mortgagebacked

securities),$3.0trillionconsistsoffirstlienmortgagesinbank,thriftandcreditunionportfoliosplusthe

unsecuritizedloansonFreddieMacandFannieMaesbalancesheet,and$1.2trillionisinprivatelabel

MBS.Secondliens,whicharemostlyheldonbankbalancesheets,totaljustunder$1trillion.Itis

importanttonotethatwhileprivatelabelsecuritizationsrepresentonly12.8%ofthefirstlienmarket,

theyrepresent40%oftheloansthatarecurrently60+daysdelinquent.

Servicersplayacriticalroleinthehousingfinancemarket.Theyarethecashflowmanagersforthe

mortgagesystem. Iftheborrowerismakinghispayments,theservicercollectsandprocessesthose

payments,forwardingtheproceedstotheinvestorinasecuritization.Ifthereisanescrowaccount,the

servicerischargedwithmakingthetaxandinsurancepayments.Iftheloangoesdelinquent,theservicer

isresponsibleforrunningthelossmitigationefforts,anendeavorthatmanyservicers,especiallysocalled

primemortgageservicers,hadlittleexperienceatpriortothecrisis.Itwasnevercontemplatedthat

theseservicingplatformswouldbeusedtoperformdefaultmanagementonthecurrentscale.Asaresult,

they

have

never

built

up

a

loss

mitigation

infrastructure.

A

set

of

national

servicing

standards,

addressing

minimuminfrastructurerequirementstohandletheservicingofdelinquentborrowerswithinaservicing

platformisthebestwaytoaddressthisissue,andIampleasedtohaveinputonthisimportanttopic.

Theservicerisgenerallypaidafixedpercentageoftheoutstandingloanbalanceforservicingamortgage.

Thisfeeisgenerallytoolargeforservicingloansthatarenotdelinquent,andtoosmalltocoverthecosts

ofservicingloanswhichhavegonebad.Thereareothersourcesofincomeaswell. Theborroweroften

makeshispaymentearlyinthemonth,andthemoniesarenotrequiredtoberemitteduntilmidmonth,


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2 May 11, 2011

givingtheservicertherighttoinvesttheseproceedsinthemeantime(float).Whentheborrowergoes

delinquent,servicerschargelatefees.Thereareanumberofancillaryfeesthatarechargedduringthe

lossmitigationprocess.Finally,servicingaloanallowsafirmtocrosssellotherfinancialproductstothe

borrower,includingautoloans,creditcards,andhomeequitylinesofcredit.Asaresult,theserviceroften

interactswiththeborrowersacrossanumberofdifferentproducts,someofwhichmaybeinthe

investment

portfolio

of

a

related

entity.

There

are

some

costs

as

wellthe

servicer

will

generally

advance

taxandinsurancepayments,andinprivatelabelsecuritizationsareusuallyobligatedtoadvanceprincipal

andinteresttotheextentdeemedrecoverable.

Thepurposeofmytestimonyistodiscussconflictsofinterestfacingmortgageservicersthatmaystop

themfromactinginthebestinterestsofmortgageinvestorsandhomeowners,andtodiscusswhichof

theseconflictscanbeaddressedthroughnationalmortgageservicingstandards.Letmebeginbypointing

outthattheinterestsofmortgageinvestorsandhomeownersarelargelyalignedfor2reasons.First,the

mortgagemarketisreliantoninvestorstocontinuetoextendcredit,therebyprovidingthenecessary

capacitytoencouragecompetitiveratesforborrowersinpursuitofhomefinancing.Second,foreclosure

is,withoutquestion,theworstoutcomeforbothinvestorsandborrowers.Itisalonganddrawnout

processinwhichaborrowerisforcedfromhishome,andaninvestortypicallysuffersalossonhis

investmentinthemortgageloansofbetween5080%ofthebalanceoftheloanamountafterthehomeis

soldandthevariouscostsarededucted.

Theinterestsofboththeborrowersandinvestorscanbemarginalizedwhentheloanisservicedbya

conflictedparty. Herearetheinherentconflictswesee.

CONFLICT#1:Largefirstlienservicershavesignificantownershipinterestsin2ndliensand

oftenhavenoownershipinterestinthecorrespondingfirstlienmortgageloansthataremade

tothesameborrowerandsecuredbythesameproperty.

