Why Lenders Don’t Modify Loans

Economists at the Federal Reserve Bank of Boston and Atlanta have researched "Why Don’t Lenders Renegotiate More Home Mortgages?". Their conclusion also applies to commercial real estate:

We argue for a very mundane explanation: lenders expect to recover more from foreclosure than from a modified loan. This may seem surprising, given the large losses lenders typically incur in foreclosure, which include both the difference between the value of the loan and the collateral, and the substantial legal expenses associated with the conveyance. The problem is that renegotiation exposes lenders to two types of risks that can dramatically increase its cost. The first is what we will call “self-cure” risk. As we mentioned above, more than 30 percent of seriously delinquent orrowers “cure” without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted. The second cost comes from borrowers who redefault; our results show that a large fraction of borrowers who receive modifications end up back in serious delinquency within six months. For them, the lender has simply postponed foreclosure; in a world with rapidly falling house prices, the lender will now recover even less in foreclosure. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain the house or may even contribute to its deterioration, again reducing the expected recovery by the lender.

Adam Levitin at Credit Slips has an excellent follow up post, and makes the point that modifications make sense even after taking into account self cure risk and redefault risk. He also nails the real reason more modifications aren’t being done:

I think servicer capacity is a major concern that applies across the board.  To start with the bulk of servicer personnel at most companies aren't even in the US; they've been outsourced.  Doing a mod is like underwriting a new loan in a distressed situation.  That's a skill, and I don't think it's what servicers were looking for over the past decade when they moved operations to India. Instead, they were looking for low-cost labor for their routine ministerial tasks, and it will take a long time for the industry to acquire the workout talent it needs.

I highly recommend reading both of these pieces – together they will give you a better understanding of modification dynamics than anything else I’ve seen written over the past 3 years.

Mortgage Modification Blues

The New York Times article "Paper Avalanche Buries Plan to Stem Foreclosures" documents the logistical nightmare of processing single family mortgage modifications. An excerpt:

A note in the system shows that the bank confirmed receiving documents on April 29 — pay stubs, tax returns, a letter disclosing her hardship, bank statements. Since then, the company has been waiting for WaMu to review the file.

But when Mr. Lavi calls, a representative coolly discloses that the application has been rejected because one document, a proof-of-insurance form, is missing. He must start over.

“The file had been submitted properly, and you didn’t put the pieces together,” Mr. Lavi says, his body quivering with anger. “I’m not going to stand in line again for another six months.”

He demands to speak to a supervisor, but the representative says none is free. He hangs up and redials, hoping to land in a different call center. Eventually, he reaches Chase’s executive offices, where Becky takes over the call.

“We’re not taking cases now,” she says calmly.

“Why was I transferred to you?” Mr. Lavi asks. Becky does not know. He implores her to keep the file open while he faxes in the lone missing document.

“Impossible,” she says, warning of “the sheer amount of papers coming in.”

So, to get a modification on a WAMU (now Chase) loan, you need pay stubs, tax returns, and bank statements? Contrast that with the process of getting the loan in the first place, as reported in the New York Times piece, “Saying Yes, WAMU Built Empire on Shaky Loans.” An excerpt:

As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers’. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.

Proper underwriting (of new loans and modifications) is labor intensive. Most servicers never had the proper underwriting infrastructure in place to originate the loans, and they certainly don’t have it now that those deals need modifications.

More at my post, “Why Did WAMU Abandon Underwriting Standards?”

Workout Strategies: “The Boss has Lost It!”

Suppose you were the only wealthy member of a very large extended family. A kidnapper takes a niece – would you pay the ransom? Of course you would. The next week the kidnapper takes a nephew, and you pay again. The third week a cousin is taken, and you realize as wealthy as you are, you can’t pay for everyone’s return. How do you break this cycle?

For lenders, loan modifications are like this. If you go strictly by the numbers, a lender will almost always lose more from foreclosing on a property than by modifying the loan. Going strictly by the numbers, however, is a slippery slope for lenders, because if borrowers believe you will always modify, you will end up modifying every loan. How do you deter the threat of default if borrowers believe you will always modify the loan to avoid a default?

One strategy is to act crazy. Ethan Bronner believes this was the strategy Israel adopted in it’s assault on targets in Gaza in December, 2008 and January, 2009. From his January 18, 2009 New York Times article, “Parsing Gains of Gaza War”:

The Israeli theory of what it tried to do here is summed up in a Hebrew phrase heard across Israel and throughout the military in the past weeks: “baal habayit hishtageya,” or “the boss has lost it.” It evokes the image of a madman who cannot be controlled.

