PIMCO, which was one of the firms spearheading the putback push against BofA, has put together a useful and rather objective analysis though Executive Vice President, Global Structured Finance Specialist, Rod Dubitsky, titled "Foreclosure Flaws Trigger New Round of Uncertainty." While not surprisingly the baseline case presented by PIMCO is a moderate one, as the asset manager claims the most likely impact is "moderate" it does acknowledge that there is a possibility for substantial complications (although Fannie's recent bail out of BofA pretty much takes cares of that). The two main adverse consequences are "corrupted title" - a topic beaten to death previously, and, more importantly, "Tax issues relating to RMBS issuance entities" on which PIMCO says "Some have argued that assigning the note for the
mortgage loan so long after closing would run afoul of REMIC rules,
which could subject RMBS deals to adverse tax consequences." Of course, as an escalation of these developments would bring the entire $8 trillion RMBS structured finance industry to a halt, we are fairly confident that as more and more settlements are instituted, that the whole fraudclosure issue will be very soon completely forgotten.
Foreclosure Flaws Trigger New Round of Uncertainty
Rod S. Dubitsky
In early October a contested foreclosure action on a tiny house in rural Maine lit the fuse of a blast that has reverberated throughout the markets, spreading renewed fear of a second downturn in the housing market and potential gridlock in the mortgage market. Specifically, the contested foreclosure action led to a deposition of an employee of GMAC Mortgage (a subsidiary of Ally Bank, fka GMAC Bank), which appeared to reveal that GMAC was cutting corners while executing the foreclosure process. The deposition led GMAC to freeze the foreclosure process, and other servicers quickly followed GMAC into the servicer confessional and likewise froze foreclosures. Further, the 50 state attorneys general launched an investigation.
Though many servicers are in the process of fixing the flawed procedures, and the long-term market impact of these revelations is uncertain, in our base case scenario we see moderate risks to housing prices and to residential mortgage-backed securities (RMBS) investments. Though the story is months old and several issues have been clarified since the story initially emerged, much uncertainty remains and many additional challenges have been raised with the foreclosure process as well as with the securitization process in general.
A Brief History of “Robogate”
Though there are several complicated threads to the story, the primary flawed processes employed by mortgage servicers can be easily summarized: 1) employees of the servicers were attesting to facts in affidavits that in fact they often didn’t have explicit knowledge of and 2) contrary to requirements, the affidavits in many cases weren’t signed in front of a notary. (We note that this should not imply there are no other broken servicer processes.) As an affidavit is a sworn statement of fact that needs to be witnessed, these two shortcuts rendered the affidavits defective. No witness and no real knowledge of the facts being attested means an affidavit is not acceptable to the foreclosure court. The media dubbed this trend of rapid, automated signing of affidavits “robo-signing” and the ensuing uproar “robogate.”
The secondary thread of the story that seems to be growing in importance is potential flaws associated with the mortgage documents and the process of transferring the documents during the securitization process. The upshot of the latest stories is that flaws in the transfer of mortgage documents associated with the securitization could increase the complexity of the foreclosure process and, in the extreme scenario, jeopardize the economic interest of the trust in the associated mortgage. Though the document flaws (as distinct from the affidavit flaws) currently appear to be limited, we are watching this thread closely to see if the issues are more pervasive.
Though some of the earlier moratoria have been lifted, it’s not entirely clear that the servicers’ processes have improved enough to satisfy the attorneys general and foreclosure judges. Further, for some servicers who have not imposed a moratorium and have indicated that their procedures were correct, in some cases evidence has emerged that calls into question the procedures of even these “compliant” servicers.
The attorneys general, who have yet to conclude their review, are rightly concerned over the possibility that streamlined foreclosure processes either 1) resulted in some foreclosures that shouldn’t have occurred (though we expect this is rare) or 2) didn’t give borrowers an adequate chance to resolve their mortgage payment difficulties (e.g., via a loan modification or other resolution). However, we don’t believe the attorneys general want to see permanent gridlock in the REO (Real Estate Owned – i.e., foreclosed homes) housing market; after all, many voters buy foreclosed homes and most voters don’t like seeing empty homes blighting their neighborhoods and failing to contribute property taxes.
Most Likely Overall Impact Is Moderate
At this point it doesn’t appear the legal right to foreclose will be severely impaired across a large number of mortgages, nor will the ability to foreclose likely be subject to massive or terminal delays. Rather, thus far it appears that servicers will ultimately be able to execute foreclosures on the overwhelming majority of mortgages. Most of the problems and flawed procedures, in short, appear to be fixable, and in our base case scenario we see the long-term impact on housing prices and RMBS as likely to be moderate.
That said, robogate and its fallout do have several implications for investors. First, the servicers will be affected by 1) higher costs (in both the short term, as the backlog is cleared, and the long term, as staffing needs to be stepped up) and 2) potential legal liability, as the various infractions may result in legal action on the part of borrowers or the attorneys general. Second, potential gridlock in the housing market and further delays in resolving the housing overhang do pose the risk of an adverse impact on home prices in the longer term, though the short-term effect could be positive as distressed supply is pulled from and kept off the market. Third, RMBS investors will likely be affected as delayed liquidations result in longer duration and higher losses (due to greater costs, resulting from the longer timelines). On the other hand, credit IO RMBS will likely benefit, as the IO (interest only) period will last longer, thereby increasing the value of the interest component of their cash flows (a credit IO is a bond that is impaired to the degree that no principal is expected to be received and the only value is remaining interest payments). Fourth, we note the foreclosure delay’s impact will depend on the bond structure, since structural nuances vary across and within deals.
