On March 4, 2009 the United States Treasury Department (the "Treasury") published guidelines (the "Guidelines") to implement the objectives of President Obama's Homeowner Affordability and Stability Plan (the "Plan") which was first announced on February 18, 2009. The Plan in part provides a $75 billion initiative to help up to 3 to 4 million "at-risk homeowners" primarily through the implementation of a program for uniform loan modifications that is described in extensive detail in the Guidelines. On April 6, 2009 an interagency working group (including the Treasury, the Federal Housing Finance Agency, Fannie Mae, Freddie Mac and others) released Supplemental Directive 09-01 (the "Directive"), which describes implementation guidelines for the Home Affordable Modification Program for first lien non-GSE mortgage loans, including the requirement that participating servicers enter into a servicer participation agreement (a "Participation Agreement") with Fannie Mae. The Directive has been accompanied by a set of Frequently Asked Questions relating to the Directive (the "Directive FAQ"), most recently issued as of May 22, 2009.
In addition, on April 28, 2009 the Obama Administration (the "Administration") announced two new initiatives, the establishment of the Second Lien Program (the "SLP", and together with the Home Affordable Modification Program initially announced under the Plan, the "Modification Program" or "Program") under the Plan, and the integration of the HOPE for Homeowners Program (the "HOPE Program") into the Plan. On May 14, 2009 the Treasury released an update relating to foreclosure alternatives and home price decline protection incentives (the "Foreclosure Alternative and Home Price Decline Update") that describes the incentives available to servicers and borrowers which are aimed at facilitating short sales and deeds-in-lieu of foreclosure and incentives to lenders/investors which are aimed at protecting against falling home prices.
We applaud the Modification Program, and believe that it represents a very well thought out and forward looking response to the problem of preventable foreclosure and insufficient modifications. We believe the Program will give servicers the tools needed to modify loans and preserve homeownership, in a way that is uniform and consistent with industry standards.
Although the Treasury has made extensive efforts to clarify various aspects of the Modification Program, there are still some remaining questions. We are writing to discuss the impact of the Modification Program on various aspects of securitization transactions, primarily the impact of modifications under the Modification Program on cashflow payments to securityholders, and to highlight certain questions raised by the terms of the Modification Program.
The Modification Program is available for "at-risk homeowners." The modification program initially announced under the Plan only applied to first lien mortgage loans, although the Guidelines contained incentives (cash payments up to $1,500) to encourage servicers to eliminate junior liens on the modified loan. The Administration then announced new details on April 28, 2009 that address modifications of second lien loans under the Plan through the SLP.
The basic eligibility requirements for a loan modification under the Program, for non-GSE first lien loans, are as follows:
- Loan must be originated on or before January 1, 2009;
- Current loan balance prior to capitalization of arrearages or advances must be within conforming loan limits1;
- Either (a) loan is currently delinquent (60 or more days) or (b) default must be reasonably foreseeable;
- Mortgaged property (or one unit if two- to four-unit) must be borrower's principal residence;
- Property cannot be vacant or condemned;
- Borrower must sign a hardship affidavit, and must document a financial hardship and not have sufficient liquid assets to make payments without the modification;
- Current front-end DTI ratio must be at least 31%;
- Servicer may not require borrower to waive legal rights as a condition to the modification;
- Loan may be in foreclosure, in which case foreclosure proceedings must be suspended;
- An escrow account for tax and insurance must be set up, if not in existence;
- Trial period documentation must be completed by December 31, 2012; and
- Current LTV is not relevant to eligibility; however, current property value is relevant to whether the NPV test is positive.
In addition to borrowers that are already in default, the Plan also addresses borrowers who are current on their mortgage payments but who are at risk of "imminent default", or where the borrower experiences a material change in circumstances or a recent or imminent payment shock that causes a financial hardship. Further, borrowers who have high total debt(i.e. not just housing debt, but also including car loans, credit card debt, etc.) equal to 55% or more of their income may still qualify for the Plan, but will be required to enter a counseling program approved by the Department of Housing & Urban Development ("HUD") as a condition for the loan modification. The borrower must provide specific documentation to the servicer to verify the borrower's financial situation. Loans may only be modified once under the Plan.
II. Servicer Participation, Details on Modification Methods and Incentives to Parties
Under the Guidelines, servicers must adhere to any existing express contractual restrictions with respect to the modification of loans. While servicers participating in the Plan are required to use reasonable efforts to remove any prohibitions contained in the relevant servicing agreements that relate to certain aspects of loan modifications and to obtain waivers or approvals from all necessary parties to implement modifications, the servicer may be limited or unable to implement that aspect of the Modification Program to the extent any aspect of the Modification Program conflicts with an express provision in a servicing agreement.
Certain aspects of the Modification Program may limit participation by servicers. One potential impediment to widespread servicer participation in the Modification Program is the concern that servicers would subject themselves to liability to certain investors by implementing loan modifications that may not be expressly contemplated by the securitization transaction documents. On May 20, 2009, President Obama signed the "Helping Families Save Their Homes Act of 2009" into law as Public Law 111-22 (the "Helping Families Act"). One of the salient aspects of the Helping Families Act is the amendment of existing Section 129A of the federal Truth-in-Lending Act, which was originally enacted by the Housing and Economic Recovery Act of 2008, to provide residential mortgage loan servicers with a safe harbor from liability in connection with entering "qualified loss mitigation plans" with borrowers. Under the Helping Families Act, a "qualified loss mitigation plan" includes a residential loan modification, workout, or other loss mitigation plan, including to the extent that the Secretary of the Treasury determines appropriate, a loan sale, real property disposition, trial modification, pre-foreclosure sale, and deed-in-lieu of foreclosure, that is described or authorized in guidelines issued by the Secretary of the Treasury or his designee under the Emergency Economic Stabilization Act of 2008 ("EESA"). As a result, this servicer safe harbor provision now applies only to loan modifications that are "described or authorized" under the Modification Program.