“This phrase means that if our civilians are attacked by you, we are not going to respond in proportion but will use all means we have to cause you such damage that you will think twice in the future,” said Giora Eiland, a former national security adviser.

I would be surprised if any lender had an explicit policy to file irrational foreclosures or seeks deficiency judgments solely as a deterrent to other borrowers. But, modifications are generally the exception and not the rule, and the signal an action sends to other borrowers is always a consideration.

Loan Paydowns from the Borrower’s Perspective

I previously posted comparing CRE underwriting in 2006 and today (bottom line, even if your project income is unchanged, loans are 15-20% smaller, mostly because cap rates have increased). Suppose you have one of those 2006 loans and it’s maturing. What should you do? A look at the numbers reveals borrowers are much better off if they can negotiate an extension.

Here’s an example drawn from an actual deal done in 2006. The original underwriting and today’s underwriting is summarized in the table below:

Key points to note:

• The value of the property is a little less than the current loan as a result of the NOI decrease and the higher cap rate. In other words, the original $2.2M cash invested is gone.
• The property now supports a loan of only $4.5M. In other words, to refinance the current loan, the borrower will have to put in an additional $1,551,328. The new debt and borrower cash investment total $8.2M on a property worth $6M.

Now, there are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). We know these biases exist, and their existence helps explain why borrowers continue to perform on loans when it makes economic sense to walk away. However, when it comes to writing seven figure checks, people get rational in a hurry. We are not going to see many people contributing large amounts of money to refinance properties which do not have equity.

So, what are the borrower’s options? One is to walk away from the original $2.2M investment and default on the loan. That would make sense if the borrower sees no possibility of a value recovery on the horizon. However, almost all borrowers do foresee a recovery, want to stay in the game, and will request an extension of the loan. The most common requests are an extension at the existing contract rate, or an extension at the current market rate. The table below summarizes the economics of those scenarios, plus a third option:

Note that although nothing solves the value problem (it takes higher NOI and/or lower cap rates to do that), there is cash flow under each scenario which is a reason for the borrower to stay with the game. To make an extension more attractive to the lender, the borrower could offer to apply some or all of that cash flow to pay down the loan, or sweep it into a reserve account as a hedge against further declines in NOI.

The third scenario (Till) represents how the loan could be restructured in a bankruptcy (for more on Till, Lee, et ux. v. SCS Credit Corp, see my post Getting Tilled: How a $6,425 Truck Loan May Decide the Fate of General Growth Properties). Since this is clearly the worst case for the lender, you might think lenders would avoid the risk and extend loans without a lot of argument. I identify some of the reasons lenders may fight it out in the post What Should Lenders Do With Maturing CRE Loans?

What Should Lenders Do With Maturing CRE Loans?

We’ve had some conversation in the comment thread on this post about what lenders should do with maturing loans. Today I will attempt to address that question in more detail, starting out with what I would do if it were my money, and moving on to some of the reasons lenders adopt different strategies.

Foreclose on properties the borrower is driving into the ground. At this point in the cycle there is no point in giving an extension or modification to a borrower who is taking actions (or inaction) which is hurting the value of the collateral. A recovery is not imminent, and if a borrower is deferring maintenance or is ineffective at leasing the property, an extension will just result in a bigger loss down the road. This situation can come about for a variety of reasons, and often  the borrower is not the villain. Usually, it’s because a borrower is under severe financial pressure on other deals, or lacks the experience to deal with difficult market conditions.

Foreclose on properties when the submarket is in a downward spiral. No matter how good a borrower is at property operations, it is very, very difficult to compete when you owe $100,000 a unit on a property and the building next door has gone through a foreclosure and the owner next door only owes $50,000 a unit, because the new owner can substantially undercut your rents and still get a good return. For an example with numbers that shows how this works, see my post CRE Loans and the Death Spiral of Doom. If your property is in a submarket with multiple foreclosures in process you will probably minimize your loss by foreclosing too.

Extend loans which have experienced, solvent borrowers in relatively stable submarkets when the property can pay a reasonable interest rate. You want an experienced borrower who is not tapped out because fundamentals will probably get worse before they get better, and you want someone who can make the right decisions and kick in some cash if necessary. You don’t want to be in a downward spiral submarket for the reasons discussed in the paragraph above. To keep the borrower motivated, you need to offer an extension long enough to get through this part of the cycle (2 years minimum, 3 or 4 more likely). A reasonable interest rate is hard to define in this market, but I think the best structure is a floating rate deal around 3% over your cost of funds, which, if you’re a bank, will probably result in a rate of 4% to 5%. I would keep the structure interest only, but require 50% of any excess cash flow to go into a reserve account to cover operating deficits, capital costs, and perhaps pay down principal if the reserve account reaches a threshold level (maybe 5% of the loan amount). This structure gives you a reasonable return, gives the borrower an incentive to maximize cash flow, and gives you both a piggybank to draw from if conditions continue to deteriorate.

