By Roland P. Reynolds,
Esq. of The Wolf Firm (Published in the Feb. 1998 issue of Servicing Management)
The news is by now well circulated that B, C and D grade loans, with their cousin the 125% LTV, are the hot (and very profitable) product in the home mortgage industry. Consumers who once thought that poor credit histories, a bankruptcy, or low home equity precluded their participation in the debt market are being courted by lenders anxious to enjoy the large fees that have been squeezed out of the conventional first home loan market. Consider this factoid: Relatively small FirstPlus Financial, a premier high LTV lender, had higher earnings in the third quarter than giant Norwest Mortgage Corp. FirstPlus's servicing was $4.7 billion. And Norwest? A whopping $198.1 billion.
There has begun a debate
A debate has begun among both academics and those in the servicing trenches as to what the default and prepayment rates of these new loans will be; a debate likely only to be resolved by the verdict of history. The argument is convincingly made that the high LTV loan is extended only to those with superior credit scores and so the default rate ought not to exceed a conventional loan, notwithstanding the risk added by the undercollateralized nature of the high ltv loan. On the other hand, only invincible ignorance could prompt an investor to deny that the B, C and D loan servicer is much less likely to enjoy timely repayment of principal and interest from its borrowers than the conventional loan servicer.
Added risk ought to be accompanied by added diligence and vigilance. Conventional loan servicers have long known that the cost of servicing a loan in default can be a disproportionately large part of operating costs. Therefore, early and aggressive loss mitigation techniques have become standard procedure. One large investor is even considering updating borrowers' credit scores after the loan is made to continually monitor each borrowers risk of default (although this plan raises serious legal issues.)
Subprime lenders have to be even more aggressive in watching over loans that are threatening to default. Higher default rates on hard money loans are to be expected, but the costs of such defaults do not have to be left to go out of control. It has been reported that loss severity on subprime securitization defaults is 30%, an astonishingly high number. Ironically, servicing organizations often employ less structure in servicing their subprime loans than their conventional loan counterparts. Fannie Mae and Freddie Mac guidelines do not apply to subprime loans. The originators are often independently owned and operate without examinations by state and federal bank and thrift regulators. These factors can give a servicer the false sense that the rules of good operating conduct do not apply to subprime or nonconforming loans. Each shop should inculcate into its operating personnel a definite ethos that the rules do apply.
In some cases loss mitigation techniques will be different for subprime or high LTV loans. When the loan does go into default, a more sophisticated analysis of the servicing options must be made than many conforming loan servicers may be used to. Often these loans will be secured by second mortgages on properties. The second position can be a substantial disadvantage. In many states there are particular laws and regulations that affect a junior lienholder differently than a senior lienholder in regard to collection activity.
Of course, the holder of a second mortgage should maintain good communications with the first lienholder. If required by state law, the servicer should be certain that a request for notice of any foreclosure action by the senior lienholder is recorded in the public records, usually of the county recorder. If a determination is made that the senior lienholder will be reinstated pending a foreclosure on the subprime loan, it is usually better to bring the senior lienholder current as soon as possible and before late charges and foreclosure fees have been incurred.
The servicer should know if the applicable state law allows collection directly on the promissory note without foreclosure, or whether the servicer has to foreclose on the secured property first. In some situations the amount of the first lien will exceed or match the value of the secured property, making foreclosure an unreasonable alternative for the junior lienholder.
In some states, this is very problematic. For instance, in California a junior lienholder is usually prohibited from seeking personal liability on the note against the borrower while the loan is still secured. The junior lienholder must either wait until the senior lienholder wipes out the junior lien in a foreclosure sale or foreclose himself. It is possible to foreclose judicially and seek a deficiency judgment against the borrower, but this can be an expensive and time intensive alternative. Also, the servicer of both the first and second liens should be aware that in some states holding a foreclosure sale on the first will forever preclude collection on the second lien and note.
Because the junior lienholder can have a lien wiped out by a senior's foreclosure sale, the mortgage lender on a second can be in the unfamiliar position of being an unsecured creditor. Therefore, the servicer needs to be aware of all the collection practices that have generally been available to all unsecured creditors. These include dunning letters, telephone calls and if necessary judicial collection actions. The collection action can be effective tool. Often the borrower will put up only token resistance to the lawsuit. The judgment for the amount owing can then be used to garnish wages or to attach bank accounts. In addition, it is a good practice to record an abstract of judgment in counties where the borrower is likely to own property. In many states the abstract immediately attaches as a lien to any property owned or purchased by the borrower. Eventually, to sell the property, the borrower will be forced to pay off the abstract. Unfortunately, payment from the abstract can sometimes be delayed for years.
One caveat: the unsecured creditor is more vulnerable to the power of the bankruptcy laws. Whereas a secured creditor will rarely lose his security, the unsecured creditor can have his entire debt discharged by the borrower.
The high LTV loan provides interesting servicing problems. Initially, one of the principal challenges to the product's attractiveness has been the impediment it created to the transfer of the borrower's property. Since the property is by definition overencumbered, without imaginative servicing it would be very difficult to sell the property. Some lenders have come up with so-called portable high LTV loans, but how much portability they really have remains to be seen. With the number of high LTV loans growing, an imaginative servicer might be well served by allowing a transfer of security or other arrangements to allow a borrower tempted to walk away from his property more flexibility.
In addition, as the bankruptcy laws change, there is a danger that the portion of the high LTV loan that exceeds the value of the property could be stripped off of the loan and treated with the much more unfavorable unsecured status.
Regulatory oversight of subprime lending practices has focused primarily on origination issues. There has been a concern among some groups that subprime borrowers are less sophisticated and more vulnerable to overreaching business practices. (This view may be more myth than fact. Recent studies of home equity loans reveal a borrower socio-economic profile that is very similar to the conventional borrower.) More extensive disclosure, and restrictions on loan terms can affect subprime borrowers practices.
It is a wise business practice to be sensitive to the allegations of overreaching when servicing subprime loans. The servicer may be well served by determining whether all borrowers are being treated by an equal measure. For instance, are some classes of borrower less likely to be a candidates for loss mitigation measures? Be sure that any written work on these issues is coordinated through your counsel in order to maintain confidentiality in case of later litigation.
For instance, broker churning has become a practice that can affect how a servicer looks at a borrower's default. Churning involves a broker who, often in the course of several months, will solicit for several home loans, each loan paying off the last and each loan from a different lender. The broker obtains substantial fees and the borrower obtains relatively little if any benefit from the new loan. This is a practice that is more common with subprime loans.
Although the servicer is not responsible for the broker's churning, if the servicer moves to foreclose, the servicer will likely be brought into any litigation brought against the broker. The better servicer practice is to identify these potential problem loans and go the extra step to use loss mitigation techniques (forbearance plans, etc.) that are short of foreclosure. Thus, the servicer will avoid costly litigation.
In sum, a sensitivity to the quirks of subprime and high LTV lending and knowledge of the unique collection avenues and impediments will benefit the servicer and allow him to control the risk that can come with these loans.
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