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Servicing in a slump.


The declining real estate values and economic downturn of late 1990 mimic the circumstances that led to the "oil patch" crisis of the mid-1980s. As these conditions continue into 1991, many lenders and servicers are rightfully concerned about the rate of default and the magnitude of potential losses that can be expected in the months to come.

Although the current situation is similar to the regional recession of the oil patch states in many ways, a brief review of the factors that contributed to the latter crisis will reveal several loss prevention and loss mitigation techniques now available to servicers that can act as powerful deterrents against borrower default. With wider and more effective use, these techniques can prove invaluable in minimizing the impact of what lies ahead.

These techniques all impact borrower motivation, which is a primary contributing factor to defaults. During the oil patch crisis, it became evident that many borrowers approached the decision to default rather lightly. Borrowers capable of continuing their payments defaulted because their equity had disappeared and they were able to improve their situation by buying another house for less than what they owed on the defaulted property. In making this decision, borrowers often disregarded their obligation to repay the loan and the significance of their actions.

In 1985, there were few, if any, adverse consequences for borrowers defaulting on their mortgage loans. Very few mortgage lenders reported defaults or foreclosures to credit bureaus. Even fewer lenders sought to recover losses by enforcing the borrower's obligation to pay through deficiency. And no one established a deficiency at foreclosure in order to report the foregiveness of debt as income to the IRS. Without these impediments to obtaining new credit or preserving capital, borrowers who experienced credit management problems or equity erosion had little incentive to work with lenders to cure loan problems in order to stay in their homes.

As long as the borrower's credit standing remained unharmed and he or she was not personally liable for any shortfall when the property was liquidated, the borrower could wait out foreclosure, saving monthly housing payments toward the down payment on a new home instead.

This is what happened in Houston. Servicers received "jingle" mail on a regular basis - borrowers simply mailed keys back to the lender and moved to new homes, sometimes right across the street, without any repercussions whatsoever.

The reasons for borrower default (i.e. changes in personal economic situation, equity erosion and poor credit management) have not changed dramatically over the years. However, borrower attitudes towards defaulting, and the way they make decisions regarding whether or not to default, have changed as a direct result of corrective actions taken by servicers to establish effective deterrents.

Most servicers now report foreclosures and serious delinquencies (over 60 days) to credit bureaus. In addition, servicers are now also required by the IRS to report any foregiveness of debt via IRS Form 1099A, allowing them to establish an additional tax liability against the borrower. However, servicers are not required to establish the deficiency necessary to create the tax liability, if one exists.

Most states allow deficiency judgements and their pursuit through the normal foreclosure process. The amount of the deficiency is established at the foreclosure sale - it is the difference between the amount owed on the day of the sale and the final bid amount at the foreclosure sale. It is this difference that establishes the deficiency for reporting a forgiveness of debt to the IRS and allows the pursuit of the borrower's other assets to cover the shortfall. Once established, very few servicers pursue deficiency actions against defaulted borrowers. Because each state has different requirements for establishing a good deficiency, it is best to consult your own foreclosure attorney before pursuing a deficiency, and then do so quite aggressively.

In order for most loss prevention and loss mitigation programs to work effectively, borrowers need to be properly motivated. Otherwise, the servicer's attempt to limit losses will be only moderately successful.

Many of the programs that gained recognition during the oil patch crisis will once again play a key role in stemming the flow of losses. Loan modifications, always a valuable servicing tool, will be given new importance, and newer programs, such as a preforeclosure sale, where the borrower is encouraged to sell the home and avoid foreclosure, will become an important tool for reducing unavoidable losses and preventing others from occurring in the first place.

In spite of the recent success of these loss prevention techniques, the most effective loss prevention tool still remains within the origination process. Two of the primary contributors to default: equity erosion and poor credit management, can be identified, and in some cases prevented, at the time of origination.

Areas such as New England, Arizona, Dade and Broward Counties in Florida, the oil patch states and other regional markets that have recently suffered high default rates, have experienced at least two of the following economic conditions: * a prior period of rapidly rising real

estate prices; * rising inventories and marketing

times for homes; * increasing unemployment; * little or no job growth potential in

the local economy.

Because these factors came on the heels of prosperity, originators did not recognize the warning signs early enough. The typical response in these regions was to try to outrun the initial downturn with creative lending programs that often either ignored the importance of a borrower's credit history, or added to the erosion of equity, or both.

The situation during this period was compounded by the presence of one or more of the following conditions: * silent seconds; * financed closing costs; * seller-paid closing costs; * all closing costs and upgrades paid

by the seller with no adjustment to

the appraised value; * automobiles, boats, trips and other

incentives "included in the price"

with no adjustment to the appraised

value; * rebates after closing; * unverified "gift letters" that reduced

the amount of the borrower's own

funds used for the down payment; * unverified explanations for poor

credit ratings.

The current economic situation has once again given rise to creative financing programs similar to those of the mid-1980s. "We're seeing increasing numbers of seller-paid concessions in many of the soft markets, which raises concerns, especially when the offset value is not accounted for in the appraisal," says Claude Seaman, PMI's vice president of the underwriting department. "These trends will require everyone to have a particularly high, local-market awareness combined with an alert origination process, to properly manage in today's economic real estate environment."

While loss prevention begins with underwriting standards in the origination process, it continues even after the loan is originated, and is the first and most important aspect of a solid delinquency servicing "workout" program. Obviously, the first order of business is getting the borrower to reinstate. So, when setting servicing priorities, servicers should focus their efforts on those borrowers who are most likely to respond to guidance.

