Tuesday, December 4, 2007

Subprime Borrower: No Mod for You! Part III

Parts I and II of this series have discussed the logistical and borrower related impediments to making Paulsen’s subprime modification plan work. This installment discusses the issues on the lender side.

To keep it simple for now, let's forget that the lenders on these deals are not single entities, they are multiple-personality schizophrenics consisting of servicers, subordinate tranche holders, senior tranche holders, and sometimes insurers. Let's also forget that even if these lender components wanted to behave rationally they are tied together in a web of contracts and fiduciary responsibilities that their respective legal counsels will not lightly bl0w off. Ignoring all this complexity, most commentary seems to assume that on the lender side a modification will result in a better recovery than a foreclosure. That's a pretty big assumption.

Certainly it does not take much imagination to envision how lenders foreclosing on houses dump supply on an already distressed market, creating a downward spiral in prices which contribute to more foreclosures. Yes, the way to avoid the spiral is to stop foreclosures through modifications. But, whether or not your losses are minimized by modifications depends on market conditions when the modification ends and what happens to your borrower in the meantime. If prices are even lower at the end of the modification or your borrower defaults during the term of your modification before prices have recovered you will be worse off than if you had foreclosed immediately. This is a real possibility, and if we actually slide into a recession I would argue it's a probability over the next 3 to 5 years.

As Yogi Berra (may have) said, "It's tough to make predictions, especially about the future." Jim Cramer's second investment commandment is "Your first loss is your best loss" (not an original idea of Jim's). Many lenders firmly believe this is true, and that's why in previous real estate recessions you saw lenders selling pools of debt at large discounts to bottom feeders willing to work through individual deals to maximize value. Some of the parties that need to buy into the plan on the lender side to make it work will have this philosophy and won't play ball.