When Can Securitized Mortgages Be Modified?

Last week I had the opportunity to talk to Diane Pendley, of Fitch ratings, about what happens to mortgage-backed securities when default rates start going up. If a bank owns a mortgage, it can just go ahead an modify the loan to its heart's content in an attempt to prevent a disastrous foreclosure. When bondholders own a pool of mortgages, however, things get a bit more complicated -- the loan servicer can only modify the mortgages to the degree it's allowed to in something known as a "pool servicing agreement", or PSA.

It turns out that in the early days of securitization, PSAs sometimes prohibited any kind of loan modification at all -- which can be disastrous for both homeowners and bondholders. That's less common now, but it's not unheard-of. Nowadays, some PSAs allow the servicers to modify as many loans as they like; others impose a 5% cap, or ask the servicer to get the go-ahead from a ratings agency before modifying more than 5% of the total number of loans.

In theory, the PSA can be changed; in practice, however, it can't be, since trying to track down all the bondholders and getting them to agree to a change would be very, very hard.

And for the time being, the caps still have not generally been reached. The big problems are in adjustable-rate mortgages which had a low fixed rate for two years and which were written in 2005 and early 2006. Those loans are only now starting to adjust up to higher and less affordable interest rates, which means that they're only now being looked at by servicers with an eye to possible modification.

Still, if nothing is done, there will certainly be problems down the road. So the American Securitization Forum is looking into the problem, and is trying to come up with some principles and best practices to recommend to the market. They're also looking to introduce new legislation, at either the state or federal level, which could overrule the language in PSAs.

Legislation would also help get around the problem of accounting regulations, which say that servicers can't modify a performing asset. That means that if a homeowner is making regular payments now, but clearly won't be able to continue to do so after her mortgage resets, the servicer at the moment has its hands tied. It would like to be proactive about the situation, but accounting rules, specifically something known as FAS 140, say that it first has to wait for the mortgage to reset and go into default.

But time is running out: soon a large number of subprime mortgage pools are going to face this problem, and the servicers have to be ready for it. The big question is whether legislators are going to be able to get something done in time to help out homeowners (and bondholders) in distress.