As a rule, first-time delinquencies should receive a lot of attention up front to minimize the likelihood of future delinquencies. Based on our experience, a first-time delinquent borrower is five times more likely to advance to foreclosure than a borrower who becomes chronically delinquent (i.e. a borrower who establishes an undesirable payment pattern with two or more delinquencies during a 24-month period). Special attention should also be given to first-time delinquencies that occur after the first two years of the loan, because as these have a substantially high tendency towards foreclosure.

Given that trend, servicers should not devote considerable time and resources to the chronic delinquent (i.e. after the first time) unless the borrower advances to the point of foreclosure.

Early payment defaults (i.e. delinquencies within the first 12 months of the loan) can act as early warning signals in periods of uncertainty. They are often an indication of a weakening local or national economy.

Charts 1 and 2 reflect the rate of change in early payment defaults (based on PMI's book of business) just prior to the major market downturn in Texas during the three-year period between 1983 and 1985; and on a national level for the three-year period between 1988 and 1990. The Texas data shows an increase in the early payment default rate between 1983 and 1984 and a much more dramatic increase between 1984 and 1985, when the economic downturn in Texas was nearing its peak. While the national graph shows a decrease in the early payment default rate between 1988 and 1989, 1990 showed a rate of increase that was even more dramatic than the rate of increase in Texas in 1985. If the current early payment default trend follows the same pattern as the trend in Texas, we could be seeing a significant increase in early defaults in 1991.

Early-payment default borrowers should be contacted very early on to determine the best workout possibilities, and the loans should be closely scrutinized for borrower misrepresentations. Roughly 10 percent of all early payment defaults have some material misrepresentation that would have kept the underwriter from approving the loan had they known all the true facts. Borrowers who misrepresent the property value, their income and/or their down payment will typically not be very good "workout" candidates.

Loan modifications play a very significant role at this point in curing defaults. This alternative has always been available but only received broad acceptance after the period of high interest rate originations in the early 1980s. It is still a valuable tool in today's ARM environment where increases in borrower payments may outpace their income. We also see more repayment plans and forbearance agreements being negotiated. Extensions as far out as 24 months are not uncommon.

Only after it can be determined that a cure is highly unlikely should the servicer proceed with a loss mitigation program. If this determination is not made first, unnecessary costs may be incurred, as defaults that should reinstate become part of the loss. The error is often made to work with a borrower on a pre-foreclosure sale when the best alternative is to get the borrower to reinstate.

The pre-foreclosure sale is a popular loss mitigation program that will minimize both lenders' and borrowers' losses if acted on promptly, and if the property is sold for full market value. The benefits of this action are eliminating or minimizing default and foreclosure expenses, increased ability to obtain full market value (since lender REO is difficult to sell for full market value) and the potential for the borrower to contribute his or her own funds toward any loss, avoiding IRS liability and an adverse credit rating.

As illustrated in Chart 3, PMI had great success with pre-foreclosure sales as a loss mitigation tool during the oil patch crisis. The chart also reflects the more recent increase in PMI's use of the same program.

When the borrowers mail in the keys or request the servicer to accept a deed in lieu of foreclosure, every effort should be made to determine whether a pre-foreclosure sale is possible. Before proceeding with a pre-foreclosure sale, obtain a full set of financials, VOEs and VODs to determine what alternatives, if any, are available. From the financials, the servicer can determine whether the borrower is able to reinstate and continue making payments. If it is necessary to proceed with a pre-foreclosure sale, the servicer will know how much can be collected from the borrower to facilitate the sale and reduce the loss.

Even if a pre-foreclosure sale will not entirely eliminate the loss, it still may be better than taking title through foreclosure. Contributions from the borrower and claim proceeds from the mortgage insurer will help to reduce the loss, making this program effective as both a preventive measure and as a mitigation tool.

Table 1 illustrates the two different outcomes of a typical case when handled early as a pre-foreclosure sale versus when title is taken through foreclosure. Had the loan in the given example not been insured, the amount of the loss incurred through foreclosure would have been significantly higher. This holds especially true in soft real estate markets where values may be declining.

Of course, it is important in all workout programs to work very closely with the investor and the mortgage insurer to make certain the servicer does not compound the situation by violating a provision in its servicing agreement or mortgage insurance policy.

If a pre-sale is not possible, the servicer should minimize the time to foreclose and sell the property while preserving deficiency rights where allowed. In order to get the most out of this mitigation tool, hire an aggressive legal collection firm and pursue the deficiencies fully.

At best, 1991 marks a year of economic uncertainty. Only time will reveal the depth and length of the housing recession currently underway and its impact on loan performance. By recognizing the early signs of market weakness, lenders can adjust underwriting programs to effectively prevent losses from new originations. The power of this technique as a loss prevention tool should not be underestimated.

Reporting delinquencies, establishing deficiencies for IRS reporting and then pursuing the deficiencies where permitted will provide the necessary additional incentives to motivate existing borrowers to cooperate and work closely with the servicer and mortgage insurer (if necessary) to cure a delinquency. Finally, pre-foreclosure sales and efficient foreclosure techniques should be employed to minimize losses that are inevitable.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Cover Report; special section on servicing management
Author:Campion, Gene
Publication:Mortgage Banking
Article Type:Cover Story
Date:Feb 1, 1991
Previous Article:Foreclosure combat.
Next Article:Maximizing manpower.

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