The Helping Families Act provides that, notwithstanding any other provision of law, whenever a servicer of residential mortgages agrees to enter into a qualified loss mitigation plan with respect to one or more residential mortgages originated before the date of enactment of the Helping Families Act, including mortgages held in securitization trusts or other investment vehicles, (i) to the extent the servicer owes a duty to investors or other parties to maximize the net present value of the mortgages, the duty will be construed to apply to all investors and parties, and not to any individual party or group of parties and (ii) the servicer will be deemed to have satisfied the duty to investors and other parties to maximize net present value if, before December 31, 2012, the servicer implements a qualified loss mitigation plan that meets the following criteria: (a) default on the payment of the mortgage has occurred, is imminent, or is reasonably foreseeable, as those terms are defined by guidelines issued by the Secretary of the Treasury or his designee under EESA; (b) the mortgagor occupies the property securing the mortgage as his or her principal residence; and (c) the servicer reasonably determined, consistent with the guidelines issued by the Secretary of the Treasury or his designee, that the application of the qualified loss mitigation plan to a mortgage or class of mortgages will likely provide an anticipated recovery on the outstanding principal mortgage debt that will exceed the anticipated recovery through foreclosure. A servicer that is deemed to be acting in the best interests of all investors or other parties under the Helping Families Act will not be liable to any party who is owed a duty, and will not be subject to any injunction, stay, or other equitable relief to the party based solely upon the implementation by the servicer of a qualified loss mitigation plan.
While the Helping Families Act appears to shield participating servicers from liability without regard to the contractual securitization provisions, one of the prerequisites for qualification under the servicer safe harbor is that the servicer adhere to a "qualified loss mitigation plan" and, as described above, the Guidelines require a servicer to adhere to any existing express contractual restrictions with respect to the modification of loans. By requiring compliance with the Guidelines, the safe harbor created under the Helping Families Act may be ineffective to the extent the modifications would conflict with express contractual provisions. The language adopted in the final Helping Families Act, while expansive, is not as sweeping as the provision previously adopted by the House of Representatives, which explicitly declared that qualified modifications could be adopted notwithstanding any contractual provision to the contrary such as quantitative or qualitative limitations set forth in a pooling and servicing agreement. Furthermore, while the safe harbor does provide for a wider scope of protection for servicers against litigation, some classes of investors may be able to assert a claim in instances where an express contractual provision in the applicable servicing agreement expressly prohibits the suggested modification and, as described below, it may be difficult for a servicer to remove or amend any contractual provision that prohibits the suggested modification, notwithstanding the fact that the servicer is required to use "reasonable efforts" to do so. In addition, the safe harbor does not afford any protection to trustees or bond administrators with respect to their application of modifications to securitization cashflows.
The Helping Families Act requires that the servicer enter a "qualified loss mitigation plan", but it is not clear whether the servicer can satisfy that condition by adopting a modification protocol that uses substantially similar procedures and methodology to that described in the Modification Program, without actually signing a Participation Agreement and without receiving incentives. A servicer might choose to implement a modification program for a portion of its servicing portfolio that is consistent with the program described in the Modification Program without signing a Participation Agreement because a participating servicer is required to implement the Modification Program for all mortgage loans it services, whether it services those loans for its own account, for the account of another party, or for a securitization. While a servicer may be interested in implementing the Modification Program for loans that it services for its own account, it may not be practical, for example, to implement the Modification Program for loans serviced for third party investors where there are restrictions to modifications under the related agreement or inconsistencies with the Modification Program, or where an investor objects to specific elements of the Modification Program (for example, the discount rate imbedded in the NPV Test). If a servicer had the ability to wall off parts of its servicing portfolio and "opt out" of the Modification Program for those parts, it might be more willing to participate in the Modification Program.
It is not clear how a servicer satisfies the requirement under the Modification Program to use "reasonable efforts" to remove any prohibitions contained in the relevant servicing agreements regarding loan modifications and to obtain waivers or approvals from all necessary parties to implement modifications, to the extent any aspect of the Modification Program is limited by or conflicts with an express provision in a servicing agreement. In some cases, this may require an amendment to the relevant agreement. It may be difficult to obtain consent from all transaction participants to such amendment. In many cases, an amendment would require investor consent. It is unclear under the "reasonable efforts" standard how far the servicer is required to go to contact all of the investors in a securitization to get their consent notwithstanding the practical impediments to doing so. Most mortgage-backed securities are held in book-entry format through The Depository Trust Company and tracking down the actual beneficial owner of a security is extremely difficult.
The Plan also does not address whether a servicer can implement the Modification Program with respect to its entire portfolio of serviced loans, sign a Participation Agreement and subsequently enter into a new servicing agreement in the future that does not explicitly conform to, or conflicts with, the Modification Program. This may be another factor that could discourage servicers from participating in the Modification Program. While to date many large servicers that service a majority of loans in the market have signed a Participation Agreement or are planning to do so, we believe that addressing the concerns above could marginally increase servicer participation in the Program.
The Plan does not provide detailed guidance as to how certain modifications would impact securitization transactions or how the incentive fees described would be applied. In addition, servicing agreements for securitization transactions generally do not contain provisions that expressly address these modifications and incentive fees. Below we provide our analysis of typical agreements and ways in which these aspects of the Plan may impact securitization transactions.
A. Joint Effort to Reduce the Borrower's Monthly Payment
The United States Treasury Department will work with financial institutions and investors to reduce the homeowners' monthly mortgage payments to an affordable level, which the Modification Program targets as equal to a 31% "front-end" debt-to-income ("DTI")ratio.2 The Guidelines include a standard waterfall (the "Waterfall") which outlines steps that a servicer must apply in the order prescribed in modifying a loan to achieve the target DTI ratio. The Modification Program provides for Treasury to share in the cost associated with a modification that reduces a borrower's front-end DTI from 38% to 31%, provided that the servicer first reduce the payments on the related mortgage to achieve a 38% front-end DTI. Thereafter, the Treasury will match further reductions in monthly payments, dollar-for-dollar with the investor, down to the 31% DTI target ratio.