These are the strategies which I think would give you the best recovery on individual deals. However, not all banks and investors pursue them, for a variety of reasons.

The lender or investor wants out of the asset class. Right now banks and institutional investors pay a price in their market value and ability to attract new investors if they have heavy CRE exposure. There is a lot of value created if you can say a problem is behind you. To create this value, the lender sells notes or forecloses on deals for less than they might realize with a hold strategy.

Regulatory Direction. Many banks are under pressure to reduce their CRE exposure. An REO may create a loss, but at least the asset is gone. A modified loan, on the other hand, will be reviewed by examiners every time.

Your First Loss is Your Best Loss. Many lenders follow this strategy on all loans until it is clear a recovery is underway (more detail here).

Avoiding Second-Guessing. Many modifications don’t work out (see this post on single family modification failures; in my experience the CRE modification failure rate is even higher). If you modify the loan and end up taking the property back anyway it’s probably because conditions have continue to deteriorate and you will recover less than you would have if you had foreclosed to begin with. It’s easy to quantify that loss, and it looks like poor judgment. On the other hand, if you foreclose, no one will quantify how much you could have saved by modifying the loan.

Pooling and Servicing Agreement constraints. If the loan is a CMBS loan, the servicing of the loan is governed by a Pooling and Servicing Agreement. Generally, in a maturity default the special servicer is charged with maximizing recovery for all investors. Although this could mean doing a long term extension at a lower interest rate, given that there’s an excellent chance the investors that actually own the loan may want out of the asset class or believe in the “first loss is the best loss” strategy, a special servicer is vulnerable to second guessing. Foreclosure is a safer strategy. Thompson Hine has a good summary of CMBS modification and extension procedures here.

Dual Track Costs. Many lenders will not begin negotiation until there is an actual or imminent default. This may be a function of a Pooling and Servicing Agreement, or the lender could just be hoping the borrower will find a way to pay the loan off. Once a default happens, many lenders will start the foreclosure while negotiating an extension so no time is lost if an agreement is not reached. This adds costs, and frequently at least some payments are not made because the borrower is also not sure an agreement will be reached. As a result, to close the extension frequently a substantial amount of money needs to be paid, and borrowers sometimes decide to walk at that point.

Workload. Modifications are enormously time consuming. The deal needs to be negotiated, approved, and documented, and frequently multiple rounds occur. A complex deal can be a full time job for an asset manager for months. It is much simpler from an asset manager point of view to foreclose. If the justification for a modification looks marginal or the borrower is difficult, this factor can swing the recommendation to foreclosure.

Given all these hurdles, it’s not surprising few long term extensions are done. If an extension is offered, it’s usually short term (90 to 180 days) and predicated on progress being made towards marketing or refinancing the property.

Americans On the Edge: Income Curtailment, Foreclosures, and Modification Redefaults

One of my earliest posts talked about the root cause of most loan defaults; household income curtailment, typically the result of a job loss, illness, or divorce. Subsequently I’ve posted on the interplay between income curtailment and home values, and the use of home equity as a piggybank when income is curtailed and how the decline in home equity has eliminated this safety net. I’ve also talked about the role income curtailment plays when borrowers who have received loan modifications default again.

So how close to the edge are American households? Way too close. From Housing Wire:

Want a stunning figure? Half of Americans now say they are only one month or less away from not being able to meet their financial obligations if they were to lose their job — just two paychecks or less. And of these, more than half — 28 percent of all Americans — say they could not survive financially for more than two weeks without their current job.

This disturbing data comes courtesy of the 2009 MetLife Study of the American Dream, released Monday, which looks at how the financial crisis has affected the American Dream and consumer perceptions. It’s all the more disturbing considering that unemployment in the U.S. has already surged to 8.1 percent, with 651,000 jobs lost last month alone.

Is it any wonder a large percentage of borrowers receiving loan modifications subsequently redefault?

