Servicers and Securitization
Monday 02/24/14     Stocks continued higher last week seemingly unaffected by deteriorating economic news. However, the Markit flash PMI provided a glimmer of hope that perhaps this bad economic news, particularly in manufacturing, is due to the weather. Last week I wrote about how rising natural gas prices, due to increased demand, may be putting pressure on the recovery in manufacturing. Therefore, a strong PMI in spite of higher natural gas prices would be even more encouraging. Unlike the strong PMI numbers, data relating to housing and the housing recovery was weak across the board, this has been the case since interest rates began rising in June on speculation of Fed tapering. In the next series of posts I will review the housing collapse, recovery, and why it may be losing steam.
Securitization & Servicers
One issue that doesn't get enough attention was the role that loan modifications (or lacktherof) played in the housing crisis. In a old fashioned mortgage, the borrower receives a loan from the bank and then sends a payment to the bank for principal and interest. If the borrower becomes unable to make their payments, the bank has the option to either default on the loan or modify the loan by either reducing the principal owed or by extending the term and reducing the payments. Since it would cost the bank a lot of time and money to foreclose and resell the home they would be more inclined to work with the borrower to modify the loan. So why didn't this happen during the housing crisis? The answer lies in the way that mortgages are packaged and serviced.
In most cases, mortgages made by a bank are immediately sold and packaged into a mortgage backed security. A mortgage backed security is basically the same thing as a bond except that it is backed by payments from mortgages. Since the owners of mortgage backed securities are wide ranging, it makes sense to have a servicer, or some institution that collects the payments and handles the clerical work such as processing payments, assessing late fees, etc. In return for their work, servicers are paid a fee, but the way that they are compensated creates a problem. A monthly servicing fee is calculated based on the unpaid principal balance of the loan. Servicers also collect fees charged to borrowers who are behind on payments or are in default. This payment structure creates a perverse set of incentives for servicers. Since servicers are paid based on the principal amount of the loan, why would they ever push for a modification that reduces the principal? What's worse is that they can collect additional late fees from customers who are behind on payments, so they will pile these onto struggling borrowers as much as possible prior to foreclosing. The administrative costs of doing a modification will reduce profitability for the servicer, while a foreclosure is much cheaper.
Mortgage servicers have been the natural byproduct of securitization. Securitization also created a strange set of incentives for the owners of mortgage backed securities. There are different tranches of mortgage backed securities holders. Some holders are higher up in the credit structure which means that losses from foreclosures will have no impact on the senior tranches, but a major impact on the lower tranches, whereas a modification will spread the risk more evenly across the tranches. The senior tranches were generally held by larger institutions with more money and influence. As a result, there were surprisingly few modifications whereas a modification would have been the obvious decision in a traditional banking relationship.
These incentives led to a rapid decline in the mortgage market. Servicers foreclosed and were met with little resistance from the senior holders of mortgage backed securities. Regulators like former FDIC chair Sheila Bair tried to pressure servicers to modify the loans, but the incentives were so skewed at the time that she was not very successful in this endeavor. This led to a glut of foreclosed properties which lowered the value of homes and made future modifications even more improbable. This feedback loop also led many homeowners to just give up and walk away from their mortgages.
Some new laws have been written to address these maligned interests, but much of the same conflicts still exist. Securitization is not neccesarily a bad thing, but there are definite cons that still need to be worked out. While the short term incentives may seem to benefit the servicers and senior mortgage backed securities holders, the long term negative consequences clearly outweigh the short term gains. These incentives need to be addressed or else this same feedback loop will reemerge the next time that there is a major decline in housing. This article in the New York Times shows that much of the same incentives are still at work.
In the next post, we will look at how a new type of investor has helped drive the housing recovery.