Prior to applying the Waterfall, a servicer is permitted to capitalize certain arrearages (thereby increasing the principal balance of the related loan), including accrued interest, past due real estate taxes and insurance premiums, delinquency charges paid to third parties in the ordinary course of servicing and not retained by the servicer, any required escrow advances already paid by the servicer and any required escrow advances by the servicer that are currently due and will be paid by the servicer during the loan's modification trial period. Certain securitization programs specifically contemplate this type of arrearage capitalization in the related servicing agreement where the servicer is typically permitted to immediately reimburse itself for the capitalized amount out of general collections of principal. Although there will be an increase in the amount of interest collections due to the higher loan balance, any reimbursement of these capitalized amounts will result in less principal available for distribution to securityholders. To the extent agreements are silent as to the capitalization of arrearages, a reasonable interpretation would be to allow the servicer to capitalize the amount of the arrearage and reimburse itself from principal collections. Again, the capitalization of the arrearage will increase the loan balance by that amount without a corresponding increase to the aggregate security balance, but the reimbursement from principal collections from the top of the waterfall will ensure that the capitalization does not produce a mismatch between the aggregate loan balance and the aggregate security balance.
i. Interest Rate Reductions
The Waterfall requires the servicer to apply one or a combination of modifications to achieve the 31% DTI target ratio. The first step in the Waterfall requires the servicer to reduce the interest rate on the related loan. The reduction in interest rates must be accomplished in increments of 0.125%, to as low as 2% in order to achieve the target 31% DTI. Servicers must keep the modified payments in place for five years to ensure long-term affordability. After five years, the payments can increase annually by a rate of 1% until the modified rate is the lesser of the fully indexed contractual rate or the Freddie Mac Primary Mortgage Market Survey rate for 30-year fixed rate conforming loans.
Most servicing agreements do not contain explicit provisions that address the application of interest rate reduction modifications to the securitization cashflow. In order to analyze the impact of an interest rate reduction in a securitization it is necessary to carefully review the various definitions in the transaction documents that relate to the payment of interest on the securities and the allocation of interest shortfalls. For example, if a security is entitled to receive interest at a rate derived from the weighted average of the net mortgage rates of the mortgage loans (a "net WAC rate"), the relevant definitions may specify that the then-current mortgage rate should be used for purposes of the calculation or alternatively those definitions may refer to the mortgage rate as indicated on the original mortgage loan schedule. To the extent a security's interest entitlement is based on the original (pre-modification) interest rates on the loans or has a security interest rate that is fixed or not otherwise based on a formula where a net WAC rate is in effect, any interest rate reductions will create an available funds shortfall that will be applied to the related securities by operation of the interest waterfall. This will typically result in the interest shortfall being borne by the most subordinate class of securities. In certain transactions where the waterfall for subordinate securities is structured so that each class receives interest and principal before the next most subordinate class receives any interest or principal, the interest rate reduction modifications could result in less principal available for distribution to a subordinate security, possibly resulting in a principal writedown to address any undercollateralization or insufficient funds to retire the entire balance of that security by its maturity. The amount of any such shortfall in interest or principal distributions could be mitigated by the Treasury's contribution to the cost of implementing the interest rate reduction, depending on how the cost share is applied.
Many securitization servicing agreements limit the ability of a servicer to implement interest rate reduction modifications. A servicing agreement may limit the amount of the reduction in the interest rate to one-half of the original rate or to another floor interest rate. In either case, such a provision may limit the effectiveness of this step of the Waterfall in achieving the DTI target ratio, in which case the servicer would be required to proceed to the next step in the Waterfall. As described above, it is unclear whether the servicer safe harbor under the Helping Families Act will protect a servicer that disregards any such limitation on interest rate reductions.
ii. Term Extension
If the reduction of the interest rate to the 2% floor is insufficient to bring the front-end DTI to 31%, or if the securitization servicing agreement contains a limitation on the extent of interest rate reductions, then the servicer must extend the term of the loan up to 40 years from the date of modification. Most securitization servicing agreements, particularly for transactions structured as real estate mortgage investment conduits ("REMICs"), prohibit term extensions beyond the maturity date of the latest maturing loan in the securitization pool or some other specified date. If a term extension is not permitted under the related servicing agreement, the amortization period must be extended. An extension in the amortization period will result in a balloon payment at maturity and that payment would be applied as a collection of scheduled principal. As a result of the extension in the amortization period, a larger proportion of the scheduled monthly payment will constitute a payment of interest which will result in more interest collections on the related loan than would be the case if the loan had not been modified. While the amount of principal paid by the borrower (assuming the balloon payment is actually paid at maturity) during the term of the loan would be unchanged, the rate of principal payments will be affected by the reduction in the principal portion of the borrower's monthly payment and, as a result, the rate of principal distributions on the securities will be similarly affected. In connection with a term extension, however, not only will the rate of principal payments (and the corresponding principal distributions) be affected but the expected life of the securities will also be extended as the entire amount of principal owing on the securities will not be due until each of the loans, as modified, has matured.
iii. Principal Forbearance
If the interest rate reduction and the term extension fail to achieve the target 31% DTI, the servicer must forbear principal. No interest will accrue on any forbearance amount but the forbearance principal will become due on the first to occur of: (i) the maturity date; (ii) the sale of the property; or (iii) upon payoff of the balance. Upon the occurrence of any of these events, there will be a balloon payment of the forbearance amount, which, for the reasons described below, should be treated as a subsequent recovery and applied accordingly to a securitization trust. The Plan instructs servicers to apply any principal prepayment on a loan with principal forbearance to the interest bearing portion of the loan balance and then any remaining amount in reduction of the principal forbearance portion.