Insuchcases,thefirstliensaretypicallyheldinprivatelabelsecuritizations,thesecondlienandthe

servicingrightsareownedbythesameparty,oftenalargebank.The4largestbanks(BankofAmerica,

WellsFargo,JPMorganChase,Citigroup)collectivelyservice54%ofall14familyservicingintheUnited

States.Theyownapproximately40%($408billionoutof$949billion)ofsecondliensandhomeequity

linesofcreditoutstanding.Thesecuritizedsecondlienmarketisverysmall.Thuswhenafirstlienina

privatelabelsecuritizationisonapropertythatalsohasasecondlien,thatsecondlienisverylikelytobe

heldinabankportfolio,andifitisinsideabankportfolioitisofteninoneofthebig4banks.

Thisisaconflictbecausetheservicerhasafinancialincentivetoservicethefirstlientothebenefitofthe

secondlienholder. Manytimethisincentiveconflictswiththefinancialinterestoftheinvestoror

borrower.Weoutlinesomeoftheconsequencesofthisconflict.

Consequence:ShortSalesandDeedsinLieuAreLessLikelytoBeApproved. Anexamplemakesthis

moreintuitive.Assumethataborrowerhasa$200,000firstlienanda$30,000secondlien($230,000lien

total)onahomethatsufferedavaluationreductiondowntoonly$160,000.Theborrowerispayingonhis

secondlien,butnotonthefirstlien.Theborrowerreceivesashortsaleofferatthemarketvalueofthe

property,andaskstheservicer(alargefinancialinstitution)toconsiderit. Iftheserviceracceptstheoffer,


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3 May 11, 2011

thesecondlien(heldonthebalancesheetofthefinancialinstitution)mustbewrittenoffimmediately.If

theservicerisalsothesecondlienholder,hemaybemoreinclinedtorejecttheshortsaleoffer.Inthis

case,acceptingtheshortsaleofferwasclearlyinthebestinterestsofbothborrowerandfirstlien

investor.Similarly,aservicerwillbelesslikelytoacceptadeedinlieuofforeclosure.Webelievethat

nationalservicingstandardsshouldexplicitlyaddressthisissue.

Consequence:LoanModificationEffortsAreSuboptimal. Loanmodificationprogramshavetwoissues:

theydonotaddresstheborrowerstotaldebtburden,andtheydonotaddressaborrowersnegative

equityposition.Asaresult,theredefaultratehasbeenenormous.Webelievethatbothofthese

shortcomingsshare,attheircore,onecommontrait:conflictedservicers.Welookateachinturn.

ModificationsFailtoAddresstheBorrowersTotalDebtBurden. Inaloanmodification,onlythe

mortgagedebtisaffected.Thatis,mostmodificationprograms,includingHAMP,thegovernmentsHome

AffordableModificationProgram,lookatthepaymentsonaborrowersfirstmortgageplustaxesand

insurance,andcomparethattotheborrowersincome.Thisiscalledthefrontenddebttoincomeratio,

andanattemptismadetoreducethepaymentstoapresetpercentageoftheborrowersincome.

Considerabankwhoservicesaborrowersfirstlien,secondlien,creditcardandautoloan.Thefirstlienis

inaprivatelabelsecuritization,allotherdebtsareonabanksbalancesheet.Thebankisobligatedto

modifyonlythemortgagedebt,leavingthecreditcardandautodebtintact.Moreover,thesecondlien

mortgagedebtisgenerallytreatedparipassuwiththefirstlien.Therearesituationsinwhichonlythefirst

lienismodified,andthesecondlieniskeptintact,makingevenlessimpactontheborrowerstotaldebt

burden.

Sincethereisnosenseofanoveralldebtrestructuring,theborrowerisoftenleftwithamortgage

paymentthatisaffordable,butatotaldebtburdenthatisnot.Forexample,theTreasuryHAMPreport

showsthattheborrowerswhoreceivedpermanentmodificationsundertheHomeAffordable

ModificationProgramhadtheirfrontenddebttoincomeratioreducedfrom45.3%toanaffordable

31.0%,whilethemedianbackenddebttoincomeratio(ortotaldebtburdenasapercentofincome)was

reducedfrom79.3%beforethemodificationtoastillunsustainable62.5%afterwards.Theresult:ahigh

redefaultrateonmodifications.Forasuccessfulmodification,aborrowerstotaldebtburdenneedstobe

completelyrestructured.