More on Loan Modifications and Moral Hazard

I’ve previously argued that moral hazard risks are overrated for a number of reasons (see this post). Niall Ferguson has a piece in the Australian which identifies another really good reason not to worry too much about moral hazard in the context of granting loan modifications. You need to evaluate how often a similar set of circumstances is likely to occur, and if a reoccurrence is unlikely, moral hazard risk is low. An excerpt:

The second step we need to take is a generalised conversion of American mortgages to lower interest rates and longer maturities…Another objection to such a procedure is that it would reward the imprudent. But moral hazard only really matters if bad behaviour is likely to be repeated. I do not foresee anyone asking for, or being given, an option adjustable-rate mortgage for many, many years.

Literally Underwater Property, Workouts, and Maintenance

You can temporarily fix almost any plumbing link with an inner tube and two hose clamps. Cut a strip of rubber long enough to cover the leak and wide enough to wrap around the pipe. Orient the long edge of the patch opposite the leak and clamp on either side of the leak. Here’s how it should look:

I know this from inspecting the aftermath of a ceiling collapse in an apartment building we had foreclosed on. The water lines were corroded, the borrower was strapped for cash, and rather than replumbing, the borrower simply slapped another patch on every section of pipe which sprang a leak. By the time we took the property back there were more patches than there was visible pipe. The cost to repair the water damage was double what it would have cost for us to advance the funds to replace the water lines.

Most of the concern expressed over underwater properties (i.e., properties whose value is exceeded by the mortgage debt) is that the borrowers have become “mortgage slaves” (see, for example, this Calculated Risk post). But, the situation has risks for the lender too. If a property is under water (i.e., the borrower has no equity), what incentive does the borrower have to maintain it? If all the cash flow from a rental property is taken for debt service, what happens when the roof starts to leak?

A frequent mistake lenders make in trying to restructure debt is to leave no incentive for the borrower to maintain the property. Best practices are to allocate enough cash flow to a controlled capital account so funds are available for repairs, and to structure some up side for the borrower if the property value improves. In the short term this results in less cash flow and a larger loss for the lender, but preserving the collateral value generally results in a higher ultimate recovery.

Workouts 101: Loan Modifications and Interest Accrual

In a previous post, I discussed when a loss has to be recognized on a modified loan. A related question which recently came up on Bronte Capital is, when can interest on a modified loan be recognized, and when is the loan no longer considered a non-performing asset?

The answer, as you would expect, is a fairly involved accounting issue, but the short answer is there needs to be a credible evaluation the payments can be made, and a sustained period (minimum of six months) where the payments were made.  The source is the FFIEC: Reports of Condition and Income Instructions Glossary Pages A-59 to A62. In part:

A loan or other debt instrument that has been formally restructured so as to be reasonably assured of repayment and of performance according to its modified terms need not be maintained in nonaccrual status, provided the restructuring and any charge-off taken on the asset are supported by a current, well documented credit evaluation of the borrower's financial condition and prospects for repayment under the revised terms. Otherwise, the restructured asset must remain in nonaccrual status. The evaluation must include consideration of the borrower's sustained historical repayment performance for a reasonable period prior to the date on which the loan or other debt instrument is returned to accrual status. A sustained period of repayment performance generally would be a minimum of six months and would involve payments of cash or cash equivalents. (In returning the asset to accrual status, sustained historical repayment performance for a reasonable time prior to the restructuring may be taken into account.) Such a restructuring must improve the collectability of the loan or other debt instrument in accordance with a reasonable repayment schedule and does not relieve the bank from the responsibility to promptly charge off all identified losses.

Workouts 101: Loan Modifications and Loss Recognition

Comments on some recent posts dealing with loan modifications suggest some people believe lenders can avoid recognizing losses by modifying loans (see Naked Capitalism "Cramdown and Future Mortgage Credit Costs", Mr. Mortgage "WAMU's New $1 Million 5-Year 1% Balloon Loan Mod", Credit Slips "Cramdown and Future Mortgage Credit Costs: Evidence and Theory") .

This is not the case.

The operative question is whether or not the modification constitutes a Troubled Debt Restructure (“TDR”). From a Center for Audit Quality guidance on the Application of FASB Statement 114:

3) How should an entity determine if a modification of the terms of a residential mortgage loan would be considered a troubled debt restructuring under Statement 15?
In accordance with paragraph 2 of Statement 15, “a restructuring of a debt constitutes a troubled debt restructuring … if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.”

This covers virtually all material modifications (certainly substantial interest rate reductions or bankruptcy cramdown modifications).

If a loan is a TDR:

Statement 114 provides guidance on how an entity should measure impairment. Specifically, paragraph 13 of Statement 114 states: “…a creditor shall measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical
expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. … The creditor may choose a measurement method on a loan-by-loan basis. A creditor shall consider estimated costs to sell, on a discounted basis, in the measure of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan.”