While most securitization servicing agreements do not specifically address how to apply a principal forbearance to the cashflow provisions, it would be reasonable to treat this type of modification as a realized loss of principal at the time of the modification and apply the loss in a manner similar to other principal realized losses.3 Typically the principal portion of realized losses are applied first to reduce any excess interest and overcollateralization, if applicable, and then through subordination. If the forbearance amount is not treated as a current realized loss, interest would accrue on an aggregate loan pool balance that is smaller than the aggregate principal balance of the securities, which could result in interest shortfalls in future pay periods, particularly in a deal with no overcollateralization or excess interest. In addition, in a shifting interest structure, without a corresponding loss allocation the forbearance amount could reduce interest and principal payments to the most subordinate securities by operation of the waterfall.
If a principal forbearance is treated as a realized loss at the time of the modification, in a "shifting interest" structure (a structure comprised of senior and subordinate securities, with no excess interest or overcollateralization), the realized loss will result in a principal writedown to the most subordinate class of securities. In this type of structure, principal collections are generally allocated as between the senior and subordinate securities on a pro rata basis. As a result, a reduction in the principal balance of a subordinate security will increase the relative proportion of the senior securities comprising the trust, and therefore increase the future principal entitlement of those senior securities.
Many transactions do not provide for the application of realized losses to senior securities in the form of a principal writedown at the time the loss is incurred. As a result, to the extent there are no subordinate securities outstanding in this type of transaction, a principal forbearance would not result in a principal writedown to the senior securities at the time of the modification but it may eventually result in insufficient funds to pay the entire outstanding balance of those senior securities. With respect to any securitization, any portion of the forbearance amount actually received should be treated as a subsequent recovery and applied in accordance with the waterfall provisions relating to subsequent recoveries.
Provisions governing distribution of subsequent recoveries appear in many securitization agreements. Subsequent recoveries that are received with respect to a particular loan typically cause (i) the principal balance of the most senior class outstanding that has absorbed any realized loss in the form of a principal writedown to be increased by the amount of the recovery and (ii) the recovery to be included as a collection of principal and distributed in accordance with the principal waterfall. Rating agencies typically require this allocation methodology to restore the securities to the state they would have been in had the realized loss (or portion of the realized loss represented by the subsequent recovery) not been originally allocated, and as if that realized loss had been the most recent realized loss allocated. Increasing the balance of a subordinate class, without directing the collected funds to that class, will increase the amount of subordination in the deal that is available as credit enhancement to the more senior securities.
iv. Principal Forgiveness
The Plan also allows, but does not require, servicers to bring down monthly payments to these DTI affordability targets by implementing principal reduction modifications (i.e. principal forgiveness). The principal reduction should be treated as a realized loss at the time the modification becomes effective. As described in II.A.iii. above, this will ensure that there is not a mismatch between the aggregate loan balance on which interest is accruing and the aggregate security balance on which interest is paid. While some securitization agreements expressly treat principal forgiveness as a realized loss, most agreements are silent on this point. However, it appears from some investor distribution statements that principal reductions are being applied in securitization transactions as current period realized losses.
B. NPV Test
The foregoing modifications are subject to the servicer's determination that a modification under the Modification Program is less costly than the process of foreclosing on the loan. Each servicer is required to apply a Net Present Value ("NPV") test on the loans which compares the NPV of cash flows expected from a modification of the loan to the NPV of cash flows expected in the absence of a loan modification. If the NPV is greater with the modification, the servicer must modify the loan. If the NPV is greater without the modification or the borrower otherwise fails to qualify for the Modification Program, the servicer does not have to apply the modification pursuant to the Plan but must seek other foreclosure prevention alternatives including deed-in-lieu of foreclosure or short sale programs. On May 14, 2009, the Treasury released the Foreclosure Alternative and Home Price Decline Update which describes the incentives available to servicers and borrowers that are intended to facilitate these short sales and deeds-in-lieu of foreclosure. Additional details of these incentives are described in VII. below.
While the Directive and the Directive FAQ include some details relating to the NPV test, certain details of the NPV test are not apparent from the published materials. For example, in all cases the NPV model must use an FHFA home price projection developed exclusively for this program. It is not clear how granular that projection is. For example, will the projection be made on a zip code level, an MSA level or some other alternative? Also, some have questioned whether the maximum discount rate that may be used when applying the NPV test (250 basis points over the weekly Freddie Mac Primary Mortgage Market Survey rate) is an appropriate cap or whether the cap should be higher.
C. Incentives to Servicers
The Plan provides for an up-front fee of $1,000 to servicers for each eligible modification that meets the Guidelines. Servicers will also receive "pay for success" fees, which will be awarded monthly as long as the borrower stays current on the loan and remains in the Plan. These "pay for success" fees are capped at $1,000 each year for three years. To qualify for the "pay for success" fees, the modification must satisfy a de minimis test where the monthly PITIA payment, as modified, is reduced by 6% or more of the monthly PITIA payment prior to modification. Because the Modification Program requires servicers to establish an escrow deposit account for all mortgage loans even if the loan being considered for modification is a non-escrowed mortgage loan, servicers should back in an escrow payment to the pre-modification PITIA in order to determine whether the modification satisfies the de minimis test. A servicer should be entitled to keep any up-front or "pay for success" fees received by the servicer in connection with a modification under the Modification Program as servicing compensation.
D. Incentives to Lenders/Investors
As described above, the Treasury will share in the cost of reducing the front-end DTI from a maximum of 38% to the target of 31%. The Treasury will provide "cost-share" compensation based on one-half of the dollar difference between the monthly payment for a 31% front-end DTI and the lesser of (i) the monthly payment for a 38% front-end DTI and (ii) the borrower's current (pre-modification) monthly payment. The compensation from the Treasury will be provided for up to five years or until the loan is paid off, if earlier.
Generally, securitization servicing agreements define all cash flows from the mortgage loans as either principal or interest collections. The allocation of specific cash flows among the classes of securities depends in part on whether they represent collections of interest or principal. A fundamental ambiguity that a servicer must address, in following the Modification Program, is that there is no clarity as to whether the cost share payments (a) should be treated as if they were a partial recovery that can be categorized as either interest or principal that otherwise would have been payable on the loan, or (b) should be treated as generic, unclassified additional recoveries from the loans.
