Does Sheila Really Understand?

It is hard to fathom how Sheila Bair, the chairman of the FDIC, can continue to misunderstand how the securitization markets have worked for the past 30 years.

The latest example involves some of her comments this week related to the newest industry snafu in connection with the processing (or shall we say “mis-processing”) of mortgage foreclosures for residential properties in the US market.  Clearly, if it turns out that there was rampant levels of “corner cutting” going on by either the lenders themselves (through their mortgage servicing arms) or by hired sub-contractors, then we will have yet another black eye for the industry to overcome on this bumpy road to recovery.

What amazes us is that Sheila appears to blame the actions of  mortgage servicers (i.e. the motivation to pursue foreclosures at the expense of loan modifications) on securitization and the motivation to take care of the bond investors first.  What she doesn’t seem to understand is that it is not the bondholders that the issuer/servicer is looking to protect; it is the “funding source” or “capital source” that the issuer is trying to protect.  If the mortgage lender does not protect its access to additional funding/capital it will not be able to sell more loans.  If it can’t sell more loans, it will have to find alternative sources of funding or face going out of business.  The reason that financing companies (both independents and subsidiaries of financial services companies like banks and insurance co’s) have utilized the capital markets through securitization and securitization structures is that it has represented the most economical feasible method for raising capital and, thereby, growing their businesses.  Take this source away and firms will have to look to more expensive funding sources.  In the case of independent companies, such other sources may not exist.

It may sound cruel but the motivation for survival of the company and its sources of capital far outweigh the motivation to help a single borrower or even a thousand borrowers through a loan modification process.

We also  find it strikingly incoherent that Ms Bair seems to believe that the obligation for a servicer to make advances on late p&i payments to bondholders demonstrates why the economics of securitization and the role of the servicer need to be revised.  She cites the ability of servicers to recover foreclosure related expenses and the obligation to make “servicer advances” on late paying loans as a negative incentive to seeking loan modifications.  Does she not understand that:

1- Even under the most extreme conditions the servicer’s obligation to make advances is not open-ended.  The servicer must exercise commercially reasonable judgment and, under the currently extreme market conditions, this might involve many months of advances.  However, in almost all structures, servicer advances are “first in line”  for recovery from the collateral pool.  Even in cases where the collateral loses half its value, the cushion is substantial  for a pool of assets with a 10-20 year cash flow.  So, we don’t buy it, even for second, that the servicer advance mechanism is a dominating motivation to foreclose.

2- No entity should know more about the value and potential for the underlying assets than the issuer/servicer.  In many or most cases, the servicer also originated the loan and if not has, at minimum, been servicing the property for sometime and should be familiar with the property, activity and market values in the local market and something about the financial condition of the borrower.  That is why the servicer is in the best position to “smooth out” cash flow streams that might be due to bondholders and that is precisely why the servicer advance function was developed.  In other words, in a well-functioning market, servicers are more than willing to finance these advances (for an above market return) because they have maximum knowledge and comfort with the underlying assets.  This in turn allows them to attract more investors or “sources of capital” to their financing activities.  Servicers were not “saddled” with this obligation.  They were/are happy to take it on.  One cannot use the “perfect storm” conditions of the past 3 years as an argument for bad economics leading to  mis-aligned motivations for servicers and the securitization structures that they have utilized to finance their activities.  Her logic just doesn’t work. 

In fact, we would argue just the opposite.  If the underlying value for a given asset/property has dropped so precipitously that the servicer no longer has confidence in that asset to produce enough value to cover its advances within a commercially reasonable period of time then that loan property should be foreclosed.  The motivation for a servicer to do so is EXACTLY the same as any lender should have.  In the case of an unsecuritzed loan, the lender would be protecting the interests of its shareholders and depositors.  In the case of a securitized loan the lender/servicer would be protecting the interests of its creditors (bondholders).  In both cases, sound business judgement should apply; not political wisdom.

About markferraris
Managing Principal Orchard Street Partners LLC

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