May 11, 2011

Laurie Goodman / lgoodman@asglp.com / 212.593.6026

5/12/2011 Testimony of Laurie Goodman, Amherst Securities Group to the Subcommittee on Housing, Transportation and Community Development of the Senate Committee on Banking, Housing and Urban Affairs TopicNational Mortgage Servicing Standards and Conflicts of Interest
Iamhonoredtotestifytoday.MynameisLaurieGoodmanandIamaSeniorManagingDirectorat AmherstSecuritiesGroup,aleadingbroker/dealerspecializinginthetradingofresidentialmortgage backedsecurities.Iaminchargeofthestrategyandbusinessdevelopmenteffortsforthefirm.We performextensive,dataintensiveresearchaspartofoureffortstokeepourselvesandcustomersabreast oftrendsintheresidentialmortgagebackedsecuritiesmarket.Iwouldliketosharesomeofourthoughts withyoutoday. Afewquicknumberswillserveasbackground.Thereis$10.6trillionworthof14familymortgages outstandingintheUnitedStates.Ofthose,onehalf,or$5.4trillion,isinAgencyMBS(mortgagebacked securities),$3.0trillionconsistsoffirstlienmortgagesinbank,thriftandcreditunionportfoliosplusthe unsecuritizedloansonFreddieMacandFannieMaesbalancesheet,and$1.2trillionisinprivatelabel MBS.Secondliens,whicharemostlyheldonbankbalancesheets,totaljustunder$1trillion.Itis importanttonotethatwhileprivatelabelsecuritizationsrepresentonly12.8%ofthefirstlienmarket, theyrepresent40%oftheloansthatarecurrently60+daysdelinquent. Servicersplayacriticalroleinthehousingfinancemarket.Theyarethecashflowmanagersforthe mortgagesystem.Iftheborrowerismakinghispayments,theservicercollectsandprocessesthose payments,forwardingtheproceedstotheinvestorinasecuritization.Ifthereisanescrowaccount,the servicerischargedwithmakingthetaxandinsurancepayments.Iftheloangoesdelinquent,theservicer isresponsibleforrunningthelossmitigationefforts,anendeavorthatmanyservicers,especiallysocalled primemortgageservicers,hadlittleexperienceatpriortothecrisis.Itwasnevercontemplatedthat theseservicingplatformswouldbeusedtoperformdefaultmanagementonthecurrentscale.Asaresult, theyhaveneverbuiltupalossmitigationinfrastructure.Asetofnationalservicingstandards,addressing minimuminfrastructurerequirementstohandletheservicingofdelinquentborrowerswithinaservicing platformisthebestwaytoaddressthisissue,andIampleasedtohaveinputonthisimportanttopic. Theservicerisgenerallypaidafixedpercentageoftheoutstandingloanbalanceforservicingamortgage. Thisfeeisgenerallytoolargeforservicingloansthatarenotdelinquent,andtoosmalltocoverthecosts ofservicingloanswhichhavegonebad.Thereareothersourcesofincomeaswell.Theborroweroften makeshispaymentearlyinthemonth,andthemoniesarenotrequiredtoberemitteduntilmidmonth,
This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

 givingtheservicertherighttoinvesttheseproceedsinthemeantime(float).Whentheborrowergoes delinquent,servicerschargelatefees.Thereareanumberofancillaryfeesthatarechargedduringthe lossmitigationprocess.Finally,servicingaloanallowsafirmtocrosssellotherfinancialproductstothe borrower,includingautoloans,creditcards,andhomeequitylinesofcredit.Asaresult,theserviceroften interactswiththeborrowersacrossanumberofdifferentproducts,someofwhichmaybeinthe investmentportfolioofarelatedentity.Therearesomecostsaswelltheservicerwillgenerallyadvance taxandinsurancepayments,andinprivatelabelsecuritizationsareusuallyobligatedtoadvanceprincipal andinteresttotheextentdeemedrecoverable. Thepurposeofmytestimonyistodiscussconflictsofinterestfacingmortgageservicersthatmaystop themfromactinginthebestinterestsofmortgageinvestorsandhomeowners,andtodiscusswhichof theseconflictscanbeaddressedthroughnationalmortgageservicingstandards.Letmebeginbypointing outthattheinterestsofmortgageinvestorsandhomeownersarelargelyalignedfor2reasons.First,the mortgagemarketisreliantoninvestorstocontinuetoextendcredit,therebyprovidingthenecessary capacitytoencouragecompetitiveratesforborrowersinpursuitofhomefinancing.Second,foreclosure is,withoutquestion,theworstoutcomeforbothinvestorsandborrowers.Itisalonganddrawnout processinwhichaborrowerisforcedfromhishome,andaninvestortypicallysuffersalossonhis investmentinthemortgageloansofbetween5080%ofthebalanceoftheloanamountafterthehomeis soldandthevariouscostsarededucted. Theinterestsofboththeborrowersandinvestorscanbemarginalizedwhentheloanisservicedbya conflictedparty.Herearetheinherentconflictswesee.