While there may be some logical appeal to treating the cost share payments as if they were either interest or principal on the related loan, as shown below there are administrative complications with that approach that diminish the appeal. And, in reality, the payments are not interest or principal on the modified loans, as they are in excess of amounts payable on the loans as formally modified.
To the extent a particular modification achieves the target DTI solely through an interest rate reduction, all amounts received by a securitization trust in respect of such cost sharing could be applied as a collection of interest. In a transaction where the agreements define the securities' interest entitlements by reference to the original (pre-modification) rate on the mortgage loans, the incentive payments would help offset any interest shortfalls that otherwise would occur as a result of the interest rate reduction modification. If transaction agreements define the securities' interest entitlements in a way that takes into account the then-current (or post-modification) rate on the mortgage loans, it could still be appropriate to apply the incentive payments in a manner that would support paying interest at the full contract rate on the securities without giving effect to the modified loan rates, at least to the extent of the incentive payments. To do otherwise could result in the incentive payments creating excess interest that would be payable to the non-economic residual (in a "shifting interest" structure) or flow through the excess cashflow waterfall (in an overcollateralization structure) as opposed to paying these amounts as current interest on the securities.
If an interest rate reduction alone is not sufficient to achieve the target DTI, the incentive payments could be allocated to the securities as interest and principal in proportion to the amount of the reduction in the borrower's monthly payment attributable to the interest rate reduction on the one hand and the principal forbearance and/or principal forgiveness on the other hand. The portion of the incentive payment allocated as principal could be applied to repay the principal loss allocated to the securities. This amount could be applied as a subsequent recovery as described in II.A.iii. above and paid to the securities as principal. To the extent the modification included a principal forbearance, the portion of the incentive payment distributable as principal to the securities should reduce the forbearance amount owed by the borrower. This is similar to the Plan's guidance on how to apply a partial prepayment on a loan with a forbearance amount. If the forbearance amount is not so reduced and the forbearance amount is ultimately paid in full and applied at the time of payment as a subsequent recovery, the aggregate amount of subsequent recoveries in respect of the related loan would exceed the amount of principal losses applied to the securities from that loan. This result would be inconsistent with the intent of applying subsequent recoveries, namely to make the trust whole for losses actually incurred from the related loan.
Clearly, the foregoing approach is administratively complex. Also, there is not an obvious way to work into this approach any allocation of cost share payments in part to remediate the effect of a term extension. Nor would that be desirable, as it would give rise to a mismatch between the amortization schedule of the loan as modified, and the scheduled balance of the loan as held by the trust.
The following addresses some ways in which the cost share payments could be applied, if they are not treated as if they represented interest or principal on the loans. Of course, these are merely suggestions, and there generally is no authority under securitization servicing agreements for how to treat these payments if they are viewed in this manner. Servicers may have difficulty in following any of these approaches, absent any authoritative guidance under the Modification Program or other established industry best practices.
One approach would be to apply all cost share payments in the aggregate, each month, under a waterfall designed to make the overall securitization whole. Following is an example of such a waterfall:
first, towards interest at the contractual pass-through rates on all classes, to cover any shortfalls resulting from the fact that the mortgage loans are not paying at their original contract rate, with funds so allocated being prioritized first to the senior classes and then according to payment priority;
second, to cover any current period realized losses;
third, as subsequent recoveries covering realized losses incurred in any prior period; and
fourth, as a reserve against any future realized losses.
Another approach would be to use these funds, after the first step above, to accelerate principal distributions on the senior classes. This approach would, however, create a mismatch between the security balance and the pool balance in a shifting interest structure.
A major advantage of applying the cost share payments in such an aggregated manner is that other incentive payments under the Modification Program could be treated the same way, such as the upfront modification fee to investors where the loan is in imminent default, as well as the home price decline reserve payments.
E. Incentives in Cases Where Default is Imminent
Because the Administration believes it is essential to provide at-risk homeowners with assistance prior to default, the Administration wants to incentivize modifications in these instances. As a result, the Plan also includes an incentive payment of $500 for servicers for loan modifications made in cases where the borrower is current on his or her payments, but is at risk of imminent default.
In addition, the Plan calls for an up-front fee of $1,500 to lenders/investors for each loan modification made in cases where the borrower is current on his or her payments, but is at risk of imminent default. To qualify for this "current borrower one-time incentive" fee, the modification must satisfy the de minimis test described in II.C. above. It is not clear how this fee should be applied in a securitization. Because the amount will not result in a reduction in the principal balance of the loan it does not seem that this amount should be applied as a principal distribution to the securities, although it may be reasonable to apply the fee against a current period realized loss. To the extent there are no current period realized losses it may be appropriate to reserve this amount to be used as an offset against future realized losses. The amount could also be treated as a collection of interest; however, absent any offsetting interest shortfalls or express language to the contrary, in a shifting interest structure, this amount may flow out to the non-economic residual if it is applied as an interest collection. Alternatively, if an aggregated approach to applying cost share payments is used, these amounts could be included in the same waterfall.
F. Incentives to Borrowers
The Plan also provides an extra incentive for borrowers to keep current under the modified loan, by giving a monthly payment on the borrower's behalf that goes directly towards reducing the principal balance on the modified mortgage loan (the "pay for performance success payment"). If the borrower stays current on his or her payments, the borrower may receive up to $1,000 each year for five years in principal reductions. To qualify for the "pay for performance success payment", the modification must satisfy the de minimis test described in II.C. above. As these incentives will be directed to the servicer and result in principal reductions to the related loan, the incentive payments should be applied as a collection of principal and a corresponding distribution to the related securities in accordance with the applicable waterfall provisions.