The final implication for investors is very difficult to quantify: If borrowers know they have a reasonable basis to legally contest the foreclosure, the recent revelations may embolden many more borrowers to do so. Even borrowers who know they can’t afford the home may choose to contest foreclosure if it increases the free rent period or if they have hope of improving their financial situation during the prolonged delay. Borrowers may cite an array of reasons to contest foreclosure: affidavit irregularities, lost notes, improper standing to foreclose, misapplied payments, incorrect ARM calculations, excessive delinquency-related expenses (late fees, inspections, force placed insurance), failure to offer a loan modification (which is required in some jurisdictions), or problems associated with the origination of the loan. In most cases, we believe delay will be the worst outcome from an investor’s perspective. We believe most title/note mortgage assignment issues appear to be fixable (at some time and expense), and more to the point, while some borrowers will challenge and successfully avoid foreclosure, most borrowers who challenge are likely only delaying the inevitable (as most such borrowers simply can’t afford the home). Nevertheless, it’s another area of uncertainty.
And on a positive note, we have no doubt that some borrowers were rushed to foreclosure when in fact they may have had a legitimate ability to pay, and to the extent the foreclosure timeout can save additional borrowers, that is clearly a good thing.
In PIMCO Advisory, we’re accounting for the impact of foreclosure freezes on RMBS prices by running delays ranging from three to 12 months across base case and stress scenarios; the values of the bonds generally don’t change more than a few points in the more extreme scenarios. In addition to longer foreclosure timelines, we are assuming higher loss severity because servicers will need to advance more delinquent interest while the foreclosure is pending. One element that is difficult to quantify is whether servicers will incur substantially more fees that may in turn be passed along to RMBS investors, thereby adding to loss severity. Though some expenses will likely be borne by investors, at this point we’re not assuming much additional loss severity other than that strictly from the extended timelines.
Further, it’s not clear at this point whether the delay should only be applied to current foreclosures or whether foreclosure timelines will become permanently longer as servicers and courthouses now take longer to process each foreclosure. We are currently applying our lags to the existing foreclosure and REO pipeline, while leaving our process for current loans unchanged. Assuming servicers increase staff to clear the backlog and adequately fix their procedures, we believe it’s reasonable to assume that foreclosure timelines will revert to pre-robogate levels (which already reflected lengthened timelines).
Less Likely but More Dire Consequences Are Possible
Following the foreclosure moratorium, market participants raised two issues that would theoretically have far more dire consequences for RMBS investors in particular and the mortgage market in general. Thus far, the likelihood of either of these worst-case scenarios appears remote, but they are worth considering.
- Corrupted title:
Some have speculated that the legal transfer of the mortgages to the
trust has been so flawed that investors in RMBS face the risk that they
don’t even have good title (i.e., ownership) of the mortgages. As a
result, servicers potentially would have no legal standing to
foreclose. A mortgage that doesn’t allow the holder to foreclose and
take title to the property and doesn’t permit the lender to enforce the
borrower’s obligation to pay is worth no more than kindlin’ wood, as
the saying goes. Thus far – despite a couple of sensational stories –
we don’t believe “kindlin’ wood” mortgages are widespread. Yes, there
was the story of the eight-year foreclosure and the foreclosure on the
homeowner who didn’t have a mortgage, but stories don’t equal
statistics. Not that we should dismiss all these stories just yet,
either; after all, mortgage origination horror stories turned out to be
the rule rather than the exception. If new information reveals far more
severe impairment in the note (obligation to pay) or the mortgage (the
lien on the property), things could get a whole lot worse for RMBS
investors (as well as other mortgage holders and guarantors, such as
Fannie and Freddie), but at this point the more extreme outcomes don’t
appear to be in the cards. However, the situation is fluid and we
continue to consult with attorneys and are actively evaluating the risk
of material impairment in the ownership of mortgages.
Relatedly, some have questioned the role of MERS (Mortgage Electronic Registration Systems), an electronic registry in whose name more than half of all mortgages are registered. MERS was established to streamline the process of mortgage assignments by having the mortgage assigned in MERS’ name so that any time an ownership interest was transferred, sellers could avoid the costly county recording process. Some are arguing that MERS doesn’t have standing to foreclose (and indeed some states have ruled thusly) and therefore foreclosures in its name are invalid. Though this may pose a risk, our understanding is that the cure for the MERS problem is simply to assign the mortgage to an entity that does have legal standing to foreclose (e.g., the RMBS trustee). Therefore, we believe that the MERS issue may result in further delays to the foreclosure process, but not permanent foreclosure freezes or impairments.
- Tax issues relating to RMBS issuance entities: RMBS are generally issued by an entity called a Real Estate Mortgage Investment Conduit (REMIC) that is exempt from federal taxes at the entity level provided it satisfies certain requirements. Broadly speaking, REMIC rules provide that a REMIC has three months to acquire its initial assets and two years to substitute a new mortgage loan for a defective one. Some have argued that assigning the note for the mortgage loan so long after closing would run afoul of REMIC rules, which could subject RMBS deals to adverse tax consequences. However, nothing that we have seen so far would validate this concern, and opinions published by securitization attorneys recently give very little credence to the REMIC tax risks. (For example, see SNR Denton’s “Commentary on Transfers of Mortgage Loans to RMBS Securitization Trusts,” October 18, 2010, www.snrdenton.com.)