CONFLICT#1:Largefirstlienservicershavesignificantownershipinterestsin2ndliensand oftenhavenoownershipinterestinthecorrespondingfirstlienmortgageloansthataremade tothesameborrowerandsecuredbythesameproperty.

Insuchcases,thefirstliensaretypicallyheldinprivatelabelsecuritizations,thesecondlienandthe servicingrightsareownedbythesameparty,oftenalargebank.The4largestbanks(BankofAmerica, WellsFargo,JPMorganChase,Citigroup)collectivelyservice54%ofall14familyservicingintheUnited States.Theyownapproximately40%($408billionoutof$949billion)ofsecondliensandhomeequity linesofcreditoutstanding.Thesecuritizedsecondlienmarketisverysmall.Thuswhenafirstlienina privatelabelsecuritizationisonapropertythatalsohasasecondlien,thatsecondlienisverylikelytobe heldinabankportfolio,andifitisinsideabankportfolioitisofteninoneofthebig4banks. Thisisaconflictbecausetheservicerhasafinancialincentivetoservicethefirstlientothebenefitofthe secondlienholder.Manytimethisincentiveconflictswiththefinancialinterestoftheinvestoror borrower.Weoutlinesomeoftheconsequencesofthisconflict. Consequence:ShortSalesandDeedsinLieuAreLessLikelytoBeApproved.Anexamplemakesthis moreintuitive.Assumethataborrowerhasa$200,000firstlienanda$30,000secondlien($230,000lien total)onahomethatsufferedavaluationreductiondowntoonly$160,000.Theborrowerispayingonhis secondlien,butnotonthefirstlien.Theborrowerreceivesashortsaleofferatthemarketvalueofthe property,andaskstheservicer(alargefinancialinstitution)toconsiderit.Iftheserviceracceptstheoffer,
This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

 thesecondlien(heldonthebalancesheetofthefinancialinstitution)mustbewrittenoffimmediately.If theservicerisalsothesecondlienholder,hemaybemoreinclinedtorejecttheshortsaleoffer.Inthis case,acceptingtheshortsaleofferwasclearlyinthebestinterestsofbothborrowerandfirstlien investor.Similarly,aservicerwillbelesslikelytoacceptadeedinlieuofforeclosure.Webelievethat nationalservicingstandardsshouldexplicitlyaddressthisissue. Consequence:LoanModificationEffortsAreSuboptimal.Loanmodificationprogramshavetwoissues: theydonotaddresstheborrowerstotaldebtburden,andtheydonotaddressaborrowersnegative equityposition.Asaresult,theredefaultratehasbeenenormous.Webelievethatbothofthese shortcomingsshare,attheircore,onecommontrait:conflictedservicers.Welookateachinturn. ModificationsFailtoAddresstheBorrowersTotalDebtBurden.Inaloanmodification,onlythe mortgagedebtisaffected.Thatis,mostmodificationprograms,includingHAMP,thegovernmentsHome AffordableModificationProgram,lookatthepaymentsonaborrowersfirstmortgageplustaxesand insurance,andcomparethattotheborrowersincome.Thisiscalledthefrontenddebttoincomeratio, andanattemptismadetoreducethepaymentstoapresetpercentageoftheborrowersincome. Considerabankwhoservicesaborrowersfirstlien,secondlien,creditcardandautoloan.Thefirstlienis inaprivatelabelsecuritization,allotherdebtsareonabanksbalancesheet.Thebankisobligatedto modifyonlythemortgagedebt,leavingthecreditcardandautodebtintact.Moreover,thesecondlien mortgagedebtisgenerallytreatedparipassuwiththefirstlien.Therearesituationsinwhichonlythefirst lienismodified,andthesecondlieniskeptintact,makingevenlessimpactontheborrowerstotaldebt burden. Sincethereisnosenseofanoveralldebtrestructuring,theborrowerisoftenleftwithamortgage paymentthatisaffordable,butatotaldebtburdenthatisnot.Forexample,theTreasuryHAMPreport showsthattheborrowerswhoreceivedpermanentmodificationsundertheHomeAffordable ModificationProgramhadtheirfrontenddebttoincomeratioreducedfrom45.3%toanaffordable 31.0%,whilethemedianbackenddebttoincomeratio(ortotaldebtburdenasapercentofincome)was reducedfrom79.3%beforethemodificationtoastillunsustainable62.5%afterwards.Theresult:ahigh redefaultrateonmodifications.Forasuccessfulmodification,aborrowerstotaldebtburdenneedstobe completelyrestructured. ModificationsFailBecauseTheyDoNotAddressaBorrowersNegativeEquitySituation.Considerthe 2MPprogram,theHAMPprogramwhichappliestosecondliens.Essentiallythisprogramtreatsthefirst andsecondlienholdersparipassuwhentheborrowersfirstlienismodified.Ifthereisaratereductionon thefirstlien,thereisalsoaratereductiononthesecondlien;ifthereisaprincipalwritedownonthefirst lien,thesecondlienalsoreceivesaprincipalwritedown.Thismakesnosense,asthejuniorlienisby definitionsubordinatetothefirstlien,andassuchshouldbewrittenoffbeforethefirstliensuffersany loss.AndifamodificationisdoneoutsideofHAMP(andtherearemorenonHAMPorproprietary modificationsthanthereareHAMPmodifications)theservicerisnotcompelledtoaddresssecondliensat all. Thenegativeequitypositionofmanyborrowerswouldbedramaticallyimprovedifthesecondlienwas eliminatedorreducedmoreinlinewiththeseniorityofthelien.Indeed,loanmodificationprograms
This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

