October 10, 2008

Don’t plan on loan modifications - here's why.

If you’re out there facing trouble with your mortgage, something that has to be rattling around in your mind is “Could my mortgage get lifted off my shoulders?”

In two words, probably not. In a lot of words we’ll attempt to explain why.

Very recent news items have probably given a lot of desperate people a false sense of hope – primarily those about Indymac and Bank of America/Countrywide. Indymac is being operated by the FDIC and BofA is basically polishing its consumer image by modifying loans Countrywide still has control of.

A little dose of reality is in order – and trying to explain it in market and accounting terms would put most readers to sleep, so we’ll use an analogy.

Imagine you want to be a farmer (investor).

You look to buy farmland along a stream or canal coming from a reservoir that is fed by a large number of water sources - basically wells up in the mountains because you need to irrigate whatever you plant every month. The reservoir/dam operator tells you how much water they are committed to release every month. It’s supposed to be a fixed, total amount that will decline slightly over some long number of years in a fairly predictable schedule.

Now, there are four of you (farmers) looking at that total monthly amount of water – you (AAA) are conservative and think you know your production rate and what you’re planting and the return you’ll get from the comparatively small amount of water you need from the stream. You buy the more expensive property furthest upstream to make sure you’ll have the same amount of water every month and you get a contract that says you’ll get it. No more, no less.

The next farm operation down the line (BBB) is paying less for that tract of land because although they may get more water to use, that amount isn’t guaranteed every month. They’re a little more willing to gamble because they think the rainfall and snowpack in the mountains is probably going to be normal. They’re pretty sure they’ll get more than enough to get a decent crop, despite knowing that their water contract isn’t a sure thing. But the relatively lower cost of the land seems to make the difference for them.

(CCC) is even more of a gambler. They’ve had enough good years behind them to take a shot at some low-cost land. They’re going to get more water than AAA and BBB but just in case, (if they aren’t completely clueless) they’ll plant thousands of acres with drought-resistant crops and hedge their bets in other investments.

The real risk takers (DDD) come in and basically say they’re so confident the weather forecasters are wrong that they’ll plant anything and everything on really cheap land downstream. They’re blinded by the money everyone else at that level has been making down here on this end because the people who say how much water is coming have told them it’s never going to stop. For years now the whole darn valley has had all the water they needed. And better yet, if the reservoir actually dries up, with the contracts they’ve got, they could even own the upstream water wells that feed the reservoir and we all know it’s eventually going to snow and rain again, right?

These farmers, not really knowing much about canals, water gates, etc., hire an expert manager (the trustee) to get the water from the stream to their farms. Everything seems fine for a few seasons. The weather forecasters (raters) aren’t predicting low rainfall levels. The reservoir/dam operator manages to keep the right amount of water going into the stream to make the water manager and his farmers happy.

Now – here’s where things come apart.

The reservoir/dam operator (the mortgage servicer) is starting to have trouble with some of the water sources (the borrowers). Some of the wells that feed the reservoir are drying up or are being blocked. In fact, the snow and rainfall feeding some of the tributaries to the wells just didn’t happen (the list of possible reasons is too long to put here) or what they’re now finding out is that thing that was supposed to be a well was nothing more than a mud puddle. And there are even quicksand areas.

So what does the reservoir/dam operator (servicer) do? Call the water manager (trustee) and let him know there isn’t as much water coming from the dam. He has to reduce the flow to the DDD farmer downstream. If things get worse, DDD doesn’t get any water at all and CCC gets cut back, and so on.

So when some of the wells run dry, these holders of the lower tier water rights suffer.

But they went in knowing the risks based on the weather forecaster’s (raters) track record. What they didn’t know is the reservoir/dam operator was paying the forecasters.

It all worked well for so long that everyone in the game was happy with it. Food was produced, consumers were getting what they wanted and everyone in on the game was putting away a fortune to retire on.

But the weather finally changed. Snow stopped falling on the mountains and runoff dwindled, wells dried up and eventually the downstream farmers couldn’t even plant, let alone harvest a crop. Their low-priced land became worthless while farmer AAA was still doing OK.

Trouble is the BBB, CCC and DDD farms had placed side-bets that they’d be able to get water and produce a crop. And their backers (other investors) had taken those bets. See, if I’m a farmer and I convince you I’m going to have $XXX after I harvest the crops, you might give me $X to let me buy seed and diesel to do it. But when there’s no water and I can’t produce anything, you’re stuck. I don’t have a penny; if I’m farmer DDD all I’ve got is equity in some dry wells up above the reservoir that I’m trying to get the water company to sell or fix.

Keep in mind it’s the financial backers of the lower-tier gambling farmers that are getting bailed out in this recent $700B legislation.

Now, back to the subject of getting a loan modified.

That water manager – the trustee works for the farmers. The reservoir/dam operator (the servicer) has a contract with the trustee. It’s the Pooling and Servicing Agreement (PSA).

Those lower-tier farmers aren’t exactly happy when things get dry. They have problems of their own. Water is everything. They want it for the crops they have in the ground – getting it next month or next year or some years down the road is out of the question. It’s this season that counts partly because of those people they gambled with (and borrowed money from).

And just to bring this to a real-world scenario – “farmer” is not really just one person. A farmer in this story can literally be dozens of bond holding entities, none of which can make decisions for the others let alone come to agreement on something.

So the normal course of events is to foreclose on the dry well and try to sell it to someone who has water from somewhere else.

Let’s say for the purposes of this analogy that when the reservoir/dam operator (servicer) takes over and shuts off a well (forecloses), they also know some people who are trucking in X tons of water to the reservoir from prior auction sales. In fact, those tons of trucked-in water are a regular part of the business. So much a part that even if five wells go dry this month, their former small flows are more than replaced by the truckloads that came in from five foreclosures in prior months.

So the FLOW of water to the farmers is actually sustained if that earlier process of selling off dry wells keeps the future tanker trucks coming – for a while, that is. Eventually, without enough producing wells, even the truckloads can’t keep the reservoir level high enough. The water company is still supplying farmer AAA, farmer BBB is getting less than they thought, farmer CCC has had to cut back their operation and farmer DDD now owns a bunch of dry wells and is beating on the water company to produce water for him again by selling them off.

But before things get to that point, between the still-working wells and trucked-in water, the reservoir/dam operator may figure they can keep the farmers happy for quite a while. And they’re the only player in the game who really knows where the water is coming from and where it’s going. Why go to the effort of modifying a well-water agreement if you can keep your down-stream customers happy?

Now, if things have gotten bad and the farmers are making threatening noises, there might be a motive to negotiate something to get more water over a period of time. But without the agreement of ALL of the farmers the trustee won’t budge. Good luck with that.

Craig and Dave

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