ModificationsFailBecauseTheyDoNotAddressaBorrowersNegativeEquitySituation.Considerthe

2MPprogram,theHAMPprogramwhichappliestosecondliens. Essentiallythisprogramtreatsthefirst

andsecondlienholdersparipassuwhentheborrowersfirstlienismodified.Ifthereisaratereductionon

thefirstlien,thereisalsoaratereductiononthesecondlien;ifthereisaprincipalwritedownonthefirst

lien,thesecondlienalsoreceivesaprincipalwritedown.Thismakesnosense,asthejuniorlienisby

definitionsubordinatetothefirstlien,andassuchshouldbewrittenoffbeforethefirstliensuffersany

loss.AndifamodificationisdoneoutsideofHAMP(andtherearemorenonHAMPorproprietary

modificationsthanthereareHAMPmodifications)theservicerisnotcompelledtoaddresssecondliensat

all.

Thenegativeequitypositionofmanyborrowerswouldbedramaticallyimprovedifthesecondlienwas

eliminatedorreducedmoreinlinewiththeseniorityofthelien.Indeed,loanmodificationprograms


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4 May 11, 2011

wouldbemarkedlymoresuccessfulifprincipalreductionwereusedonthefirstmortgageandthesecond

lienwereeliminatedcompletely.Ourresearchhasshownthataprincipalreductionmodificationhasthe

highestlikelihoodofsuccessfullyrehabilitatingaborrower,andwillultimatelyresultinthelowestre

defaultrate.

PrincipalReductionsareUsedinLoanModificationsLessFrequentlyThanTheyShouldBe,Dueto

ConflictedServicers. Evenwiththecurrentparipassutreatmentonfirstandsecondliens,webelieve

therearefewerprincipalreductionmodificationsonloansownedbyprivateinvestorsthantherewould

beifarelatedentityoftheservicerdidnotownthesecondlien.Thatis,webelievebanksarereluctantto

takeawritedownonasecondlienthatispayingandcurrent;asaresult,theydoafirstlienmodification

whichislesseffective,tothedetrimentoftheborrower/homeowneraswellastotheprivateinvestors

whoownthefirstlienloan.Inadditionwebelieveconflictedservicersarecounselingborrowerstoremain

currentontheirsecondliens,therebyallowingthemtopostponethewritedownonthesecondlien,and

increasingthelikelihoodofaparipassumodification.

PrincipalReductionsAreAlsoUsedLessFrequentlyDuetoDistortionsInTheCompensationStructure.

Servicingfeesarebasedontheoutstandingprincipalbalance.Thus,whenaprincipalreductionisdone,

theservicingfeeisreduced,asitisbasedonalowerprincipalamount.Sinceitcostsmoretoservice

delinquentloansthantheservicerisreceivinginfees,andthisisexacerbatedbythewritedown,itaddsto

thereluctancetodotheprincipalwritedown.

Withservicerstryingtominimizethewriteoffofsecondlienholdingsandmaintainservicingfees,itis

nosurprisethatweseedistortedoutcomesforborrowersandinvestorsinloansthatbanksservicefor

privateinvestors.

Hereissomeevidenceofthedistortion.Wecanseeamarkeddifferenceinservicingbehaviorforfirst

liensownedbybanksandthosewherethefirstlienisNOTownedbyabankportfolio. Accordingtothe

OCC/OTSMortgageMetricsreportofQ42010,banksdidaprincipalreductionon17.8%oftheirfirstlien

portfolioloans.Thesewereloansinwhichtheyownthefirstlien,generallyownthesecondlien(ifthereis

one),andmodifiedthefirstlientoachievethehighestnetpresentvalue.Bycontrast,thosesamefinancial

institutionsdidaprincipalreductionononly1.8%ofloansownedbyprivateinvestorsand0%ofFannie

Mae,FreddieMacandgovernmentguaranteedloans.Whiletherearemajorobstaclestoprincipal

reductioninthecaseofGSE(GovernmentSponsoredEnterprise)loansorgovernmentguaranteedloans,

therearefewobstaclestodoingprincipalreductiononprivateinvestorloans.OnlyafewPSAs(Pooling

andServicingAgreements)prohibitsuchbehavior.AndtheOCC/OTSMortgageMetricReportnumbersfor

Q42010werenotafluke;intheimmediatelyprecedingcalendarquarterQ32010,banksdidprincipal

reductionson25.1%oftheirownloans,butononly0.2%ofloansownerbyprivateinvestors.