All of which is to say the loan needs to be marked to market. So, while a modification may postpone the actual cash loss on a deal, on the financial statements the loss needs to be recognized at the time of the modification.

Is it possible a lender could use overly optimistic cash flow assumptions to defer and/or minimize losses? Absolutely, but examiners are sensitive to this possibility, and TDRs get a lot of scrutiny during exams.

Crowe Horwath provides a good general overview of TDRs here.

Single versus Multi-Asset Borrowers

One of the most irritating workouts I’ve participated in happened in Los Angeles in 1992 while I was Assistant Director of Special Assets at Home Savings (then the country’s largest S&L). Irritating, because the problem was largely self-inflicted.

We had made 17 loans secured by apartment buildings to Shashikant Jogani. At the time, Shashi was one of the largest apartment owners in Southern California. From a later court filing:

In 1979, plaintiff Shashikant Jogani (who prefers to be called Shashi on appeal) began investing in residential apartment properties in and around Los Angeles County. By 1989, he owned properties having a fair market value of $375 million and a net equity of $100 million. Because of an economic recession that started in the late 1980’s and continued into the mid-1990’s, Shashi faced defaults and foreclosures on valuable properties.

We knew some of our deals with Shashi were struggling, but we thought most of the loans would weather the storm. However, Shashi and his advisors asked for a meeting and presented an ultimatum – modifications to all his deals, or he would file bankruptcy.

At that point in the recession we were well acquainted with bankruptcy proceedings; in fact, sometimes we required borrowers to file bankruptcy to confirm our workout plan so if there was a subsequent default we wouldn’t have to go through an adversarial bankruptcy filing then. So, the threat of a bankruptcy filing ordinarily was not something that concerned us. Shashi’s case was a different, because he held almost all of his properties as an individual. A bankruptcy filing would not just involve our 17 properties, it would involve more than 50 properties and more than a dozen lenders. It would be a procedural nightmare, and there was a good chance our properties which had equity would end up supporting other lenders’ problem properties. Shashi of course knew this, and used it as leverage to negotiate with all his lenders.

We ended up agreeing to split the properties into three groups. For the most severely troubled properties Shashi stipulated to the appointment of a receiver and did not oppose our foreclosures. The marginal properties got substantial modifications (a significant reduction in interest rate for an extended period). For the properties which were performing adequately we agreed to an interest only period and allowed the excess cash flow to support Shashi’s other deals. And, we required Shashi to form separate legal entities for the properties which received modifications and transfer ownership to those entities so if the modifications didn’t work out we would not be facing the same nightmare again. As it turned out that requirement was a good idea, because Shashi subsequently defaulted on the marginal group.

Most lenders require a single asset borrowing entity to avoid these kind of entanglements. However, this ownership structure can protect owners too. The Pierce County Housing Authority recently learned this lesson; lawsuits related to mold at one of its apartment complexes put the entire Authority into bankruptcy a few months ago. From the Tacoma News Tribune:

 

The Pierce County Housing Authority prefers to declare bankruptcy rather than fight multiple lawsuits over a mold-ridden apartment complex in Puyallup.

 

The agency’s six-member board of commissioners voted Monday to take the step. If approved, bankruptcy protection would prevent 81 current and former residents from collecting damages they say they suffered from mold at Eagle’s Watch, a 193-unit complex on South Hill.

 

Charlie Gray, deputy director of the Housing Authority, said Wednesday that bankruptcy is the only way the agency can continue to operate and provide affordable housing for about 8,000 clients throughout the county

 

…[The Housing Authority] owns 1,123 apartment units in 13 complexes throughout the county, along with 134 homes.

Had Eagle’s Watch been owned by a single asset entity, it’s likely damages would have only attached to that single asset.

Isolating ownership of multifamily projects makes sense for both owners and lenders.

Loan Modification Menu

There are a lot of different ways to modify a mortgage. Here are a few:

Delinquent Payments	Repay over a fixed period (e.g., 6 months, 12 months)
	Accrue to principal, payable at balloon
	Forgive the delinquent payments
Late Charges	Repay over a fixed period (e.g., 6 months, 12 months)
	Accrue to principal, payable at balloon
	Forgive the late charges
Amortization	Waive amortization (i.e., interest only) for a period
	Recast loan over remaining term or amortization period after delinquent payments/and/or late charges are accrued or after an interest only or reduced payment rate period
Interest Rate/Payment Rate	Reduce payment rate for a period, continue to accrue at note interest rate
	Reduce interest rate for a period
	Reduce payment and/or interest rate, capture all or a portion of net cash flow on an income property
Principal	Forgive a portion of the principal balance
	Bifurcate loan – reduce the principal balance on a first lien, the reduction amount becomes a subordinate lien due on sale or default (subordinate piece may or may not accrue interest or require payments)

These options can be used in various combinations, so there are quite a few possibilities.

