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March 10, 2008 8:47 pm

Mortgage principal forgiveness will meet resistance from servicers

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This article is provided to FT.com readers by Debtwire—the most informed news service available for financial professionals in fixed income markets across the world. www.debtwire.com

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Mortgage servicers modifying loans under Hope Now are unlikely to allow principal forgiveness readily, especially when the loans have been securitized, servicers and industry analysts told Debtwire. That may lead to temporary forgiveness through the creation of soft second lien loans, said one industry consultant.

In a speech before the Independent Community Bankers of America last week, Federal Reserve Chairman Ben Bernanke encouraged servicers to use principal forgiveness for loss mitigation. He argued that principal writedown makes solid economic sense in some cases, notably when stressed borrowers owe more on their mortgages than their houses are worth.

But servicers face strong disincentives to paring down non-performing mortgages because of potential legal exposure should RMBS investors decide they are unwilling to write down principal. What’s more, documents governing the securitization may not allow for such modifications.

Even if servicers have the will to forgive debt, they may not have the systems or personnel in place to handle this type of modification.

The end result is that principal forgiveness “is not a really common type of modification you might see,” said Mary Kelsch, a senior director in the operational risk group for Fitch Ratings. While most pooling and servicing agreements do not “state specifically [that servicers] cannot do specific types of modifications,” she said, most servicers would “probably seek legal counsel to determine the best course of action.”

Anecdotally, she said, “with modifications in general, I think they get varying direction” from attorneys as to what is permissible or not, with “some…doing whatever they can to save the mortgage” and “others being a little more cautious.”

If servicers “started forgiving large chunks of principal, what if the house later appreciates and then the investor has lost out on that money that may have prevented foreclosure today?” As a result, investors might well be reluctant to accept a pure write-down of principal, she said, and servicers would be likely to look first for other ways of keeping borrowers in their homes, such as reducing interest rates or extending loan terms.

The American Securitization Forum weighed in on the issue in a statement following Bernanke’s comments. Principal forgiveness, “should be made only in accordance with contractual terms, and in circumstances in which a servicer concludes that the modification is likely to maximize the recovery on the mortgage loan,” the trade group said ”In considering partial principal reductions for a mortgage loan that is ‘under water,’ servicers would have a clear basis for concluding that the related borrower is unable to meet the original terms of their obligation, rather than simply being unwilling to do so.”

Servicers themselves agree that the issue is a complex one. When evaluating changes to securitization cash flows that weren’t contemplated at issue, servicers have to consult trustees on behalf of the end investors and master servicers, said David Vida, president of Plano, Texas-based servicer Strategic Recovery Group.

And in some cases, pooling and servicing agreements may need to be amended, he added. “I think there’s going to be some challenges for servicers to deal with, just structurally.” Vida said his company is doing modifications of this nature, but for unsecuritized whole loans, where it is simpler to consult the investor who owns the loan.

Nonetheless, there are certain areas of the country – notably in parts of the Midwest – where mortgages now exceed the value of the homes that back them. Homeowners caught in that bind could make payments on smaller mortgages and seem like viable candidates for forgiveness.

Investors in some of these areas are recovering less than the typical 45% to 50% of principal owed when foreclosed homes are sold. “There are cases where…it makes sense to forgive principal,” said Phillip E. Comeau, head of Synergystic Associates, Inc., a mortgage industry consulting firm.

Consumer advocates have been asking servicers to consider this option for many months. “We run into a lot of people who could keep their houses” if the principal owed on their mortgages was lowered, said a director of a nonprofit housing retention firm in Detroit. However, the nonprofit director said, most servicers cannot or will not consider the option.

Part of that pushback may be logistical, the nonprofit director said. Servicers are already swamped with calls from borrowers seeking modifications and do not have enough personnel to efficiently manage what modifications they are already doing, he said. Because principal reduction is “not a common option” in loss mitigation software, he said, it is likely that servicers would have to upgrade their systems significantly to be able to handle them more easily.

Nevertheless, there might well be ways to work out principal forgiveness that satisfies all parties involved, Comeau said. For example, some servicers are reducing principal initially to match the current value of the house, while carving the remaining balance into a soft second lien that can be recovered when the house is eventually sold, he said. A soft second lien refers to a loan where the borrower makes no payments, although the loan retains a lien on the property until the sale.

Unlike simply writing down principal altogether, this would allow investors some chance at recovering the full amount of their principal later on. While servicers and investors have said in conversations that they would be reluctant to “totally write it off…they could live with putting the money at the back end,” Comeau said.

And with housing markets in vicious cycle of lower real estate prices, defaults, foreclosures and then lower real estate prices, it is critical to find solutions, Comeau added. “When you look at places like the Midwest...the Michigan area, this is exactly the type of workout that should be happening, and happening broadly.”’

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