Solution:ToIncreasetheUseofPrincipalReductionsasaLoanModificationTool. Nationalservicing

standardsshouldrequirethatservicersperformthemodificationwiththehighestnetpresentvalue,

whichwillusuallybeaprincipalreduction.UnderHAMP,theservicerisrequiredtotesttheborrowerfora

modificationusingboththeoriginalHAMPwaterfall,aswellasthePrincipalReductionAlternative,which

movesprincipalreductiontothetopofthewaterfall.IfthePrincipalReductionAlternativehasthehighest

netpresentvalue,servicersarenotobligatedtouseit.UseofthePrincipalReductionAlternativeis


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5 May 11, 2011

voluntary,atthediscretionoftheservicer.HAMPshouldbeamendedtorequiretheuseofthePrincipal

ReductionAlternative,ifithasthehighestnetpresentvalueofthealternativestested.

ConsequenceofPariPassuTreatmentofFirstandSecondLiens:HigherFirstLienBorrowingCosts.We

believealargeerrorwasmadeinoptingtotreatthefirstandsecondliensparipassuformodification

purposes.Theconsequenceofthisisthatfirstmortgageswillbecomemoreexpensive,asinvestorsrealize

theyarelesswellprotectedthantheirlienprioritywouldindicate. Itisveryimportanttorealizethat

underpresentlawandpractices,asecondmortgagecanbeaddedafterthefact,withoutthefirstlien

investorevenknowingit.Butadditionofasecondliensignificantlyincreasestheprobabilityofdefaulton

thefirstmortgage.However,aspresentlyconstructed,ifaborrowergetsintotrouble,thefirstandsecond

mortgagesaretreatedsimilarlyformodificationpurposes.Sincethatraisestheriskforthefirstlien

investor,itshouldalsoincreasethecostofdebtforthefirstlienborrower.(Wehaventseenthisreflected

inpricingyet,asfewmortgageshavebeenoriginatedforsecuritization;mostmortgagesissuedsincethe

paripassudecisionwereinsuredeitherbytheGSEsortheU.S.government.)

SolutionstoMaintainLienPriority

Whatcanbedoneaboutconflictsofinterestinherentinanentityservicingapoolofloansandowningthe

secondlien(whilethefirstlienisownedbyanoutsideinvestor)?Thereareatleast3alternativesolutions

fornewlyoriginatedmortgages.Thefirsttworequirecongressionalconsent,whilethethirdwouldrequire

actionsbythebankregulatoryauthorities.Thesesolutionstothereorderingoflienprioritiesarebeyond

thescopeofnationalservicingstandards.

Alternative1.Thissolutionwouldcontractuallyrequirefirstlieninvestorstoapproveanysecondlien(or

alternatively,approveanysecondlienwithaCLTV[(combinedloantovalue,theratioofthesumofallthe

liensonthepropertytothemortgageamount)exceedingapresetlevel,suchas80%].Ifthefirstlien

holderdoesnotapproveit,yettheborrowerstilltakesoutasecondlien,thefirstlienmustbepaidoff

immediately(thedueonsaleclauseisinvoked).Thismaysoundharsh,butitreallyisnot.Currently,ifa

borrowerwantstorefinancehisfirstlien,thesecondlienmustexplicitlyagreetoresubordinatehislien.

Theinfrastructuretoarrangethesetransactionsexistsandworkssmoothly.Prohibitionofexcessive

indebtednessiscommonincorporatefinance.Thisisdonethroughloancovenantsthatlimittheamount

ofjuniordebtthatcanbeissuedwithouttheconsentoftheseniornoteholders.Thisalternativemaybe

requiredtorestarttheprivatemortgagemarketsandwouldrequireanamendmenttotheGarnSt.

Germain DepositoryInstitutionsActof1982.Thatactprohibitstheseniorlienholderfrominvokingthe

dueonsaleclauseiftheborroweroptstoplaceasecondlienontheproperty.

Alternative2.PlaceanoutrightprohibitiononsecondmortgageswherethecombinedCTLVexceedsa

designatedlevel,suchas80%,atthetimeoforiginationofthesecondlien.

Alternative3.Establisharulethatalendercannotserviceboththefirstandsecondlienswhileowning

onlythesecondlien.


