A Servicer's Alleged Conflict Raises Doubts About 'Skin in the Game' Reforms

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Carrington Capital Management, a former subprime securitization specialist, salvaged an impressive amount of money from its low-ranked residential mortgage-backed securities, thanks to the unusual strategies of its servicing affiliate.

By stockpiling foreclosed homes and declaring borrowers current — sometimes unilaterally — Carrington received payments that would otherwise have protected other investors from future losses. In a single deal that American Banker analyzed, Carrington's actions likely netted its investment fund more than $20 million.

"They appear to have managed their book for their own personal benefit in a way that screws the investors," said Laurie Goodman, an Amherst Securities analyst who flagged Carrington's modification practices in research notes.

Carrington is not a bank; it competes with them, and its inner workings raise unsettling questions about the mortgage market and some of the proposals to fix it.

Carrington's performance suggests that forcing securitizers to retain exposure to their own deals may not reliably guarantee quality origination and aligned incentives among investor classes, and shows how hard it is for investors to figure out how pools of collateral are being managed. It also demonstrates how the basic structure of a securitization — that the claims of some classes of investors outrank others — can be turned on its head.

Depending on how the Obama administration structures planned retention requirements, the same incentives that Carrington created for itself could be institutionalized nationwide.

"A lot of people say, well, there's not enough skin in the game," said Eric Higgins, a professor of management and finance at Kansas State University who has researched the performance of private-label mortgage securities. "But maybe it's more of a regulatory issue. … Drawing $20 million of overcollateralization out of a deal that's going to end up with a 45% delinquency rate, you should not be allowed to do that."

An internal audit viewed by American Banker shows Carrington holds similar stakes in at least 17 more deals.

While Carrington's servicing practices benefited itself, Carrington argues that its strategy also aligned the interests of both homeowners and the trusts it oversees. The company's real estate disposal strategies were reasonable, it said, and it has salvaged value by giving borrowers repeat modifications. Moreover, Carrington's bottom-ranked positions in its deals come with special discretion over default management, the company notes.

Carrington's strategy has been "to reduce losses and maintain payment streams for the trusts, by modifying loans for homeowners who are having difficulty and avoiding the sale of properties at historic market lows," company spokesman Chris Orlando said.

Evaluating Carrington's claim of good results is difficult because the company's actions, regardless of their long-term impact, have had the effect of improving the deals' short-term appearance. While Goodman and some Carrington investors anticipate that senior bondholders will eventually face greater losses due to Carrington's actions in the deal reviewed by American Banker, those losses have not materialized yet.

BIRTH OF A STRATEGY

Carrington is the product of Bruce Rose.

A former airline mechanic and pilot, Rose moved into finance at the beginning of the 1980s. While working at Solomon Brothers, he became familiar with subprime through helping to finance the early shops producing such securities, according to a Reuters profile. In 2003, he left Citigroup Inc. to start his own mortgage securities hedge fund. Carrington Capital Management's business was to package subprime debt into private-label securities, retaining the highest-yielding, lowest-ranking portion of the deals for itself.

"From its inception, [Carrington] had a consistent philosophy: maximize asset value over the long term, focus on return over volume and align interests and incentives," Orlando said. "That's where you see the risk-retention concept come into play."

That concept led Carrington to insist on a special feature of deals in which it invested: Despite holding the lowest-ranked slices of the securitization, Carrington claimed a high degree of authority over handling troubled collateral. Among its privileges was the right, as Carrington would note later in court, to "direct the servicer regarding the disposition and sale of properties whose mortgages go into default."

Neither the ratings agencies nor investors appear to have objected to this detail, and Carrington had an important asset: close ties with a subprime origination star, New Century Financial. The Irvine, Calif., firm provided seed funding to Carrington in exchange for a stake in its fund, and it often supplied loans to Carrington and serviced its deals.

The collapse killed off New Century and many of the subprime originators Carrington worked with, and subprime investment funds were overwhelmed by losses, litigation and redemption requests. A March 2007 BusinessWeek article with the headline "Who Will Get Shredded?" declared that Carrington "may have gotten badly burned" by its ties to the then-floundering New Century and "seems particularly vulnerable."

Instead of retreating, Carrington waded further into the industry. In May 2007 it paid $188 million to purchase New Century's servicing rights and infrastructure out of bankruptcy. In the company's investor letter that June, Rose heralded the purchase.

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