 wouldbemarkedlymoresuccessfulifprincipalreductionwereusedonthefirstmortgageandthesecond lienwereeliminatedcompletely.Ourresearchhasshownthataprincipalreductionmodificationhasthe highestlikelihoodofsuccessfullyrehabilitatingaborrower,andwillultimatelyresultinthelowestre defaultrate. PrincipalReductionsareUsedinLoanModificationsLessFrequentlyThanTheyShouldBe,Dueto ConflictedServicers.Evenwiththecurrentparipassutreatmentonfirstandsecondliens,webelieve therearefewerprincipalreductionmodificationsonloansownedbyprivateinvestorsthantherewould beifarelatedentityoftheservicerdidnotownthesecondlien.Thatis,webelievebanksarereluctantto takeawritedownonasecondlienthatispayingandcurrent;asaresult,theydoafirstlienmodification whichislesseffective,tothedetrimentoftheborrower/homeowneraswellastotheprivateinvestors whoownthefirstlienloan.Inadditionwebelieveconflictedservicersarecounselingborrowerstoremain currentontheirsecondliens,therebyallowingthemtopostponethewritedownonthesecondlien,and increasingthelikelihoodofaparipassumodification. PrincipalReductionsAreAlsoUsedLessFrequentlyDuetoDistortionsInTheCompensationStructure. Servicingfeesarebasedontheoutstandingprincipalbalance.Thus,whenaprincipalreductionisdone, theservicingfeeisreduced,asitisbasedonalowerprincipalamount.Sinceitcostsmoretoservice delinquentloansthantheservicerisreceivinginfees,andthisisexacerbatedbythewritedown,itaddsto thereluctancetodotheprincipalwritedown. Withservicerstryingtominimizethewriteoffofsecondlienholdingsandmaintainservicingfees,itis nosurprisethatweseedistortedoutcomesforborrowersandinvestorsinloansthatbanksservicefor privateinvestors. Hereissomeevidenceofthedistortion.Wecanseeamarkeddifferenceinservicingbehaviorforfirst liensownedbybanksandthosewherethefirstlienisNOTownedbyabankportfolio.Accordingtothe OCC/OTSMortgageMetricsreportofQ42010,banksdidaprincipalreductionon17.8%oftheirfirstlien portfolioloans.Thesewereloansinwhichtheyownthefirstlien,generallyownthesecondlien(ifthereis one),andmodifiedthefirstlientoachievethehighestnetpresentvalue.Bycontrast,thosesamefinancial institutionsdidaprincipalreductionononly1.8%ofloansownedbyprivateinvestorsand0%ofFannie Mae,FreddieMacandgovernmentguaranteedloans.Whiletherearemajorobstaclestoprincipal reductioninthecaseofGSE(GovernmentSponsoredEnterprise)loansorgovernmentguaranteedloans, therearefewobstaclestodoingprincipalreductiononprivateinvestorloans.OnlyafewPSAs(Pooling andServicingAgreements)prohibitsuchbehavior.AndtheOCC/OTSMortgageMetricReportnumbersfor Q42010werenotafluke;intheimmediatelyprecedingcalendarquarterQ32010,banksdidprincipal reductionson25.1%oftheirownloans,butononly0.2%ofloansownerbyprivateinvestors. Solution:ToIncreasetheUseofPrincipalReductionsasaLoanModificationTool.Nationalservicing standardsshouldrequirethatservicersperformthemodificationwiththehighestnetpresentvalue, whichwillusuallybeaprincipalreduction.UnderHAMP,theservicerisrequiredtotesttheborrowerfora modificationusingboththeoriginalHAMPwaterfall,aswellasthePrincipalReductionAlternative,which movesprincipalreductiontothetopofthewaterfall.IfthePrincipalReductionAlternativehasthehighest netpresentvalue,servicersarenotobligatedtouseit.UseofthePrincipalReductionAlternativeis
This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