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6 May 11, 2011

CONFLICT#2:AffiliateRelationshipswithProvidersofForeclosureServices

Theserviceroftenownsashareincompaniesthatprovidesancillaryservicesduringtheforeclosure

process,andchargesabovemarketratesonsuch.Entitiesthatprovideservicesduringtheforeclosure

processthatarepossiblyownedbyservicersincludeforceplacedinsuranceprovidersandproperty

preservationcompanies.(Thesecompaniesprovidemaintenanceservicesaswellaspropertyinspection

services.)Evenwhenaservicerisnotaffiliatedwiththecompanyprovidingtheservice,theyoftenmark

upthefeesconsiderably.

Whatistheconsequenceofaffiliatesoftheservicerchargingabovemarketfees?Suchfeesareaddedto

thedelinquentamountoftheloan,makingitmuchharderforaborrowertobecomecurrent.Moreover,

whenaloanisliquidated,theseverityontheloan(thepercentageofthecurrentloanamountlostinthe

foreclosure/liquidationprocess)willbemuchhigher,tothedetrimentoftheinvestor(s)inthatmortgage.

Italsotendstomakeservicerslessinclinedtoresolvetheloanthroughashortsale,asfeeincomethatwill

beearnedintheinterim(astheloanwindsitswaythroughalengthyforeclosureprocess)isquite

attractive.

Problem:Distortionintheservicingfeeschedules: Wehaveheardassertionsthat,sinceservicersare

inadequatelypaidforservicingdelinquentloans,therelatedfeesareawaytomakeupthedifference.Itis

absolutelythecasethatservicersaredefinitelyunderpaidforservicingdelinquentloans.However,they

areoverpaidforservicingperformingloans.Moreover,exante(attheinceptionoftheloan),theservicer

hadagreedtoservicetheloansattheagreeduponprice. Itsjustthatexpost(atthepresenttime),given

theamountofdelinquentloansthataccumulatedversusoriginalexpectations,theiroriginalagreement

hasturnedouttobeabaddeal.Butintherealworld,adealisadeal!Forinstance,myownfirmAmherst

SecuritiesGroupcantagreetoaconsultingcontractatafixedprice,thencomebackandrenegotiate

becauseitismoreworkthanwethoughtitwouldbe.

Problem:NoDisclosureofFees.Servicerswilltellyouthattheservicestheyprovideareessential,and

theywouldbeprovidedatsimilarpricesbyanythirdparty.Byowningorhavinganinterestinawider

arrayofservices,theservicersalsohavemorecontroloverthetimingandcanmorecloselymonitorthe

qualityoftheservicersprovided. However,neitherborrowersnorinvestorshaveanywaytoconfirmthis.

Theancillaryfeesarenotbrokenoutinaformthatistransparenttoanyoneoutside.

PartialSolution:MakeBetterFeeDisclosureaPartofNationalServicingStandards.TheNewYorkState

BankingDepartment,intheirRegulationsforServicingLoans(part419),requiresthatservicersmust

maintainascheduleofcommonfeesonitswebsite,andmustincludeaplainEnglishexplanationofthe

fee,andanycalculationdetails.Inaddition,theservicershouldonlycollectafeeiftheamountofthatfee

isreasonable,andfeesshouldbechargedonlyforservicesactuallyrenderedandpermittedbytheloan

instrumentsandapplicablelaw.Attorneysfeeschargedinconnectionwithaforeclosureactionshallnot

exceedreasonableandcustomaryfeesforthatwork.Attheminimum,thistypeoflanguageshouldbe

adoptedfornationalservicingstandards.

ForcePlacedInsuranceHighlightstheConflictsofInterest.Theservicer,oranaffiliateoftheservicer

oftenownashareofaforceplacedinsurer.Thisinsuranceisusedtoprotectthehomewhenthe


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7 May 11, 2011

borrowerisnolongermaintaininghisexistingpolicies.Giventheconflicts,itisunrealistictoexpecta

servicertomakeanunbiaseddecisiononwhentobuythisinsurance(thereisatendencytobuyitwithout

tryingtoretainthehomeownerspolicythatwasalreadyinplace)aswellashowtopriceit(thereisa

tendencytopricetoohigh).

