Roger Ashworth

Negative Equity Trumps Unemployment in Predicting Defaults

In this article, the authors show that negative equity alone is a more important predictor of defaults than unemployment. They also establish that when the borrower is significantly underwater, high unemployment can act as a trigger, amplifying the level of defaults.

Modification Success—What Have We Learned?

In this review of modification activity, the authors show that the key ingredients of modification success are principal reduction, substantial pay relief, and modifying early in the delinquency cycle. When all three of these ingredients are present, a modification has a good chance of success. They also demonstrate that success rates on modifications generated by the market’s methods are overstated: These methods do not take into account loans that have liquidated or re-defaulted on an earlier modification.

The Case for Principal Reductions

Principal reduction modifications are a cornerstone of the preliminary term sheet released by the State Attorneys General in March 2011.As a result, there has been increased attention to the success of these modification programs and the attendant moral hazard issues. In this article, the authors make a case for principal reductions, arguing that because negative equity drives defaults, principal reduction is the most successful type of modification. They offer some suggestions on better aligning incentives to minimize the strategic default issue. They also present evidence that it is very dangerous to not do these modifications and hence exacerbate the vicious home price depreciation/negative equity cycle.

Mortgage Modification Activity—Recent Developments

This very detailed article focuses on recent trends in modification activity in the non-agency securitization market. The authors focus primarily on two trends: the increased share of principal reduction modifications and the increased share of second and subsequent modifications. They show that principal reductions result in higher modification success rates than other modification types, even controlling for pay relief. They also show that second and subsequent modifications have higher re-default rates than first modifications. Finally, the authors focus on the variations in modification activity and modification success rates among subprime servicers.

A Look at Freddie Mac’s Loan-Level Credit Performance Data

In March 2013 Freddie Mac released loan-level credit performance data on 15.7 million fully documented, amortizing 30-year fixed-rate mortgages purchased over the last 13 years. This is the first time loan level agency data has been provided; it is part of the broader effort to promote risk-sharing initiatives with the private market. In this article, we take a first look through the data, highlight the importance of FICO and LTV, and discuss the implications for risk sharing and guarantee fees going forward.

The Coming Crisis in Credit Availability

Credit availability was too loose in the 2005–early 2007 period. Borrowers were able to buy homes with low (or no) down payments and very little documentation of income and assets. In an over-reaction, credit availability is now too tight; it is increasingly difficult for borrowers who are “outside the credit box” to qualify for a mortgage, as the authors quantify with their Credit Availability Index. The authors’ concern is that the new regulatory actions, many of which are spawned by Dodd–Frank, have the potential to make credit even tighter. They focus on the Qualified Mortgage (QM) Rule, the Qualified Residential Mortgage (QRM) Rule, the High Cost Mortgage Rules (HOEPA) and “disparate impact.” They believe the interaction among these rules is being ignored, as different regulatory agencies preside over each one.

Alternative Compensation Arrangements for Mortgage Servicing—The Debate Begins

On January 18, 2011, the Federal Housing Finance Agency (FHFA) announced a joint initiative among Fannie Mae, Freddie Mac, FHFA, and the U.S. Department of Housing and Urban Development (HUD) to consider alternative structures for future mortgage servicing compensation. This initiative is aimed at new production of agency loans. The question is how to better align the fee structure with the servicer’s cost structure and how to create a servicing asset that is more capital friendly under Basel III. In this article, the authors discuss some of the proposals that have been put forth. They conclude that it makes sense to lower the minimum servicing fees on performing loans (coupled with a reduction in pooling flexibility for servicers), and to raise them on non-performing loans (coupling this with the elimination of the stigma on switching servicers).

Option ARMs: Performance and Pricing

This article establishes that defaults on Option ARMs will be quite high because 1) borrowers have self-selected this mortgage to achieve the lowest possible payment, allowing them to stretch to be in a house they could not afford; 2) negative equity is a large issue for this market; and 3) payment shock still looms. However, the poor collateral performance is fully reflected in the low asset prices. Putting together the high default rates with our expected severities and current market prices, we establish a methodology to compare option ARMs to alternative MBS investments. We conclude, based on market prices when the article was written, that better value can be found in the option ARM market than alternatives—the subprime market or the market for Alt-A hybrid floaters.

Government Programs to Refinance (or Modify) Performing Borrowers in Private Label Securitizations: Implications for Investors

With the success of the HARP program for agency borrowers, the authors expect to see a push on the part of the Obama Administration to offer performing borrowers who fall outside of the agency purview a way to lower the payments on their mortgages, either through refinancing or modification. This article examines the various legislative proposals discussed to create a refinance vehicle for these borrowers. It also takes a close look at actions that could be taken by the U.S. Treasury, without legislation, using the HAMP framework to lower the coupons on the mortgages, with some compensation to the lenders/investors. The article explores the impact on private-label security (PLS) investors of the Merkley Refinancing Plan and the Treasury proposal to modify mortgages. Under the refinancing proposals, the loans are removed from the PLS trust; whereas, under the modification proposal, the loans remain in the trust. The cost/benefit methodology for PLS investors is very similar: The benefit of the lower default rate must be weighed against the cost of the forgone coupons on the mortgages that would not have defaulted. The authors find, under plausible assumptions, both programs are modestly net-present-value negative to investors; that can be corrected with some redesign.

Investors Beware: Flaws in the Residential Mortgage Securitization Process

This article focuses on some of the less discussed flaws in the securitization process. In particular, the authors focus on: 1) the enforcement of representation and warranty violations, 2) defects in the deal closing process, and 3) defective transaction surveillance and reporting. The authors make the case that, even if you knew the prepayment rates, default transition rates and severities, you could not necessarily determine the cash flows and hence the yield on the security. Even if the deal modeling is correct (and, as the authors have shown, there can be issues) and the documents are internally consistent, there is a total lack of transparency in reporting on modifications and liquidations. More irritating, it is very difficult to tie out the cash coming into the deal with what is actually distributed to investors.