 voluntary,atthediscretionoftheservicer.HAMPshouldbeamendedtorequiretheuseofthePrincipal ReductionAlternative,ifithasthehighestnetpresentvalueofthealternativestested. ConsequenceofPariPassuTreatmentofFirstandSecondLiens:HigherFirstLienBorrowingCosts.We believealargeerrorwasmadeinoptingtotreatthefirstandsecondliensparipassuformodification purposes.Theconsequenceofthisisthatfirstmortgageswillbecomemoreexpensive,asinvestorsrealize theyarelesswellprotectedthantheirlienprioritywouldindicate.Itisveryimportanttorealizethat underpresentlawandpractices,asecondmortgagecanbeaddedafterthefact,withoutthefirstlien investorevenknowingit.Butadditionofasecondliensignificantlyincreasestheprobabilityofdefaulton thefirstmortgage.However,aspresentlyconstructed,ifaborrowergetsintotrouble,thefirstandsecond mortgagesaretreatedsimilarlyformodificationpurposes.Sincethatraisestheriskforthefirstlien investor,itshouldalsoincreasethecostofdebtforthefirstlienborrower.(Wehaventseenthisreflected inpricingyet,asfewmortgageshavebeenoriginatedforsecuritization;mostmortgagesissuedsincethe paripassudecisionwereinsuredeitherbytheGSEsortheU.S.government.) SolutionstoMaintainLienPriority Whatcanbedoneaboutconflictsofinterestinherentinanentityservicingapoolofloansandowningthe secondlien(whilethefirstlienisownedbyanoutsideinvestor)?Thereareatleast3alternativesolutions fornewlyoriginatedmortgages.Thefirsttworequirecongressionalconsent,whilethethirdwouldrequire actionsbythebankregulatoryauthorities.Thesesolutionstothereorderingoflienprioritiesarebeyond thescopeofnationalservicingstandards. Alternative1.Thissolutionwouldcontractuallyrequirefirstlieninvestorstoapproveanysecondlien(or alternatively,approveanysecondlienwithaCLTV[(combinedloantovalue,theratioofthesumofallthe liensonthepropertytothemortgageamount)exceedingapresetlevel,suchas80%].Ifthefirstlien holderdoesnotapproveit,yettheborrowerstilltakesoutasecondlien,thefirstlienmustbepaidoff immediately(thedueonsaleclauseisinvoked).Thismaysoundharsh,butitreallyisnot.Currently,ifa borrowerwantstorefinancehisfirstlien,thesecondlienmustexplicitlyagreetoresubordinatehislien. Theinfrastructuretoarrangethesetransactionsexistsandworkssmoothly.Prohibitionofexcessive indebtednessiscommonincorporatefinance.Thisisdonethroughloancovenantsthatlimittheamount ofjuniordebtthatcanbeissuedwithouttheconsentoftheseniornoteholders.Thisalternativemaybe requiredtorestarttheprivatemortgagemarketsandwouldrequireanamendmenttotheGarnSt. GermainDepositoryInstitutionsActof1982.Thatactprohibitstheseniorlienholderfrominvokingthe dueonsaleclauseiftheborroweroptstoplaceasecondlienontheproperty. Alternative2.PlaceanoutrightprohibitiononsecondmortgageswherethecombinedCTLVexceedsa designatedlevel,suchas80%,atthetimeoforiginationofthesecondlien. Alternative3.Establisharulethatalendercannotserviceboththefirstandsecondlienswhileowning onlythesecondlien.