Therehavealreadybeenseveralattemptstoaddressthisissue.TheNewYorkStaterequirements

explicitlyaddressforceplacedinsurance(hazard,homeowners,orfloodinsurance),anddetailssituations

inwhichitshouldnotbeused.Aservicerisprohibitedfrom(1)placinginsuranceonthemortgaged

propertywhentheinsurerknowsorhasreasontoknowtheborrowerhasaneffectivepolicyforthe

insurance;(2)failingtoprovidewrittennoticetoaborrowerwhentakingactiontoplaceinsurance;and

(3)requiringaborrowertomaintaininsuranceexceedingthereplacementcostofimprovementsonthe

mortgageproperty.

TheStateAttorneysGeneralproposedsettlement(circulatedinMarchofthisyearbutnotyetapproved)

containssimilarprovisionsgoverningtheplacementofforceplacedinsurance.Theservicermustmake

reasonableeffortstocontinueorreestablishtheexistinghomeownerspolicyifthereisalapsein

payment.Theservicermustadvancethepremiumifthereisnoescroworinsufficientescrow.Ifthe

servicercannotmaintaintheborrowersexistingpolicy,itshallpurchaseforceplacedinsurancefora

commerciallyreasonableprice.

However,theAttorneysGeneralproposedsettlementwentonestepfurtherthantheNewYorkState

requirementsitsuggestedtheeliminationoftheconflictofinterestbyprohibitingtheseservicersfrom

placinginsurancewithasubsidiaryoraffiliatedcompanyoranyothercompanyinwhichtheservicerhas

anownershipinterest.

Solution:ForcePlacedInsuranceConflicts.NationalServicingStandardscanbeusedtorequireservicers

tokeepexistinghomeownerspoliciesinplaceaslongaspossible,asboththeNewYorkState

requirementsandtheproposedAttorneysGeneralsettlementdo. Ifitisnotpossibletoreestablishthe

existinghomeownerspolicy,measuresmustbeincludedtomakesurethepricingofthepurchaseis

reasonable.Moreover,followingtheleadoftheAttorneysGeneralsettlement,nationalservicing

standardsshouldprohibittheplacementofforceplacedinsurancewithasubsidiary,affiliatedcompany,

oranyothercompanyinwhichtheservicerhasanownershipinterest.

Solution:DealingwithOtherAncillaryFees. UndertheAttorneysGeneralproposedsettlement,the

servicercannotimposeitsownmarkupsonanythirdpartyfees.Subsidiariesoftheservicer(orother

entitieswheretheservicerorrelatedentityhasaninterestinsuchathirdparty)areprohibitedfrom

collectingthirdpartyfees.Moreover,servicersareprohibitedfromsplittingfees,givingoraccepting

kickbacksorreferralfees,oracceptinganythingofvalueinrelationtothirdpartydefaultorforeclosure

relatedservices.WeatAmherstSecuritiesGroupagreewiththeserecommendations.Theseideasshould

becomeapartofameaningfulsetofnationalservicingstandards.


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8 May 11, 2011

CONFLICT#3:ConflictsofInterestintheGovernanceofaSecuritization,IncludingEnforcement

ofRepresentationsandWarranties

Whiletheenforcementofrepandwarrants(representationsandwarranties)doesnotdirectlyaffect

borrowers,webelieveitisaveryimportanttopicforinvestor,andservestohighlighttheconflicts

betweenservicersandinvestors.

Violationsinvolvingrepsandwarrantsarebecomingincreasinglycommonasseeninrecentlitigation.That

is,loansinasecuritizationoftendonotconformtotherepresentationsmadeaboutthecharacteristicsof

theseloans.Forexample,aloanmayhavebeenrepresentedasanowneroccupiedpropertywheninfact

itisnot;oraborrowerliedaboutincometoadegreethatshouldhavebeenpickedupintheorigination

process;etc.Oncearepandwarrantviolationisdiscovered,atpresentthetrusteeischargedwith

enforcement[theremedyisgenerallythatthesponsorororiginatorrepurchasesthatparticularloanout

ofthepoolatpar(anamountequaltotheoriginalbalanceontheloanlessanypaiddownprincipal)].

However,thetrusteedoesnothavetheinformationtodetecttheviolations,theydonothavedirect

accesstotheloanfiles.Moreover,astheyhavelittleincentivetodetectrepandwarrantviolations,since

thetrusteeisnotcompensatedfordetectingviolationsandthebenefitsofdoingsoactuallyaccrue

elsewhere(totheinvestors).

