Fitch Inc. said a subprime mortgage servicer survey it conducted in the first quarter found that repayment and forbearance plans are becoming less effective for resolving loan defaults.
Liquidating assets through foreclosure — generally considered the least effective loss-mitigation technique — may be the only way for servicers to manage the most serious defaults, the rating agency said in a report released Monday.
"There will be some borrowers that find they just cannot afford the homes they are in," Diane Pendley, managing director of operations risk for Fitch, said in an interview Tuesday.
The report said, "Increasing numbers of stressed mortgage loan borrowers are turning to … servicers for assistance in helping them keep their homes."
There has also been political pressure on servicers to provide such assistance from politicians such as Senate Banking Committee Chairman Chris Dodd.
Servicers use repayment plans, forbearances, and loan modifications to help borrowers pay loans when they are faced with temporary income disruptions like an illness or unemployment.
Fitch said those practices historically have been used to resuscitate 50% to 75% of defaulted loans but were never intended as a way to bail out adjustable-rate borrowers trapped in mortgages they cannot afford.
Such practices "are not expected to work for some borrowers facing ARM resets, because they will not be able to afford the new monthly payment," the report said.
More than 30% of subprime ARMs are scheduled to reset this year, and almost another quarter are set to adjust next year.
Ms. Pendley said the loss-mitigation strategies remain useful for traditional subprime borrowers at risk of default. "They are still very effective for certain borrowers … working off the basic assumption that the borrower can still afford to make that payment."
Still, fearing that ineffective loss-mitigation techniques could make poorly performing loans look healthy, and in turn expose bondholders to more risk, Fitch said it would revise its grading criteria beginning in August.
"Fitch's new rating criteria will reflect the risk of early overcollateralization … followed by high levels of borrower redefault, where such risk is deemed to be substantial," Glen Costello, an analyst with the agency, wrote in a research note published Monday.
Ted Korzenski, a senior vice president at Clayton Holdings Inc.'s Quantum Servicing Corp., said servicers ultimately are responsible for determining the fate of each defaulted loan.
"I'm not going to put a borrower on a modification if I re-underwrite their current debt scenario and find out they can't afford that modified term," Mr. Korzenski said. "You don't just go off willy-nilly and put people on modification." He said the redefault rate at his Shelton, Conn., firm was about 20%; the industry average is hovering at 20%-25%.