This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

CONFLICT#2:AffiliateRelationshipswithProvidersofForeclosureServices
Theserviceroftenownsashareincompaniesthatprovidesancillaryservicesduringtheforeclosure process,andchargesabovemarketratesonsuch.Entitiesthatprovideservicesduringtheforeclosure processthatarepossiblyownedbyservicersincludeforceplacedinsuranceprovidersandproperty preservationcompanies.(Thesecompaniesprovidemaintenanceservicesaswellaspropertyinspection services.)Evenwhenaservicerisnotaffiliatedwiththecompanyprovidingtheservice,theyoftenmark upthefeesconsiderably. Whatistheconsequenceofaffiliatesoftheservicerchargingabovemarketfees?Suchfeesareaddedto thedelinquentamountoftheloan,makingitmuchharderforaborrowertobecomecurrent.Moreover, whenaloanisliquidated,theseverityontheloan(thepercentageofthecurrentloanamountlostinthe foreclosure/liquidationprocess)willbemuchhigher,tothedetrimentoftheinvestor(s)inthatmortgage. Italsotendstomakeservicerslessinclinedtoresolvetheloanthroughashortsale,asfeeincomethatwill beearnedintheinterim(astheloanwindsitswaythroughalengthyforeclosureprocess)isquite attractive. Problem:Distortionintheservicingfeeschedules:Wehaveheardassertionsthat,sinceservicersare inadequatelypaidforservicingdelinquentloans,therelatedfeesareawaytomakeupthedifference.Itis absolutelythecasethatservicersaredefinitelyunderpaidforservicingdelinquentloans.However,they areoverpaidforservicingperformingloans.Moreover,exante(attheinceptionoftheloan),theservicer hadagreedtoservicetheloansattheagreeduponprice.Itsjustthatexpost(atthepresenttime),given theamountofdelinquentloansthataccumulatedversusoriginalexpectations,theiroriginalagreement hasturnedouttobeabaddeal.Butintherealworld,adealisadeal!Forinstance,myownfirmAmherst SecuritiesGroupcantagreetoaconsultingcontractatafixedprice,thencomebackandrenegotiate becauseitismoreworkthanwethoughtitwouldbe. Problem:NoDisclosureofFees.Servicerswilltellyouthattheservicestheyprovideareessential,and theywouldbeprovidedatsimilarpricesbyanythirdparty.Byowningorhavinganinterestinawider arrayofservices,theservicersalsohavemorecontroloverthetimingandcanmorecloselymonitorthe qualityoftheservicersprovided.However,neitherborrowersnorinvestorshaveanywaytoconfirmthis. Theancillaryfeesarenotbrokenoutinaformthatistransparenttoanyoneoutside. PartialSolution:MakeBetterFeeDisclosureaPartofNationalServicingStandards.TheNewYorkState BankingDepartment,intheirRegulationsforServicingLoans(part419),requiresthatservicersmust maintainascheduleofcommonfeesonitswebsite,andmustincludeaplainEnglishexplanationofthe fee,andanycalculationdetails.Inaddition,theservicershouldonlycollectafeeiftheamountofthatfee isreasonable,andfeesshouldbechargedonlyforservicesactuallyrenderedandpermittedbytheloan instrumentsandapplicablelaw.Attorneysfeeschargedinconnectionwithaforeclosureactionshallnot exceedreasonableandcustomaryfeesforthatwork.Attheminimum,thistypeoflanguageshouldbe adoptedfornationalservicingstandards. ForcePlacedInsuranceHighlightstheConflictsofInterest.Theservicer,oranaffiliateoftheservicer oftenownashareofaforceplacedinsurer.Thisinsuranceisusedtoprotectthehomewhenthe
This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

