Lately, the financial industry is profoundly and painfully re-learning that a borrower’s defaulted mortgage is inherently a very local thing, affected by local courts and local judges, local sheriffs and constables, local municipal regulations and city ordinances. It’s an oddity of the huge machinery of mortgage finance, really, that an industry so defined by its global reach — there is a multi-billion dollar market in TBA mortgage-backed securities, after all, where the underlying loans are assumed to be largely fungible — can be simultaneously so susceptible to such local vagaries. But now, with millions of borrowers defaulting on their mortgages, the hard lessons of locality are coming back to haunt an entire industry. “We used to keep lists [covering local foreclosure proceedings] in our drawers back in the 90s, and it mattered then,” said one long-time MBS analyst I spoke with. “The problem is that demand from yield-y investors overran the bid from the investors who understood mortgage credit and analyzed it very carefully. In the 90s, people were very familiar with every wrinkle and zip code in a deal. Certainly they were when they bought junior tranches.”
Especially the next time you read about an investor lawsuit pushing billions of dollars’ worth of buybacks because issuers ‘misrepresented’ what investors were buying. Or the next time someone pops off about the ‘need’ to provide better data and disclosure to investors, so better investment decisions can be made. Some litigious investors might be surprised to find they’re catching a falling knife. “The more careful investors smelled something stinky even back in the late 90s when the rating agencies started to shrink credit support on prime and Alt-A — in some deals it might take only a few bad loans to take an entire credit tranche out,” said the analyst I spoke with. “Such good investors were priced out of the market by the quest for yield when the curve started to flatten and the galloping demand from emerged from CDOs. CDOs just waved the loans in, thanks to the rating agencies' idea of limited correlation via geographic distribution. And foreign investors did not bother to become experts in the 50-state patchwork that is U.S. real estate law and bankruptcy code.”
And now the same investors that never bothered to consider the question of locality in the first place are the same ones surprised to find that huge, national servicing platforms are having trouble managing all of the local things — you know, like affidavit signing procedures — that come with a borrower’s default? Pols on Capitol Hill, too, can be seen ranting and raving as publicly as possible about a need to reform mortgage lending, to get servicers to start ‘following the rules.’ If only those rules were something that could actually be accomplished using ‘one size fits all’ legislation. Everyone is missing the point. Location matters. Just ask any of the investors that survived the manufactured housing mess of the mid 1990s. “The real investors were treated to a preview of this debacle with the manufactured housing mess,” said the analyst. “They learned, others did not.” The real legacy of robo-signing All of America has learned in recent weeks that there is, for example, a massive difference between a mortgage loan made in California and a mortgage loan made in Florida, regardless of credit profile. Only now is it becoming painfully obvious to all market participants that seemingly arcane differences between a judicial and non-judicial foreclosure process, for example, can meaningfully lead to significant differences in a deal’s cash flow. How? While the average loan in foreclosure nationally has gone an average of 484 days since last payment, according to data from Lender Processing Services [stock LPS][/stock], five U.S. states boast averages well north of 500 days: New York, Florida, New Jersey, Hawaii, and Maine. All of these five states utilize the judicial foreclosure process.
What investor these days wouldn’t give their left kidney to swap out a security backed largely by a pool of New York loans (600 days in foreclosure, on average) for security largely backed by loans from Arizona (369 days in foreclosure, on average)? That extra years’ worth of relative carry cost until liquidation is coming directly out of the trust, and out from the pockets of investors. Carry costs traditionally eat up 1.5% of unpaid principal balance on a delinquent loan each month, investors have told me — likely even more in many instances, nowadays. But the effects of locality go well beyond the state level. You need only consider that Chicago sheriff Tom Dart has decided not to enforce evictions in one county in Illinois to see that hyper-local effects can drive substantially greater losses on some loans versus others. The takeaway here: not all debt is as fungible as everyone tends to believe. And this has huge implications, not only for investors, but for servicers as well. In a recent news report, Bank of America [stock BAC][/stock] spokesman Dan Frahm lamented about the lack of a uniform standard for foreclosure affidavits — implying that BofA’s real problem isn’t that it cuts corners in loan servicing. The real problem, instead, is that big-box servicers simply have a hard time digesting an increasingly complex patchwork of local ordinances, regulations, and courtroom rules. I’ve written about the servicing mindset before, but it’s instructive to consider how servicing as an industry has become so highly concentrated in so few giant institutions: most servicers are paid a fixed amount, commonly 25 basis points off of each deal they service. And in a business where payments to servicers are fixed, scale economies rule — the more homogenous a loan can become, the more everything tends to look the same, and the more of that same thing you can pump through your machine, the more money you can make. If anything, many servicers ultimately end up reflecting the mindset of the investors they so often serve: they are paid as if every loan is the same, and so in return they act as if every loan were the same. What servicers really want, then, is uniformity. It’s inherent in the business model. So long as investors seem content to pay for loan servicing in this manner, I don’t know that I see anything changing in terms of how servicers approach the management of borrowers in default. There is little incentive to do otherwise. But I think it’s time to admit that this is a broken model, and it’s not one that will get fixed by any chest thumping currently coming out of Washington. If investors are committing time to re-thinking the securitization process as a whole — and they are — how servicers get paid should be near the top of this list. There are new-breed servicers that specialize in defaulted loans, and work with a niche group of private investors (or are captive to them): I coined the term ‘high-touch servicing’ in early 2008 to describe this group, a term that has now become part of industry lexicon. These servicers operate on a different level: paid for performance, and by outcome, they invest more in the people and processes needed to find an disposition other than foreclosure. One servicer I know of tells me that they short-sale everything they get, and if that doesn’t work, they’ll work to execute a deed-in-lieu (and if they must foreclose, they move like the wind to get it done right). Another high-touch servicer utilizes a single-point of contact start to finish on a default, so a borrower has a real person — the same person — to speak to throughout the process, rather than a call center somewhere offshore. Still others are writing down principal at an amazing clip, because the investors they work for bought their distressed loans at a discount and can afford to do so.
Those borrowers lucky enough to see their troubled loan land in one of these shops must feel a little bit like they’ve won the lottery, relative to their friends and neighbors who are stuck in call center hell and multiple requests to re-send the same lost documentation over and over again. These niche servicers represent a growing part of the mortgage industry, but by no means are they yet in the majority. But “yet” may prove to be the operative word here, and that’s certainly the hope of myriad private equity and investment funds that back many of these shops. As the debate ramps up about what to do with the GSEs, and Congress appears set to address their fate sometime in 2011, I’m hearing rumblings that the GSEs’ own view of the servicing model may change, too. “They’ll have to separate performing loan servicing from defaulted loans, and ensure that everything is done servicing released,” said one CEO at a high-touch servicing shop. “There’s no other way forward from where they are now. It’s already being discussed.” In fact, the market is already doing part of this of its own accord, not content to wait and see what the GSEs do.
BlackRock [stock BLK][/stock] said last week it will look to bring $1 billion in private jumbo securitizations to market soon, for example, and will be splitting the servicer from the originator in order to prevent conflicts of interest (and assuage investor concern). It’s a good start. If market constituents want to see a return of the private RMBS market, there are plenty of hurdles, to be sure — but chief among them these days is finding a servicing model that can instill some modicum of confidence in investors. Doing so ahead of any Congressional mandates for the GSEs strikes me as good a measuring stick of success as any other.