Majority Opposes Using Bailout Funds to Help Defaulting Homeowners

Housing Wire picked up a press release summarizing a survey performed for Reecon Advisors, Inc., which states, “a majority of Americans, 51 percent, opposes using Federal bailout funds to help pay the mortgages of homeowners who are in default. Forty-three percent of those surveyed favor helping homeowners in trouble.”

Although the release has a lot of information about the margin of error, etc., I couldn’t find anywhere what the exact survey questions were. If the release accurately represents the survey responses, I have to think the word “bailout” might has some influence on the results.

The answer to the question will also vary with the kind of borrower the person who answers the question is thinking of at the time. Here is a list of considerations from one of my earlier posts:

Modest housing versus luxury housing. Some believe people who got in trouble buying high end housing should not be helped.
Long term owner versus recent owner. Some argue recent purchasers who bought at the top should take their lumps.
Owner occupied versus investor/speculator. Some argue investors and speculators should not be bailed out.
Limited opportunity for recovery versus good future prospects. Some argue those who are in a position to start over should not be helped.
Loan funds used for necessities/productive purposes versus loan funds used for frivolous purposes. Some argue people who bought big screen TVs and new pickups with their home equity lines do not deserve help.
Limited capacity and/or duped versus knowledgeable and/or complicit. Some argue those who knew or should have known the risks of the loan they were entering into should not be helped.
Unable to make contractual payments versus able to make contractual payments. Some argue those who are able to make their contractual payments should not receive relief.
Able to make modified payments versus unable to make modified payments. Some argue to receive a modification ability to succeed under the modification should be demonstrated.
No housing alternatives versus those with housing alternatives. Some argue those who have housing alternatives after foreclosure (e.g., move back in with Mom and Dad) should not be helped.

I would like to think the majority of Americans are not opposed to federal help for a low income, elderly, long term owner of a modest home who was duped into a subprime loan used to repair the roof and who could afford a loan at a reasonable rates.

The release is correct in stating that public opinion will play an important role in determining what assistance, if any, homeowners will receive. I think the process would be better served if future surveys delved a little deeper into how the public views the issue.

Redefaults on Modifications: History Repeats Itself

The 50%+ redefault rate on loan modifications in this downturn continues to make news (most recently Naked Capitalism and Housing Wire). In Crabgrass Frontier: The Suburbanization of the United States Kenneth Jackson writes about the Home Owners Loan Corporation (HOLC), a loan program signed into law by FDR on June 13, 1933. This program provided a lot of assistance:

Between July 1933 and June 1935 alone, the HOLC supplied more than $3 billion for over one million mortgages, or loans for one-tenth of all owner occupied, non-farm residences in the United States.

$3B was a lot of money back then. To put it in perspective, it represented about 2.5% of the GDP for 1933 and 1934. An equivalent amount would be about $677 billion today. In the 2nd quarter of 2008 there were roughly 75,715,000 owner occupied housing units in the US, so a program similar in scope today would be about 7.5 million mortgages. This is a pretty good sized sample.

How did things go? Again, from Jackson:

…in some states over 40% of all HOLC loans were foreclosed even after refinancing.

I wrote about why this happens here.

Loan Modifications Don’t Get Done: History Repeats Itself

HUD’s Hope for Homeowners modification program has been a dismal failure, with only 312 applications since October (vs. a target of 400,000 over three years, more details at Calculated Risk and Market Movers).

I’ve previously written about how difficult it is to do modifications on a large scale; the logistics are difficult, and borrowers are often not inclined to participate.

Unsuccessful government housing programs during downturns are not new phenomena. From Crabgrass Frontier: The Suburbanization of the United States by Kenneth Jackson:

On July 22, 1932 the President affixed his signature to the Federal Home Loan Bank Act (Public Law 304) to establish a credit reserve for mortgage lenders and thus to increase the supply of capital to the market…within the first two years of the law’s operation, 41,000 applications for direct loans were made to the banks by individual homeowners. Exactly three were approved.

A plug for this book – it is a fascinating account of housing in the United States. The link is to the 1987 edition, but it looks like there is a new edition pending which I am looking forward to.