G. Home Price Decline Reserve Payments
The Administration, together with the Federal Deposit Insurance Corporation, has created a partial guarantee program. The Plan calls for an insurance fund to be established by the Treasury in an amount up to $10 billion dollars. The insurance fund will be designed to discourage servicers that fear that home prices will fall even more in the future from opting to foreclose on mortgages that could be viable in the present day. This fund would incentivize servicers to make additional modifications in the present day by assuring that investors will have access to insurance reserves if home valuations decline more going forward. The Plan states that owners of loans that are modified would be provided with an additional insurance payment on each modified loan that will be tied to declines in the S&P/Case-Shiller home price index. These payments could be set aside as reserves, providing a partial guarantee in the event that home price declines, and therefore losses in cases of default, are higher than expected.
The Foreclosure Alternative and Home Price Decline Update specifies that incentive amounts will be calculated based on a formula incorporating (i) declines in average local market home prices over recent quarters prior to the quarter in which the loan was modified based on housing price indices and (ii) the average price of a home in each particular market. If a modification is successful at the end of the Trial Period referred to in II.H. below, 1/24th of the aggregate incentive payment for the related loan will accrue to the lender/investor each month for up to 24 months. The incentive payments will be made at the end of the first and second year of the modification, presumably in an amount equal to half of the total payable at the end of each year. Any such payment could be applied by the servicer to reduce the principal balance of the related loan and applied to the securitization trust as a payment of principal. This would ultimately result in a smaller realized loss if and when the related loan is liquidated. Alternatively, if an aggregated approach to applying cost share payments is used, these amounts could be included in the same waterfall.
H. Trial Period
The Guidelines describe a modification trial period (the "Trial Period") that will last 90 days (three scheduled payments under the modified terms) or longer if necessary to comply with investor contractual obligations. A modification under the Modification Program is not considered effective until the first month following the successful completion of the Trial Period. Successful completion of the Trial Period means that the borrower is current (under the MBA delinquency calculation4) at the end of the Trial Period. No incentive payments will be made under the Modification Program to the servicer, lender/investor or borrower during the Trial Period, and no such payments will be made if the Trial Period is not successfully completed. The Modification Program does not provide any guidance as to what a servicer should do to the extent a borrower is delinquent in making any of the payments during the Trial Period. Because the borrower is only required to make all required Trial Period payments no later than 30 days from the date the final payment during the Trial Period is due, a borrower may "successfully" complete the Trial Period notwithstanding the fact that the borrower was delinquent in making those payments.
Loans that were delinquent at the start of the Trial Period should continue to be treated as delinquent until the successful completion of the Trial Period. Whether a loan is treated as current or delinquent will impact various cashflow triggers and could affect the application of principal distributions to different classes of securities. Upon successful completion of the Trial Period, assuming outstanding arrearages have been paid or capitalized, the loan should be treated under the securitization transaction documents as current, provided that there is no express provision in the transaction documents that requires a longer trial period or a different treatment of the loan's delinquency status. In addition, because during the Trial Period the securities will be expecting payments in accordance with the pre-modification contractual terms, the arrearage resulting from the difference between the contractual monthly payments and the payments under the modified terms during the Trial Period (which would be advanced by the servicer during the Trial Period) should be capitalized by the servicer at the end of the Trial Period and, as described above under II.A., reimbursed to the servicer from principal collections in order to avoid producing a mismatch between the aggregate loan balance and the aggregate securities balance.
The Directive indicates that servicers are not required to verify financial information of the borrower prior to the effective date of the Trial Period and instead may rely on recent verbal financial information provided by the borrower. However, to the extent the verified information is different from the information used by the servicer to place the borrower in the Trial Period, the Trial Period may need to restart, the borrower may be determined not to be eligible for the modification or, as a result of the verified financial information, the monthly payment under the final modified terms may cause the NPV test to be negative, in which case the servicer would not be obligated to perform the modification. Given these possible outcomes, there may be advantages or disadvantages to verifying financial information prior to the commencement of the Trial Period. It is not clear what the prevailing practice will be among servicers.
III. Second Lien Modification Program and Integration of HOPE Program
As announced on April 28, 2009, the new SLP under the Plan will provide additional assistance to at-risk borrowers who have more than one lien on their property. After evaluating industry concerns that the Plan did not address the issues with existing second liens, the Administration decided to create and implement the SLP under the Plan. The SLP provides guidelines for the modification of second lien loans in instances where the first lien has been modified, and seeks to encourage servicers and investors to facilitate the refinancing of at-risk loans into new loans under the HOPE Program. The Treasury will share the costs of these second lien modifications with investors, and also pay each investor who is willing to extinguish principal on a second lien an upfront amount according to a pre-set formula. Servicers and borrowers will receive "pay-for-success" fees for second lien modifications in a similar fashion to those already provided with respect to the modification of first liens under the Plan. Finally, servicers and investors will also receive upfront "pay-for-success" fees for any at-risk loan that is refinanced under the HOPE Program.
A. SLP Details and Incentive Payments to Parties
The SLP will be a corresponding program to the first lien modification program under the Plan, and will facilitate automatic modification of the borrower's second lien loan when the first lien is modified. The April 28 announcement from the Treasury states that the SLP will "facilitate automatic modification of a second lien when a first lien is modified for participating servicers" and that the SLP will be a "voluntary parallel program to the first lien modification program." This seems to suggest that a borrower who qualifies for a modification of his first lien will automatically qualify for a modification of the related second lien, but the servicer of the second lien will be able to use its discretion in offering the modification to the borrower. This may create some issues if the servicer of the first lien is different from the servicer of the second lien where the two servicers may have competing interests or where there are two different owners of the first and second liens. While the servicer (or owner/investor) of the second lien may wish to have the second lien modified, the servicer (or owner/investor) of the first lien may wish to require the second lien servicer/owner to accept a payoff of the second lien. It is not clear whether the first lien servicer has this option or whether a servicer can ignore or opt out of the SLP altogether.
