The subprime servicing is still in its infancy, with major players still competing for mar- ket dominance, and in doing so often employing fundamentally different business models to guide their efforts. One question that continues to divide the industry is whether there are meaningful differences between prime and subprime borrowers. While some industry experts interviewed for this report stressed that the differences were pronounced, others contend that the differences between subprime and prime borrowers were simply a matter
of degree. In any event, to the extent that such differences exist, they imply different lev- els of success for different servicing approaches in each market.
Evaluating evidence for the claim that prime and subprime borrowers are different re- veals that prime borrowers, in addition to having superior credit backgrounds, tend to have larger cash reserves and more stable employment histories than subprime borrowers. They may also have greater sources of emergency cash, such as friends and relatives with funds available to help them overcome a temporary financial hardship. In combination, these features make prime borrowers unlikely to become delinquent or to default on their loans. As Figure 11 shows, serious delinquencies rise steadily as credit quality declines. The same is true for defaults.
Figure 11: Likelihood of Delinquency and Default by Credit Quality
Prime borrowers’ more robust position vis-à-vis delinquency and default suggests that the appropriate servicing model for them is one in which the servicer initiates foreclose pro- ceedings as quickly as possible once significant trouble is detected. Typically, prime bor- rowers are more likely to cure a delinquency if they have the desire to remain in the home because of additional resources available to them as compared to subprime borrowers. Therefore, loans that become severely delinquent are typically cases where the borrower has given up trying to save the loan. Following a divorce, for example, neither spouse
FHA Total
Conforming Jumbo
Share of All Mortgages (%) 59.95 22.34 9.43 91.75
Serious Delinquency Rate (%) 0.94 5.31 6.40 2.23
AA+ AA A B C CC Total
Share of All Mortgages (%) 0.47 3.42 1.94 0.87 0.66 0.89 8.25
Serious Delinquency Rate (%) 7.70 16.60 22.50 32.60 39.70 43.60 23.80
Notes: Share of mortgages based on 2001 dollar volume of originations. Serious delinquency rate based on Freddie Mac experience for loans originated in 2000; FHA serious delinquency rate from Feshbach (2002) for loans originated in 2000, Jumbo serious delinquency rates average over all current years and are from Loan Performance (2002); subprime performance from Option One Mortgage Corp (2002).
Source: Cutts and Van Order (2003).
Prime
Conventional
may have an interest in remaining in a home with little equity. In such a situation, accel- erating the foreclosure process is the best option for the lender.
The extent to which prime and subprime loans differ with respect to market value of the homes that serve as collateral introduces another source of variation in servicing. Com- pared to prime loans, subprime loans are far more common in marginal neighborhood where foreclosing may not net the lender sufficient value to justify the cost of the proc- ess.
Those arguing that subprime borrowers are different also point out that thin cash cushions and more frequent employment gaps make delinquency a structural aspect of subprime payment streams. (One servicing manager estimated that one in four subprime borrowers becomes delinquent at some point.) Borrowers facing a three-month layoff may be unable to pay during that period but able and eager to begin paying again when they are rehired. At this point the loan is severely delinquent but, unlike in the prime market, the severe delinquency does not reflect the borrower’s unwillingness to make the loan work, but rather the inability to pay off arrears.
An additional potential difference relates to the greater prevalence of inappropriately originated loans in the subprime market. To the extent that broker malfeasance produces loans for which borrowers are marginally qualified, delinquencies and defaults will also be higher, and servicing will be more challenging. A further source of difference is sug- gested by Cutts and Van Order (2003), who hypothesize that subprime borrowers may be more likely to ‘borrow’ from the noteholder by deliberately not paying their loan for a month or two in order to address other financial concerns. When they come current a few months later they take the penalty for doing so as an interest payment on what amounts to a short-term loan.
Extrapolating from these characteristics implies a very different and higher-cost servicing model that potentially requires increased human contact and hence reduced scope for economies of scale to operate. Subprime collateral is also likely to be weaker because it
tends more often to be located in marginal neighborhoods and because the subprime homeowner may have fewer resources available to maintain the home’s quality. In addi- tion, subprime loans tend to be smaller and the homes less expensive, meaning that less equity is typically available to reward the effort and expense of going through foreclo- sure. Further, as the preceding paragraph suggests, even fairly severe delinquencies are not necessarily indicative of the subprime borrower’s lack of willingness to remain in the home. Given the high cost of foreclosure it is therefore almost always in the interest of the investor to employ a workout if the delinquent borrower has the ability and willing- ness to do so.
Another key issue is the servicer’s differing incentive for pursuing loss mitigation in the prime and subprime markets. Cutts (2003a: 2) claims that servicers in the conforming market are very price-conscious because they are compensated by “a flat servicing fee with fee/bonus incentives from investors for achieving low incidences of default. Thus any change in practice that streamlines processes, reduces the incidence of foreclosure and REO, or increases the cure rate on delinquent loans will result in a direct increase in profitability for the servicer.” In the subprime market, however, third-party servicing is less common and servicers are more often in line to take the first losses due to default and delinquency (referred to in the servicing industry as having ‘skin in the game’).
This investor/servicer role may provide stronger incentives to avoid foreclosures than do the bonus fees and provide the potential for obtaining superior results for other investors participating in the transaction. Said one official from a major subprime issuer/servicing organization “the fact that we have our own money on the line should a pool of subprime loans experience unexpectedly higher rates of foreclosure helps us to market our securi- ties to other investors. We believe, and have put substantial amounts of our own money at risk in support of this proposition, that with greater attention to customer service, and our efforts to promote good customer relations, we can reach borrowers in distress sooner, and help them to get back on track and avoid costly foreclosures. Time will tell if we are right, but our growth in profitability and market share suggests that we are moving in the right direction.”
Because risk levels are less well established in the subprime market and because the risk of credit losses is higher, potential returns to the residual-holder from minimizing credit losses are much larger on a subprime than a prime securities issue. Therefore, subprime servicers holding residual risk can devote additional effort to foreclosure avoidance and loss mitigation beyond what would be economic in the prime market, with the expecta- tion of making it up via improved performance of the residual interest in the securities they hold. This is true even in comparison to a prime market servicer holding a residual interest in a loan pool because the payoff for success is larger in the subprime market to compensate for the demonstrably higher credit risk of the borrowers.
4.4 CONCLUSION
Servicing approaches in the subprime mortgage market are still being developed, tested, and perfected. Competing servicing models exist side by side in the marketplace, as the industry seeks to better understand what servicing best practices can be simply trans- ferred from the prime mortgage sector, and what practices must be adapted to reflect the differences associated with subprime borrowers, subprime loan products, and the neighborhoods in which they are typically located. To date, while no approach is domi- nant, most industry participants recognize that the enormous opportunities for loss reduc- tion exist during the servicing process. Sustained lower loss rates will translate directly into increased profitability for issuers by reducing credit enhancement requirements and/or by allowing securities constructed from the same pool of loans to be sold for higher price. Fortunately this market incentive should also work to improve outcomes for subprime borrowers. Lacking clear answers to many basic questions, now is the time for interested parties — industry, governments, and community-based players alike — to ex- plore the potential for collaborative solutions to mitigate the substantial costs associated with the unexpectedly high level of foreclosures affecting many low-income communi- ties.
Section 5: DISPOSITION OF FAILED LOANS: WORKOUTS,