Home Equity and Income Curtailments

The stereotype is the grasshopper home owner refinances or takes out a home equity line to buy that new big screen TV. No doubt to a certain extent that happens, but (via Economist's View) research shows:

..."In the early years of this century we saw a form of self-administered welfare payment develop where home-owners cash in on their homes, in boom times: to support children, smooth over a fall in income, or meet the costs of relationship breakdown." ...

I’ve previously talked about how income curtailment is usually the initial trigger for home defaults. This research suggests income curtailments were managed at least in part by drawing on home equity, but once that’s gone (or no longer available) defaults are more likely to occur. Lack of equity is also a factor in why workouts often don’t work; once the equity cushion is gone any income hiccup creates a new problem (more on that here).

The Problem with Interest Only

There are a lot of CMBS interest only loans out there. Deal Junkie cites some numbers from REIT Wrecks:

Scheduled maturities of fixed-rate CMBS debt reach peaks of $98 billion in 2015, $128 billion in 2016 and $127 billion in 2017. 65% to 85% of those loans are interest-only for the entire or partial term. As for the near future, 80% of the loans maturing in 2008 and 2009 have been amortizing over the full term, significantly bettering the odds that these loans can be refinanced.

I’m not a big fan of interest only for reasons discussed below, but I think the focus on the higher refinance risk of IO loans is misplaced. To make my point, let’s look at what happens on a typical deal with a 10 year term and a 3 year interest only period. Here is the math:

The first thing to notice is the IO payment is 19% lower than the 30 year P&I payment. Obviously, a lower payment could be used to justify a higher loan amount, but to my knowledge in the CRE world people underwrote on the fully amortizing payment (this was apparently not true in the residential mortgage world). With CRE, the goal of the IO structure was to increase cash flow during the early years of the deal which resulted in a higher IRR for the borrower, and not to obtain a larger loan amount.

Next, notice in year 3 when amortization kicks in, the payment increases to 4% more than what the payment would have been under the 30 year amortization deal (because the loan has to fully amortize over 27 years instead of 30). 4% is not a big increase – it’s reasonable to expect operations would improve enough over a 3 year period to handle that (and, it was fairly common for lenders to agree to use a 30 year schedule at the end of year 3 anyway, so there would be no increase at all over what the payment would have been had it amortized from the beginning). The new payment amount is 29% higher than the IO payment was, but again that shouldn’t make a difference because the deal was originally underwritten assuming the amortizing payment. Here is a chart showing how the payments change:

(click to enlarge in a new window)

As long as the loan was underwritten to the fully amortizing payment to start with, the impact of the IO structure on payments is minimal.

What about refinance risk? The UPB on an IO loan will be higher than a loan which amortized from the beginning, but in the grand scheme of things there is not that big a difference. Here is a chart of the outstanding UPB of a 30 year amortization loan and a 3 year IO loan over the first 7 years:

(click to enlarge in a new window)

There is not a huge difference. Via The Big Picture, the NYT has a great training video from World Savings showing a loan broker explaining to a borrower what an idiot she is to worry about amortization:

(click the NYT link and scroll down to view the video). The irony is, he’s right; what happens to the market during the loan term is much, much more important than the amortization.

So why don’t I like IO loans? My concern is a tactical one, and relates to what happens if there’s a downturn during the IO period (like now, for example). When cash flow starts to approach breakeven owners get more attentive to their properties, and I believe that 19% payment difference between IO and amortizing payments results in IO borrowers being less focused during slowdowns. Also, if things get really bad one of the easiest modifications to do is to go IO for a while; there’s no loss to the lender, and the deferred principal is recouped at the balloon. If the deal is already IO, you don’t have that tool.

WORKOUTS 101 – Where Will the Money Come From? Where Will It Go? Down the Legal Black Hole?

When an income property loan gets into trouble, you need to take a few minutes and realistically assess the sources of funds for the deal and how they should be used.

Potential Sources of Funds

• Income from the property (NOI)
• The property itself, i.e., you foreclose upon or take a deed in lieu of foreclosure on your collateral
• The sponsor's outside resources (any cash or property the sponsor might contribute which is not your collateral)

Potential Uses for Funds

• Your debt (principal, interest)
• The property itself (operations, capital requirements)
• Your attorneys and third party foreclosure costs
• The sponsor's attorneys
• The sponsor's outside obligations (other properties, living expenses, etc.)

Eventually I will discuss each source and use in more detail, but for now here are the two most common mistakes lenders make:

Starving the Collateral. If the sponsor is asking for a workout, the property has probably been on the slippery slope to default for some time. If you end up taking back the collateral, your recovery is going to be even worse if the property continues spiraling down. Spending pennies on the property during the workout period will save dollars in the end.

