Mortgage investors say they need more protection from further home price declines than the government is currently offering them in return for allowing loans to be modified.
The Obama administration's Home Affordable Modification Program, which pays incentive fees to servicers that rewrite loan terms, includes extra payments to investors that consent to modifications in declining housing markets. These payments, for as much as $5,000, are meant to compensate the investor for the risk that the borrower will end up defaulting again and the home will be foreclosed on and sold into an even more depressed market.
But Magnetar Capital LLC, an Evanston, Ill., hedge fund, is lobbying for the government to provide much greater downside protection for holders of private-label mortgage-backed securities and whole loans.
Rather than receive a flat fee, like that provided through the Obama program's Home Price Decline Protection plan (which took effect Sept. 1), Magnetar wants the government to guarantee a minimum recovery of 75% of the newly underwritten value of a home. As part of the hedge fund's plan, the government would create a mechanism to ensure servicers are disposing of properties efficiently, just as Fannie Mae and Freddie Mac monitor servicers of the mortgages they guarantee.
Currently, without either such monitoring or a backstop, "the investors are the ones who are going to lose money," said Michael Henriques, a principal at Magnetar. "We have no idea whether servicers are making the right decisions in modifying loans."
While it is unclear whether Magnetar's plan would be adopted by the Treasury Department, the push indicates investors are skeptical about recent signs that the housing market has bottomed. They are taking into account a significant backlog of defaulted loans that have not yet completed or even begun the foreclosure process and expectations that the failure rate on modified loans will be high. "Investors are really worried about the loan mods that fail," said Laurie Goodman, a senior managing director at Amherst Securities Group LP.
Mortgage assets are currently trading at steep discounts, Goodman said, because with no floor for home price declines, investors are factoring in what she calls a "substantial uncertainty premium" for the worst-case loss scenario.
Some mortgage industry lobbyists are backing Magnetar's plan.
"While it's unlikely that property values would drop another 25%, it stops the death spiral" of home prices, said Anne Canfield, the executive director of the Consumer Mortgage Coalition, which represents national mortgage lenders and servicers, including the largest banking companies.
In a 32-page report, Henriques and the other two principals at Magnetar, David Snyderman and David Wecker, wrote that there is "a misalignment of interests" between investors and servicers on loans modified through the Obama program.
Government policies have not addressed the risk from "severity upon default," which is the percentage of the face value of a loan that an investor does not recover through the sale of a foreclosed property, the report said.
"Modifications that don't work are likely to be costlier to investors than a timely liquidation," the Magnetar principals wrote. Yet servicers are given incentives to modify loans "on any hint of borrower distress without regard to the effect on the value of the loan."
Henriques, a veteran of Deutsche Bank AG's securities unit and Goldman Sachs Group Inc., said the private-label investors typically get very limited information on their collateral — like loan number, Zip code and the ultimate severity of the loss — because of concern for the borrower's privacy. "We see high severities on loans liquidated in Texas or Oregon and the trustee can't tell us anything," he said. "If a servicer forgives 40% of a borrower's principal balance, that may be the right thing to do, but we have no idea."
Some borrowers "have no real chance of paying and are going to redefault anyway," Henriques said, which calls into question whether a borrower should receive a loan modification in the first place. "Servicers' incentives are to make the portfolio look better."
Wecker, who like Snyderman used to work at the private-equity firm Citadel Investment Group, said Magnetar's proposal should stabilize ratings for private-label securities by providing a guarantee on a significant –— though not the entire — portion of the principal balance of most senior securities. Such stabilization would reduce forced selling by banks and insurers, he said.
"The reason prices for these securities were falling through the floor is that investors are underwriting to a worst-case scenario," Wecker said. "When money managers are looking at investing in something, there's a big difference between making 10% and potentially losing 70%.”"
Under the Magnetar proposal, lenders would pay a 10-basis-point fee for the 75% guarantee, though a range of values could be considered, he said.
Canfield said potential ratings upgrades resulting from the guarantee would provide capital relief to banks while pension funds and institutional investors that can only invest in AAA-rated securities would come back into the private-label mortgage-backed market. "This would really benefit everyone by bringing real money back into the mortgage space."