For amortizing loans, the Treasury will share the cost of reducing the interest rate on the second mortgage to 1 percent. All participating servicers will be required to follow these steps, in the specified order, in connection with the modification of amortizing second lien loans: (i) reduce the interest rate to 1 percent; (ii) extend the term of the modified second mortgage to mirror the term of the modified first mortgage; (iii) forbear principal in the same proportion as any principal forbearance on the first mortgage (with the option of extinguishing principal as discussed below); (iv) after five years, step up the interest rate to the then current interest rate on the modified first mortgage;5 and (v) re-amortize the second mortgage over the remaining term at the higher interest rate(s). Investors will receive an incentive payment from Treasury equal to half the difference between (i) the interest rate on the modified first lien as modified and (ii) 1 percent (subject to a floor). Payments received from the Treasury could be applied as distributions of interest on the securities as these payments correspond exclusively to interest. Note that the payment will belong to the securitization trust that holds the second lien which is often different from the securitization trust that holds the corresponding first lien.
For interest-only loans, the Treasury will share the cost of reducing the interest rate on the second mortgage to 2 percent. All participating servicers will be required to follow these steps, in the specified order, in connection with the modification of interest-only second lien loans: (i) reduce the interest rate to 2 percent; (ii) forbear principal in the same proportion as any principal forbearance on the first mortgage (with the option of extinguishing principal as discussed below); (iii) after five years, step up the interest rate to the then current interest rate on the modified first mortgage;6 and (iv) amortize the second mortgage over the longer of the remaining term of the modified first lien or the originally scheduled amortization term (with amortization to begin at the time specified in the original contact). Investors will receive an incentive payment from Treasury equal to half the difference between (i) the lower of the contract rate on the second lien and the interest rate on the first lien as modified and (ii) 2 percent (subject to a floor), to be applied as described in the preceding paragraph.
The SLP also provides for a "pay for success" fee that is similar to the first lien modification program under the Plan. Under the SLP, servicers can be paid $500 upfront for a successful modification and then future success payments of $250 per year for 3 years, as long as the modified first lien remains current. Borrowers are also paid a success fee of up to $250 per year for as many as 5 years. These payments to the borrower get automatically applied to the principal on the first lien in order to help the borrower build equity in the home and should be applied as described in II.F. above. Note that while directing this payment to reduce the outstanding principal on the first lien will help the borrower build equity in the home, the separate securitization trust that owns the second lien will not get the direct current benefit of the payment as a principal distribution on the related securities. Investors in the pool of second liens would only receive a benefit from this incentive payment to the extent the borrower ultimately defaults and the loan is liquidated, resulting in additional amounts available to satisfy the outstanding balance due on the second lien. While it is expected that most modifications under the SLP will be done in tandem with a modification of the corresponding first lien under the Modification Program, to the extent the servicer of the second lien independently modifies the second lien under the SLP, the $250 per year borrower success fee may never inure to the benefit of the investors in the second liens.
Further, under the SLP, a lender or investor has an option to write down principal on the second lien in exchange for an immediate payment from the Treasury pursuant to a preset formula. Under the formula, for loans that are 180 days or more delinquent (calculated in accordance with the MBA method) at the time of modification, the lender or investor will be paid 3 cents per dollar of unpaid principal balance extinguished. For loans that are less than 180 days delinquent, the lender or investor will be paid from 4 cents to 12 cents per dollar of unpaid principal balance extinguished, depending on the borrowers' back-end DTI ratio7 under the Plan, and the current LTV ratio on the secured property. Any amounts received from the Treasury in respect of principal extinguishment on a second lien held in a securitization should be distributed in the same manner as if the loan had been the subject of a short payoff.
B. HOPE Program
The new initiative announced by the Administration on April 28, 2009 provides a framework for the HOPE Program to be directly incorporated into the Plan. According to the new details, when a borrower is being evaluated for a trial modification under the Plan, the servicer will be required to evaluate the borrower for a HOPE Program refinance and to offer the refinancing opportunity to the borrower if they qualify. In circumstances where the servicer determines that the borrower qualifies for the HOPE Program refinance, the servicer is required to offer the refinance at the same time as the modification offer. If a borrower chooses a HOPE Program refinance, the proceeds received from the new mortgagee would be used to reduce the balance of the refinanced loan and would be distributed to the related securities as a principal prepayment. The difference between the outstanding balance of the original loan and the balance of the new loan will be applied as a realized loss. By adding the HOPE Program to the Plan, the investor has the option to take a loss today for some guaranteed amount of principal, instead of entering into an extended modification agreement with the borrower for a period of years.
Servicers and investors who refinance borrowers into HOPE Program loans will also receive "pay for success" fees similar to the other incentive payments under the Plan. Servicers can receive a $2,500 upfront incentive payment for a successful HOPE Program refinance which they should be entitled to keep as servicing compensation. Further, lenders who originate new HOPE Program refinances are eligible for success fees of up to $1,000 per year for up to 3 years as long as the refinanced loan remains current. Note that these pay for success fees are only available to participants in the Plan, and not other lenders who solely make HOPE Program refinances. In addition, because a refinanced loan is not owned by the securitization trust that owned the original loan, the "pay for success" fees payable to the lender that originated the HOPE Program refinance will not benefit the securitization trust.
IV. Supplemental Directive 09-1 and Fannie Mae and Freddie Mac Involvement
The Directive, which describes implementation guidelines for the Modification Program, includes the requirement that participating servicers enter into a Participation Agreement with Fannie Mae in its capacity as financial agent for the United States (as designated by the Treasury) on or before December 31, 2009. In addition to providing additional details regarding the Modification Program (such as details for applying the NPV test and verifying borrower income and occupancy status), the Directive specifies that none of the incentive payments described in II. above will be paid if (i) the servicer has not executed a Participation Agreement or (ii) the borrower's front-end DTI ratio starts below 31% prior to the implementation of a modification under the Modification Program.