Over Reliance on Attorneys. Lenders tend to forget that money spent on attorneys does not get spent paying their debt and/or stabilizing their collateral. To the extent you minimize legal involvement, there is more money available for you. This is not to say attorneys shouldn’t have a role – they do. You need the attentive participation of an experienced attorney when:

• You are an inexperienced workout person and you do not have full access to someone who is (e.g., a supervisor). In my opinion if you have not been directly involved in 50+ workouts you are not experienced. Pick your own number, but be aware people are generally overconfident of their own abilities.
• You are absolutely certain you will recover every nickel of what you're owed plus costs. In this circumstance, it doesn't matter how much you spend, so litigate away. If you think this guideline fits your case you are almost certainly not experienced and should be hiring an attorney anyway.
• You are too busy to focus on the deal; go ahead and outsource at $200 an hour if your organization is too stupid to staff its workout group adequately.
• You work for an organization where you need to cover your ass. Even successful workouts tend to disappoint, and losses if a foreclosure or bankruptcy ensue almost always grow over time. No matter how experienced you are or how well you handle a situation, in some organizations it will not be good enough. If you work in such a place, you need an attorney participating in the deal to function as a lightening rod.
• You have a realistic chance of extracting more outside resources from the sponsor if you litigate. Like certainty of collection, inexperienced people tend to think this is true more often than experienced workout people do.
• Without litigation (a receiver, etc.) your sponsor is going to divert property income, waste the collateral, etc. Most lenders assume this will happen and are too quick to pull the trigger. If your sponsor believes he or she is the best person to run the property and that the deal can be saved, a receivership action is a direct route to a bankruptcy filing. That might be inevitable – in fact, if you think the sponsor is unfit to run the property you might as well get it over with. But, if you have time to monitor your deal and a cooperative, competent sponsor you are better off holding off on the receiver.
• It’s time to document the agreement you've worked out. No matter how good you are, it's never a good idea to enter into an agreement without review by experienced counsel.

Investor Litigation and Mortgage Relief Plans Revisited

It’s been a little more than a year since I last addressed this topic. As usual, things turned out a little differently than I expected.

Back then, the Market Movers theory was investors would not litigate over the modification plans because it would be hard to calculate damages, the litigation wouldn’t scale, and the bondholders were not a litigious group. I agreed with Felix that the economics of the litigation was not attractive and that the investors were not naturally litigious, but thought damages would not be hard to establish and that servicers would take a cautious approach which would lead to few modifications being done.

I think I was right about few modifications being done, but Felix and I both underestimated the desire of bondholders to get out from under the deals. The litigation has started (links to NY Times and Housing Wire stories). The bondholder remedy sought is the repurchase of the loans at par. That’s an ambition goal, but if they’re successful it would be a huge recovery. The threat may be enough to force a nice settlement, and the possibility will surely cause modification efforts on securitized deals to grind to a halt until the matter is settled.

Re-Defaults: Why Workouts Usually Don’t Work Out

A number of blogs are reporting and commenting on the fact that 50%+ of the loan modifications completed in early 2008 are back in default (see Market Movers Re-Defaults, Naked Capitalism, Housing Wire, and Calculated Risk here and here,

There’s no big mystery as to why most modifications don’t work out.

• Borrowers generally make their payments until they can’t. With home borrowers, that happens when there is some kind of income curtailment (job loss, illness, divorce, etc.) and their savings are gone. With income property borrowers it happens when income from the property no longer supports the debt and the borrowers’ liquidity reserves are depleted.
• If a modification is done, the lender almost always addresses only the income curtailment or operating income problem. So the borrower’s immediate problem is resolved, but there is no safety cushion if there is a new income curtailment or further decline in property income, because the savings/liquidity reserve has not been replenished.
• As a result, any new income curtailment or further decline in project operating income results in an immediate default.

Why do lenders do minimal modifications? Imagine a modification which reduces the interest rate to what the borrower can pay, and provides a deposit into the borrower’s savings account in case they lose their job again or property income declines further. Even if you take a security interest in the savings account (itself an administrative nightmare), someone still needs to advance the funds to set up the account, which will increase the loss reserve on the loan. That’s not likely to happen with a portfolio lender, and the chances are nil on a securitized loan.

Of course, if values have recovered since the modification was done the borrower could sell the property. That hasn’t happened yet, and won’t for a long time. So, we can continue to anticipate most modifications will re-default, because every bump in the the road breaks an axle at this stage of the game.