As the debate evolves over whether the government should require a systematic approach to loan modifications, one element that so far has taken place mostly behind the scenes is advancing with a new sense of urgency.
The issue involves establishing accounting and reporting standards to deal with any broad changes to loan structures that might be introduced. As much as any other factor in the debate, those standards will be critical to evaluating the quality of securities backed by the loans and to the ultimate distribution of funds to investors in various tranches.
Market participants have known about the complexity of this problem for some time, even though answers have yet to emerge. Fitch Inc. raised the issue in a report in June, when it said that variations in reporting modifications then taking place on a loan-by-loan basis - and which therefore did not all conform to any uniform standard - "make it difficult to track the quantity and characteristics of modified loans."
In addition, "extensive use of modifications, coupled with the reporting of modified loans as contractually current," could effectively upend the way mortgage-backed investors were paid by redirecting funds to junior investors in a way that hurt more senior claimants, the rating agency said. That is because the modifications would keep loans current past designated "trigger" dates, and so create a risk of inappropriate release.
Rod Dubitsky, a fixed-income analyst with Credit Suisse Group Inc., said basic information on loan modifications is woefully inadequate.
"Nobody knows how many mods are being done," he said. "So just a simple example: You have two servicers doing the same type of mods. One might report the original coupon but only collect the modified rate. So when we look at the loan-level data, we see it as a 10% coupon, but maybe the servicer's collecting 7%, because they modified the loan. Whereas another one for the same mod might report the modified rate. … Some guys do trial mods where they don't formally ink the paperwork for several months, so it might initially not show up as a mod to us, but then maybe four or five months later it shows up as a mod."
Both Mr. Dubitsky and Diane Pendley, a managing director with Fitch, said that there have been too few modifications for reporting problems to pose too much difficulty yet.
"It is unfortunate in many ways for the market: There just have not been enough modifications to be material in any one transaction to date," Ms. Pendley said.
But Mr. Dubitsky said the issue would matter "hugely" if activity picks up.
Some clarity on the issue may be coming soon. The American Securitization Forum is coordinating efforts to establish uniform reporting requirements and other standards.
Ms. Pendley said she expects the forum to put out standards soon, perhaps as early as this week. "It's our understanding that it will include a statement in there as to where the modified loans would continue to show delinquent, for I believe it could be up to a year" for the purposes of releasing capital meant to protect senior tranches.
The trade group would not discuss the matter beyond press releases it issued last week. One of those releases quoted from testimony given by Tom Deutsch, the group's deputy executive director, before a House Financial Services subcommittee.
"We believe that streamlining the process of evaluating borrower characteristics and matching them up efficiently with the appropriate loss-mitigation options will ultimately help servicers manage their responsibilities in a changing market, while appropriately balancing the interests of borrowers and investors," he said.
In the June report, Fitch published a table showing servicers the information on modifications it wants to rate bonds.
Ms. Pendley said that if Fitch did not get the information it wanted, it still would take that into account in its rating analysis and "be more conservative, with the assumption that there were modifications that were affecting the actual numbers."
In the June report, Fitch addressed problems challenging the servicing industry, including a rising workload because of increasing defaults and financial problems at some of their lender parents.
Ms. Pendley said some, "depending on the sophistication of their systems," will face difficulties in adjusting to a uniform reporting regime. "It would be either very simple to make this change, or it could be a matter of developing some type of an ad hoc, adjunct system."