The Participation Agreement includes the terms for payment of incentive fees to the servicer in connection with the Modification Program and includes certain events of default by the servicer or investors or borrowers that could result in a reduction or withholding of incentive payments or termination of the Participation Agreement. In addition, each Participation Agreement will set forth a "program participation cap" that limits the amount of funds available to pay servicer, borrower and investor compensation in connection with the related servicer's modifications. The Treasury will establish each servicer's initial program participation cap by estimating the number of modifications expected to be performed by the servicer during the term of the Modification Program, and thereafter may be adjusted based on the Treasury's full book analysis of the servicer's loans. Once a servicer's cap is reached, a servicer cannot enter into any agreements with borrowers for a new loan modification under the Modification Program and no incentive payments will be made with respect to any new loan modification.
Servicers are required to provide periodic loan level data to Fannie Mae at the start of the Trial Period and during the Trial Period, for loan set up of the approved modification and monthly after the modification is set up on Fannie Mae's system. Exhibits to the Directive include the comprehensive set of data fields a servicer is required to report to Fannie Mae. This reporting is in addition to the existing reporting a servicer will be performing in accordance with the terms of the agreement with the investor or securitization trust. To the extent this reporting is viewed as significantly burdensome by a servicer, the servicer may be discouraged from participating in the Modification Program.
The Treasury has selected Freddie Mac to serve as compliance agent for the Modification Program. In this role, Freddie Mac employees and contractors will conduct independent compliance assessments (including evaluation of documented evidence to confirm adherence to Modification Program requirements relating to borrower and property eligibility, compliance with underwriting guidelines, execution of the NPV test and the Waterfall, completion of borrower incentive payments, investor subsidy calculations and data integrity) and review of loan level data for eligibility and fraud.
V. IRS Addresses Impact of Modification Program on REMICs and Investment Trusts
On April 10, 2009, the Internal Revenue Service (the "IRS") published Revenue Procedure 2009-23 (the "Revenue Procedure"), which addresses the consequences of certain modifications of residential mortgage loans owned by REMICs or investment trusts made pursuant to the Modification Program. The Revenue Procedure provides that if one or more mortgage loans held by a REMIC or investment trust is modified in accordance with the Modification Program, the IRS will not (i) challenge a securitization vehicle's qualification as a REMIC on the grounds that the modifications are not among the exceptions to the significant modification rule; (ii) contend that the modifications are prohibited transactions on the grounds that the modifications result in one or more dispositions of qualified mortgages and that the dispositions are not among the exceptions in the REMIC rules for dispositions of qualified mortgages; (iii) challenge a securitization vehicle's classification as an investment trust on the grounds that the modifications manifest a power to vary the investment of the certificateholders; and (iv) challenge a securitization vehicle's qualification as a REMIC on the grounds that the modifications result in a deemed reissuance of the REMIC regular interests.
Also on April 10, 2009 the IRS published Notice 2009-36 (the "Notice") in which it announced that the IRS and the Treasury intend to issue regulations regarding the application of section 860G(d) of the Internal Revenue Code to certain amounts that may be paid to REMICs as part of the Modification Program. The Notice specifies that pending the issuance of these regulations, taxpayers may rely on the Notice and, accordingly, any payment made to a REMIC under the Modification Program will not be subject to the 100 percent tax on prohibited contributions.
The Revenue Procedure is effective for modifications to mortgage loans made on or after March 4, 2009. The regulations referred to above are expected to be effective for payments made on or after March 4, 2009.
VI. Foreclosure Alternatives Incentives
The Foreclosure Alternative and Home Price Decline Update describes a program (the "Foreclosure Alternative Program") that provides incentives to borrowers, servicers and investors to encourage short sales and deeds-in-lieu of foreclosure as a way to avoid the foreclosure process. Borrowers will be eligible for the Foreclosure Alternative Program if they meet the minimum eligibility criteria for a modification under the Modification Program but do not qualify for a modification (because the NPV test is negative) or are unable to sustain payments during a Trial Period or a modification. Prior to proceeding to foreclosure, participating servicers must evaluate each eligible borrower to determine if a short sale is appropriate. Considerations in the determination include property condition and value, average marketing time in the community where the property is located, the condition of the title (including the presence of junior liens) and a determination that the net sales proceeds are expected to exceed the investor's recovery through foreclosure.
Incentive payments under the Foreclosure Alternative Program include: (i) compensation to servicers of up to $1,000 for successful completion of a short sale or deed-in-lieu; (ii) incentive compensation to borrowers of up to $1,500 to assist with relocation expenses; and (iii) up to $1,000 contributed by the Treasury to investors to share in the cost of paying junior lien holders to release their claims, with the Treasury contributing $1 for every $2 paid by the investors. The "investors' share" of any such payment to a junior lien holder would be made out of proceeds from the short sale or deed-in-lieu that would otherwise be applied in repayment of the first lien and as a result, increase the magnitude of the loss on the first lien. Incentive payments to servicers and borrowers should be retained by those parties without any impact on the securitization trust. To the extent a securitization trust receives an incentive payment from the Treasury, the amount contributed should be applied as additional liquidation proceeds which will have the effect of reducing the amount of the realized loss incurred with respect to the related first lien.
VII. Additional Questions Raised Under the Modification Program
While many issues and ambiguities surrounding the Modification Program have been clarified by the Treasury, some questions remain unanswered:
- A borrower is only eligible under the Modification Program if the property securing the mortgage loan is the borrower's primary residence as documented by the borrower. The Modification Program does not address whether a modified loan would still be in "good standing" if the borrower continues to own the property after the modification but no longer occupies the property as his primary residence.
- The original Guidelines seemed to suggest that a hardship screen was only required for borrowers for which default was imminent or reasonably foreseeable, but the Directive states that all borrowers seeking a modification must sign and submit a hardship affidavit. However, it is not entirely clear whether a servicer is required to verify the existence of the hardship for a borrower who is already in default, or whether a servicer is required to verify such borrower's assets.
- The Modification Program does not make clear whether a servicer is required to verify the borrower's assets, if a borrower is in imminent default and the reason cited in the borrower's hardship affidavit for the impending default is income reduction or an upcoming increase in the monthly mortgage payment.
- The payment of incentive fees under the Modification Program to a securitization vehicle may raise questions as to the related accounting treatment.