Servicers(whodohavetheinformationtoidentifyrepandwarrantviolations)oftenhaveafinancial

disincentivetodoso,astheywouldbeputtingtheloanbacktoanaffiliatedentity. Forexample,the

largestbanksoftenserveasoriginators,dealsponsors(underwriters)andservicersonsecuritizations.

Thereisnothingwrongwiththis,aslongasthereisamechanismtoallowforenforcementoftherepsand

warrants.

Solution:ProperlyEnforcingRepsandWarrants.Itiscriticaltohaveapartythatisincentedtoenforce

them,

and

has

both

access

to

the

information

and

enforcement

authority.

This

can

best

be

achieved

throughanindependentthirdpartychargedwithprotectinginvestorrights,whoispaidonanincentive

basis.Somecurrentdealsnominallyhaveathirdpartychargedwithprotectinginvestorrights,butthat

partyisnotempowered,doesnothaveaccesstonecessaryinformation(theloanfiles),andisnotpaidon

anincentivebasis.ThissetofconflictsshouldbeaddressedthePSAs(purchaseandsaleagreements)for

newsecuritizations. NationalServicingStandardsshoulddirectservicerstomakesurethatthereisan

adequateenforcementmechanismforrepsandwarrants.

CONFLICT#4:TheServicingFeeStructureisUnsuitabletoThisEnvironment

Therearemanysituationsinwhichtransferringtheservicingofaloanonwhichtheborroweris

delinquenttoaservicerthatspecializesinlossmitigationwouldbethebestoutcomeforbothborrowers

andinvestors.Anumberofspecialservicershavehadconsiderableexperiencetailoringmodificationsto

theneedsofindividualborrowersandtendtoprovidemorehandholdingtotheborrowerpost

modificationthanwhatamajorservicerisstaffedtoprovide.Consequently,theredefaultrateson

modifiedloansaremuchlowerwithspecializedservicerswhofocusonlossmitigation.


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9 May 11, 2011

Servicingtransferissuesaremadeverydifficult,asmanydealsdonotprovideforadequateservicingfees

toencouragesuchatransfer.Wemadethepointearlierthatservicersarecompensatedtoohighlyfor

servicingcurrentloans,nothighlyenoughforservicingdelinquentloans.Ifcompensationisinadequate,it

willbeverydifficulttoconvinceaspecialservicertoservicetheloan.

Solution:RevamptheServicingFeeStructure.Therehasbeenaconsiderableamountofdiscussionabout

revampingthestructureofservicingfees,toallowforlowerfeesforperformingloansandhigherfeesfor

nonperformingloans.TheFHFAhasorganizedanumberofmeetingstodiscusstheseissues,andhas

outlinedthealternatives.Iffeesweretobealteredsuchthatfeesforservicingcurrentloanswerelowered

whilefeesforservicingdelinquentloanswereraised,itwouldallowthespecialservicertobeadequately

compensatedforhishightouchefforts.This,inturn,wouldmakeitmucheasiertotransferdelinquent

loanstoservicerswhowoulddoabetterjobatlossmitigation.

Therehasbeensomeconcernabouttheincentiveissuesthatwouldarise.Givenhigherservicingfeesfor

servicingnonperformingloans,willservicersbedisincentedtomakeaproactivephonecallwhena

borrowermissesonepayment?Willtheoriginator/affiliatebelessconcernedaboutthequalityofloans

theyoriginate?WethinkthereisaverysimplesolutiontothisgivetheGSEsorprivatelabelinvestors

theabilitytomovetheservicingwhenthehigherfeesarescheduledtotakeeffect.

CONFLICT#5:TransparencyforInvestorsIsWoefullyInadequate.

Manyoftheconflictsareobscuredbyservicersasaresultofthepoorreportingtheyprovideonamonthly

basis.Webelievethatwithmoretransparency,manyoftheseconflictswouldbemorevisibleand

servicerswillbelessinclinedtoactagainsttheinterestsoffirstlienborrowersandinvestors.Inaprivate

labelsecuritizationthereisoftenalargedifferencebetweenthemonthlycashpaymenttheinvestor

expectedtoreceiveandwhatisactuallyreceived.Moreover,aninvestorisunabletodelveintothecash

flowinformationfurther,ashelackstheinformationontheactionsoftheservicerthatwouldbe

necessarytoreconcilethecashflows.WhenIreceivethestatementfrommybankeachmonth,Ibalance

mycheckbook,reconcilingthedifferences.Investorswanttobeabletodoexactlythiswiththecashflows

fromthesecuritizationsinwhichtheyhaveaninterest.Thereareseveralculprits:

