Making Modifications Work

Lew Ranieri, often credited with creating the mortgage-backed securities industry when he was at Salomon Brothers in the early 1980s, has returned to try to save America from the worst effects of that accomplishment. In 2008, Ranieri established the Selene Residential Mortgage Opportunity Fund, raising money primarily from foundations and pension funds, to buy and restructure failed mortgages created to feed the securitization process. In doing so, he is showing how mortgage modifications can work – and why the federal Home Affordable Modification Program (HAMP) has done so poorly by comparison.

Selene focuses on two elements of the workout process that HAMP, and most servicers, have been unwilling or unable to implement. The two are (1) individualized consultations with borrowers to see what each can afford – and how committed they are to home ownership and (2) principal write-downs to the point where borrowers have equity in their homes. Most mortgage modification programs have been loath to write down substantial amounts of principal because of concerns about the reaction of the investors who hold the mortgages and because of the risk of “moral hazard” (that once borrowers see that default can lead to debt forgiveness, even more will choose to default).

Selene avoids both these problems by buying portfolios of defaulted loans. With no MBS investors looking over its shoulder, Selene does not need to worry about the restrictions of a Pooling and Servicing Agreement. And having purchased the mortgages at a hefty discount, typically 40 to 50 percent of face value, it can afford to offer substantial principal reductions and still prosper. And Selene is willing to purchase not just defaulted loans, but also REO (bank real-estate owned) properties. Selene recently purchased approximately 1,000 residential properties from Taylor, Bean & Whitaker’s bankruptcy estate for roughly $80 million.

Profit Prospects

Of course, Selene will never turn a profit if the default rate on modified loans is comparable to those in the government backed-modification programs, which often experience re-default rates of 50 percent or more. To avoid this problem, Selene indicates that its intent is to focus on borrower characteristics that predict loan performance; not just employment and income, but also commitment and motivation. According to a recent profile in Fortune magazine, one important indicator is the borrower’s contact record from the prior servicer. Borrowers who made repeated and determined efforts to contact the servicer in order to save their homes are less likely to default if the loan is properly restructured. Borrowers who showed a less committed attitude are poorer candidates for a workout.

What is still is unclear is the extent to which the broader loan-modification industry could learn from Selene’s approach Taking a 50 percent write-down to turn a default into a performing loan is not a particularly rousing success. And it is still unclear to what extent Selene’s successes will pan out over the long term, and whether the success it does achieve is due to its ability to cherry-pick the loans it is willing to buy, leaving more problematic loans and troubled borrowers for others to deal with.