In 2008 you got significant pushback from the bond holders for your aggressive modifications, with principal reductions, of loans in their securities. How was that resolved?
Yes. Towards the end of 2007 in particular was when there was a big shift, at least on our thinking. Although we always found that it was best to keep borrowers in their home, up until 2007, you could generally keep somebody in their home if they had a temporary disruption in their ability to pay. You could usually spread that delinquency that occurred during the disruption out, sometimes over maybe three years, if need be, and allow them to catch up gradually.
But you never really had to truly modify the terms of the loan. What we think of today as a loan modification was very rarely used up until 2007, and partly it was because people had jobs, property values were going up. Until that point in time, if somebody lost their job for three months or they had a medical issue, they would get behind, but you could start working with them, and as long as you were flexible, you could get them back paying.
But by mid-2007 to late-2007, it became clear to us that the strategy that had worked for a long time no longer worked, that borrowers’ property values were not going up. In fact, they were going down. There was no chance for them to ever refi. Their incomes were not only not going up, in many cases they were starting to go down, maybe they were losing overtime, bonuses weren’t there, or if they were self-employed, instead of working 50 hours a week they could only work 35 hours a week.
So we started to realize that strategy would no longer work. We’re not seeing people with temporary problems. We’re seeing them with what appear to be long-term problems. It was just simply they could no longer make their mortgage payments.
That was when we realized that loan modification was really the only solution. And with property values starting to go down, we realized, even in 2007, 2008, that many of these homeowners were underwater. We looked at it and said “When we do the net present value calculation to determine what you are going to get if you do a modification versus what you are going to get if you foreclose, well, you weren’t going to get any of the amount that they were underwater if you foreclosed anyway.”
So actually, a principal reduction loan modification looked at the time like it would be the best solution for the homeowner and really shouldn’t be any worse off for the investor. The problem was that not all investors were created equal. Certain investors were going to take that write-down as an immediate loss as opposed to being able to defer it over some longer period of time.
There was also a little bit of the moral hazard question. The borrowers signed a note. Why is it fair that they’re getting some of the money that was lent to them forgiven? We said it’s all about minimizing your loss, and the best way to do that is get them paying, and get them paying as much as they can over a long period of time. It’s just not realistic to think that they’re going to pay over a long period of time if they’re underwater.
But we were the lone wolf out there. Nobody else in the industry, that I am aware of, was doing any meaningful amounts of principal reduction. And unfortunately, we buckled to the pressure and, for a time, we definitely scaled it back almost to the point of suspending it and moved more to the traditional modification, which just lowered interest rates, extended amortization period, those kind of things.
What brought you back to doing principal reductions?
We eventually came back to greater use of principal reduction as the underwater mortgage problem got worse. Next to unemployment, negative equity is the largest driver of delinquencies. Our data shows that a borrower with negative equity is two to three times more likely to default than one with even some small portion of positive equity.
It seems that every pooling and servicing agreement is written differently. Does the PSA contractually limit your ability to reduce principal?
No. In the private-label security world, trust me, I heard a lot of those same stories very early on. And yet, when we actually read our documents, we found less than 10 percent, closer to only about 5 percent of the time, was there any true restriction on how you could work out a loan. Except for that small percentage, our PSAs are silent about modifications. But every PSA has one thing in common: they dictate that the servicer must service loans, and resolve delinquencies, in the best interest of the investor, ie, the loan owner. So where our net present value analysis shows that a principal reduction modification that is sustainable by the homeowner will likely return more cash flow to the investor than a foreclosure, we are not only legally permitted to do that type of mod, we are arguably required to do it.
As long as you were working out a loan with the intent of maximizing the value for the trust or the investor, there was nothing specific that said you couldn’t lower an interest rate or you couldn’t extend the amortization period, or you couldn’t do a principal reduction. Even though people said over and over that that’s why they couldn’t do anything, it really did not exist in the vast majority of the documents.
Investors still, I think from time to time, question whether modifications are what should be done to maximize their investment. But as far as explicit contractual restrictions, they generally were found not to exist.
Now, the GSE world is different in that Fannie and Freddie and FHA set policy on how their loans are going to be dealt with, and you have to go to them for approval for every single workout that you do. And if they’re not doing principal reductions, they’re not doing principal reduction. There’s no way around it.
We were able to prove through our modeling and everything that [principal reduction is] a win for the investor in the loan. And oh, by the way, it’s a win for Ocwen too because, as a servicer, if we foreclose, we lose that asset, and we lose any ability to earn anything off of it. Whereas, if we are able to keep the homeowner in the home paying on that existing loan, then we continue to make a servicing fee for hopefully many years to come.