 borrowerisnolongermaintaininghisexistingpolicies.Giventheconflicts,itisunrealistictoexpecta servicertomakeanunbiaseddecisiononwhentobuythisinsurance(thereisatendencytobuyitwithout tryingtoretainthehomeownerspolicythatwasalreadyinplace)aswellashowtopriceit(thereisa tendencytopricetoohigh). Therehavealreadybeenseveralattemptstoaddressthisissue.TheNewYorkStaterequirements explicitlyaddressforceplacedinsurance(hazard,homeowners,orfloodinsurance),anddetailssituations inwhichitshouldnotbeused.Aservicerisprohibitedfrom(1)placinginsuranceonthemortgaged propertywhentheinsurerknowsorhasreasontoknowtheborrowerhasaneffectivepolicyforthe insurance;(2)failingtoprovidewrittennoticetoaborrowerwhentakingactiontoplaceinsurance;and (3)requiringaborrowertomaintaininsuranceexceedingthereplacementcostofimprovementsonthe mortgageproperty. TheStateAttorneysGeneralproposedsettlement(circulatedinMarchofthisyearbutnotyetapproved) containssimilarprovisionsgoverningtheplacementofforceplacedinsurance.Theservicermustmake reasonableeffortstocontinueorreestablishtheexistinghomeownerspolicyifthereisalapsein payment.Theservicermustadvancethepremiumifthereisnoescroworinsufficientescrow.Ifthe servicercannotmaintaintheborrowersexistingpolicy,itshallpurchaseforceplacedinsurancefora commerciallyreasonableprice. However,theAttorneysGeneralproposedsettlementwentonestepfurtherthantheNewYorkState requirementsitsuggestedtheeliminationoftheconflictofinterestbyprohibitingtheseservicersfrom placinginsurancewithasubsidiaryoraffiliatedcompanyoranyothercompanyinwhichtheservicerhas anownershipinterest. Solution:ForcePlacedInsuranceConflicts.NationalServicingStandardscanbeusedtorequireservicers tokeepexistinghomeownerspoliciesinplaceaslongaspossible,asboththeNewYorkState requirementsandtheproposedAttorneysGeneralsettlementdo.Ifitisnotpossibletoreestablishthe existinghomeownerspolicy,measuresmustbeincludedtomakesurethepricingofthepurchaseis reasonable.Moreover,followingtheleadoftheAttorneysGeneralsettlement,nationalservicing standardsshouldprohibittheplacementofforceplacedinsurancewithasubsidiary,affiliatedcompany, oranyothercompanyinwhichtheservicerhasanownershipinterest. Solution:DealingwithOtherAncillaryFees.UndertheAttorneysGeneralproposedsettlement,the servicercannotimposeitsownmarkupsonanythirdpartyfees.Subsidiariesoftheservicer(orother entitieswheretheservicerorrelatedentityhasaninterestinsuchathirdparty)areprohibitedfrom collectingthirdpartyfees.Moreover,servicersareprohibitedfromsplittingfees,givingoraccepting kickbacksorreferralfees,oracceptinganythingofvalueinrelationtothirdpartydefaultorforeclosure relatedservices.WeatAmherstSecuritiesGroupagreewiththeserecommendations.Theseideasshould becomeapartofameaningfulsetofnationalservicingstandards.