Insufficienttransparencyonliquidations.Whenaloanisliquidated,investorsoftenreceiveonlyonenumbertherecoveredamount.Servicersprovidenotransparencyonwhatthehomehasbeensold

for,whatadvancesweremadeontheloan,whattaxesandinsurancewere,whatpropertymaintenance

feeswere,norwhatthecostsofgettingtheborroweroutofthehousewere.Abreakdownofthese

costs/feeswouldhelpinvestorsunderstandseveritynumbersthatweredifferent(oftenmuchhigher!)

thananticipated.Itwouldalsoallowinvestorstobettercomparebehavioracrossservicers,allowingfor

identificationofthemostefficientservicers,andexposingtheunderperformers.

Insufficienttransparencyonserviceradvances.Aservicerusuallyadvancesprincipalandinterestpaymentsondelinquentloans,allowingforapaymenttotheinvestoreveniftheborrowerisnotpaying.

Theseadvancesarerequiredtobemadeaslongastheservicerdeemsthemtoberecoverable.Thereis

oftenlittleinformationonwhichloansarebeingadvancedon,whichmakesitverydifficultforinvestorsto

figureouthowmuchcashtheyshouldexpect.


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10 May 11, 2011

Insufficienttransparencyonmodifications.Similarly,whenaloanismodified,investorsoftencanttellhowthatloanhasbeenmodified.Hastherebeenaninterestratereduction,atermextension,a

principalforbearance,orprincipalforgiveness?Howlongwillanyreducedinterestratebeineffect,and

howwillitreset? Wereanydelinquentpaymentsforgiven? Whilesomeservicersarebetterthanothers

atreportingthisinformation,investorsareoftenforcedtoinfer(guess!)itfromthepayments.

Insufficienttransparencyonprincipalandinterestrecaptures.Whenaservicermodifiesaloan,theservicerisentitledtorecapturetheoutstandingprincipalandinterestadvances.Thoseamounts,payable

totheservicer,havethefirstclaimrightsoncashflowsofthesecuritization.Investorsoftenreceiveless

moneythananticipatedduetotheserecaptures.Thereiscertainlynothingwrongwithservicers

recapturingfundstheyadvanced,butinvestorswanttoknowhowmuchhasbeenrecapturedandfrom

whichloans.

[NOTE: Asanaside,wehaveoftenheardassertionsthatservicershaveanincentivetospeedilymovea

borroweralongintheforeclosureprocess,astheycanrecovertheiradvances.Thatchargehasnever

madeanysensetous.Bymodifyingaloan,servicerscanrecoveradvances.Moreover,bymodifying,the

servicerreceivesbonusesfromtheU.S.governmentfromusingtheHomeAffordableModification

Program(HAMP).Finally,thelongertheprocess,themoreancillaryfeeincomeisgeneratedforthe

servicer.]

Theresultofthelackoftransparencyisthatinvestorscantreconcilethecashflowsonthesecuritization

theyhaveinvestedin.Theydontknowhowmuchisbeingadvanced,whatarethetermsofthe

modificationsonthemodifiedloans,andhowmuchoftheprincipalandinterestadvancestheserviceris

recapturingwhendoingthemodification.

Solution:Transparency. Webelievetheremittancereportsforfuturesecuritizationsshouldcontainloan

byloaninformation,andthatloanbyloaninformationshouldberolledupintoaplainEnglish

reconciliation.Nationalservicingstandardsshouldencouragethistransparency.

CONCLUSION

Insummary,wehavediscussed5conflictsofinterestbetweenservicersandborrowers/investors.They

involvethefollowing:

(1) servicersoftenownjuniorinterestsindealstheyservice,butinwhichtheydonotownthefirstliens

(2) theserviceroftenownsashareincompanieswhichcanbebilledforancillaryservicesduringtheforeclosureprocess,andchargesabovemarketratesontheseservices

(3) thereareconflictsofinterestinthegovernanceofthesecuritization,includingtheenforcementofrepandwarrantissues

(4) servicingtransferscanbeproblematicduetoamisalignedservicercompensationstructure(5) transparencyforinvestorsismissing


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11 May 11, 2011

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