This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

CONFLICT#3:ConflictsofInterestintheGovernanceofaSecuritization,IncludingEnforcement ofRepresentationsandWarranties
Whiletheenforcementofrepandwarrants(representationsandwarranties)doesnotdirectlyaffect borrowers,webelieveitisaveryimportanttopicforinvestor,andservestohighlighttheconflicts betweenservicersandinvestors. Violationsinvolvingrepsandwarrantsarebecomingincreasinglycommonasseeninrecentlitigation.That is,loansinasecuritizationoftendonotconformtotherepresentationsmadeaboutthecharacteristicsof theseloans.Forexample,aloanmayhavebeenrepresentedasanowneroccupiedpropertywheninfact itisnot;oraborrowerliedaboutincometoadegreethatshouldhavebeenpickedupintheorigination process;etc.Oncearepandwarrantviolationisdiscovered,atpresentthetrusteeischargedwith enforcement[theremedyisgenerallythatthesponsorororiginatorrepurchasesthatparticularloanout ofthepoolatpar(anamountequaltotheoriginalbalanceontheloanlessanypaiddownprincipal)]. However,thetrusteedoesnothavetheinformationtodetecttheviolations,theydonothavedirect accesstotheloanfiles.Moreover,astheyhavelittleincentivetodetectrepandwarrantviolations,since thetrusteeisnotcompensatedfordetectingviolationsandthebenefitsofdoingsoactuallyaccrue elsewhere(totheinvestors). Servicers(whodohavetheinformationtoidentifyrepandwarrantviolations)oftenhaveafinancial disincentivetodoso,astheywouldbeputtingtheloanbacktoanaffiliatedentity.Forexample,the largestbanksoftenserveasoriginators,dealsponsors(underwriters)andservicersonsecuritizations. Thereisnothingwrongwiththis,aslongasthereisamechanismtoallowforenforcementoftherepsand warrants. Solution:ProperlyEnforcingRepsandWarrants.Itiscriticaltohaveapartythatisincentedtoenforce them,andhasbothaccesstotheinformationandenforcementauthority.Thiscanbestbeachieved throughanindependentthirdpartychargedwithprotectinginvestorrights,whoispaidonanincentive basis.Somecurrentdealsnominallyhaveathirdpartychargedwithprotectinginvestorrights,butthat partyisnotempowered,doesnothaveaccesstonecessaryinformation(theloanfiles),andisnotpaidon anincentivebasis.ThissetofconflictsshouldbeaddressedthePSAs(purchaseandsaleagreements)for newsecuritizations.NationalServicingStandardsshoulddirectservicerstomakesurethatthereisan adequateenforcementmechanismforrepsandwarrants.

CONFLICT#4:TheServicingFeeStructureisUnsuitabletoThisEnvironment
Therearemanysituationsinwhichtransferringtheservicingofaloanonwhichtheborroweris delinquenttoaservicerthatspecializesinlossmitigationwouldbethebestoutcomeforbothborrowers andinvestors.Anumberofspecialservicershavehadconsiderableexperiencetailoringmodificationsto theneedsofindividualborrowersandtendtoprovidemorehandholdingtotheborrowerpost modificationthanwhatamajorservicerisstaffedtoprovide.Consequently,theredefaultrateson modifiedloansaremuchlowerwithspecializedservicerswhofocusonlossmitigation.

This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

 Servicingtransferissuesaremadeverydifficult,asmanydealsdonotprovideforadequateservicingfees toencouragesuchatransfer.Wemadethepointearlierthatservicersarecompensatedtoohighlyfor servicingcurrentloans,nothighlyenoughforservicingdelinquentloans.Ifcompensationisinadequate,it willbeverydifficulttoconvinceaspecialservicertoservicetheloan. Solution:RevamptheServicingFeeStructure.Therehasbeenaconsiderableamountofdiscussionabout revampingthestructureofservicingfees,toallowforlowerfeesforperformingloansandhigherfeesfor nonperformingloans.TheFHFAhasorganizedanumberofmeetingstodiscusstheseissues,andhas outlinedthealternatives.Iffeesweretobealteredsuchthatfeesforservicingcurrentloanswerelowered whilefeesforservicingdelinquentloanswereraised,itwouldallowthespecialservicertobeadequately compensatedforhishightouchefforts.This,inturn,wouldmakeitmucheasiertotransferdelinquent loanstoservicerswhowoulddoabetterjobatlossmitigation. Therehasbeensomeconcernabouttheincentiveissuesthatwouldarise.Givenhigherservicingfeesfor servicingnonperformingloans,willservicersbedisincentedtomakeaproactivephonecallwhena borrowermissesonepayment?Willtheoriginator/affiliatebelessconcernedaboutthequalityofloans theyoriginate?WethinkthereisaverysimplesolutiontothisgivetheGSEsorprivatelabelinvestors theabilitytomovetheservicingwhenthehigherfeesarescheduledtotakeeffect.

CONFLICT#5:TransparencyforInvestorsIsWoefullyInadequate.
Manyoftheconflictsareobscuredbyservicersasaresultofthepoorreportingtheyprovideonamonthly basis.Webelievethatwithmoretransparency,manyoftheseconflictswouldbemorevisibleand servicerswillbelessinclinedtoactagainsttheinterestsoffirstlienborrowersandinvestors.Inaprivate labelsecuritizationthereisoftenalargedifferencebetweenthemonthlycashpaymenttheinvestor expectedtoreceiveandwhatisactuallyreceived.Moreover,aninvestorisunabletodelveintothecash flowinformationfurther,ashelackstheinformationontheactionsoftheservicerthatwouldbe necessarytoreconcilethecashflows.WhenIreceivethestatementfrommybankeachmonth,Ibalance mycheckbook,reconcilingthedifferences.Investorswanttobeabletodoexactlythiswiththecashflows fromthesecuritizationsinwhichtheyhaveaninterest.Thereareseveralculprits: Insufficienttransparencyonliquidations.Whenaloanisliquidated,investorsoftenreceiveonly onenumbertherecoveredamount.Servicersprovidenotransparencyonwhatthehomehasbeensold for,whatadvancesweremadeontheloan,whattaxesandinsurancewere,whatpropertymaintenance feeswere,norwhatthecostsofgettingtheborroweroutofthehousewere.Abreakdownofthese costs/feeswouldhelpinvestorsunderstandseveritynumbersthatweredifferent(oftenmuchhigher!) thananticipated.Itwouldalsoallowinvestorstobettercomparebehavioracrossservicers,allowingfor identificationofthemostefficientservicers,andexposingtheunderperformers. Insufficienttransparencyonserviceradvances.Aservicerusuallyadvancesprincipalandinterest paymentsondelinquentloans,allowingforapaymenttotheinvestoreveniftheborrowerisnotpaying. Theseadvancesarerequiredtobemadeaslongastheservicerdeemsthemtoberecoverable.Thereis oftenlittleinformationonwhichloansarebeingadvancedon,whichmakesitverydifficultforinvestorsto figureouthowmuchcashtheyshouldexpect.
This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

May 11, 2011

 Insufficienttransparencyonmodifications.Similarly,whenaloanismodified,investorsoftencant tellhowthatloanhasbeenmodified.Hastherebeenaninterestratereduction,atermextension,a principalforbearance,orprincipalforgiveness?Howlongwillanyreducedinterestratebeineffect,and howwillitreset?Wereanydelinquentpaymentsforgiven?Whilesomeservicersarebetterthanothers atreportingthisinformation,investorsareoftenforcedtoinfer(guess!)itfromthepayments. Insufficienttransparencyonprincipalandinterestrecaptures.Whenaservicermodifiesaloan,the servicerisentitledtorecapturetheoutstandingprincipalandinterestadvances.Thoseamounts,payable totheservicer,havethefirstclaimrightsoncashflowsofthesecuritization.Investorsoftenreceiveless moneythananticipatedduetotheserecaptures.Thereiscertainlynothingwrongwithservicers recapturingfundstheyadvanced,butinvestorswanttoknowhowmuchhasbeenrecapturedandfrom whichloans. [NOTE:Asanaside,wehaveoftenheardassertionsthatservicershaveanincentivetospeedilymovea borroweralongintheforeclosureprocess,astheycanrecovertheiradvances.Thatchargehasnever madeanysensetous.Bymodifyingaloan,servicerscanrecoveradvances.Moreover,bymodifying,the servicerreceivesbonusesfromtheU.S.governmentfromusingtheHomeAffordableModification Program(HAMP).Finally,thelongertheprocess,themoreancillaryfeeincomeisgeneratedforthe servicer.] Theresultofthelackoftransparencyisthatinvestorscantreconcilethecashflowsonthesecuritization theyhaveinvestedin.Theydontknowhowmuchisbeingadvanced,whatarethetermsofthe modificationsonthemodifiedloans,andhowmuchoftheprincipalandinterestadvancestheserviceris recapturingwhendoingthemodification. Solution:Transparency.Webelievetheremittancereportsforfuturesecuritizationsshouldcontainloan byloaninformation,andthatloanbyloaninformationshouldberolledupintoaplainEnglish reconciliation.Nationalservicingstandardsshouldencouragethistransparency.

CONCLUSION
Insummary,wehavediscussed5conflictsofinterestbetweenservicersandborrowers/investors.They involvethefollowing: (1) liens servicersoftenownjuniorinterestsindealstheyservice,butinwhichtheydonotownthefirst

(2) theserviceroftenownsashareincompanieswhichcanbebilledforancillaryservicesduringthe foreclosureprocess,andchargesabovemarketratesontheseservices (3) thereareconflictsofinterestinthegovernanceofthesecuritization,includingtheenforcementof repandwarrantissues (4) (5) servicingtransferscanbeproblematicduetoamisalignedservicercompensationstructure transparencyforinvestorsismissing
This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

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This material has been prepared by individual sales and/or trading personnel and does not constitute investment research.

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May 11, 2011