Investors Resist Modifying Mortgages

NEW YORK (AP) - Regulators want banks to help subprime mortgage borrowers avert disaster by easing their loan terms, but for bond investors, the cure may not be better than the disease.

Changing the terms of these home loans -- which are made to risky borrowers with poor credit profiles -- after they have been packaged into bonds leaves investors scrambling to adjust to new terms they hadn't expected at the outset. That type of uncertainty, the concern is, could make an already unpopular asset class even more unpopular.

As foreclosures soar, and with subprime delinquency rates as high as 26 percent in a few states, the Federal Reserve and the entire bank regulatory community last week sent out a strong message: banks should do what they can to help borrowers stay in their homes.

Specifically, institutions that are in charge of collecting mortgage payments should see if there is any way they can rewrite, or modify, existing loans to lower mortgage payments and ward off foreclosures, the regulators said.

While investors in the $1 trillion subprime mortgage bond market -- who have seen even the highest credit-quality securities go from easily tradable to difficult to sell or even value -- should be happy with any news that can spare them large losses, they are far from overjoyed.

Rather, investors are wary of loan modifications since, though the practice has been around for years, it hasn't ever been applied on a grand scale or at a time when home prices were falling around the country.

It's not clear, for example, that modifying the terms of a loan will ultimately bail out many struggling homeowners over the long term.

"Even in the best of times, (many of) these modifications just served to push off foreclosures for a later period when home prices were increasing," said James Grady, a structured finance portfolio manager for Deutsche Asset Management in New York.

"Now with home prices declining, you're arguably just increasing your loss severity."

By far the biggest objection investors have to loan modifications, though, is that if borrowers, for example, are suddenly paying a lower interest rate, then investors don't get the cash flows they expected when they bought the bonds.

"That's coming out of someone's pocket. That's not a free ride," Grady said.

And that's not great news for subprime mortgage bonds as an asset class, considering how difficult it is at the moment to value the bonds and how reluctant investors have been to buy them of late.

For this reason alone, massive loan modifications could make investors continue to shun subprime bonds for a while.

"You may find investors no longer willing to buy future or similar securities on the same terms" as they did earlier, Grady said.

The problem isn't only related to the likelihood of receiving a lower rate of interest, either. On top of that, investors in bonds backed by loans that end up being modified also tend to find themselves having to hold those securities for far longer than originally expected.

That's because borrowers who might have refinanced into new loans had the terms of their loans remained the same choose instead to take the modified rate and keep their loans longer. And bondholders, as a result, don't get cash back early from as many loans as they had anticipated.

Suddenly, a bond that investors had expected to hold for three or four years now lasts 10 or 11 years, said Walter Schmidt, manager of securitized products strategy for FTN Financial in Chicago. That not only upsets investors' cash-flow calculations, "you're extending the time over which you have credit risk" to bear as an investor, he said.

On the other hand, because loan modifications may stop some borrowers from defaulting -- at least for a certain time -- that may help investors who own the very lowest classes of bonds, from BBB-minus to the unrated piece.

These classes of bonds, because they absorb losses first, stand to benefit the most from any measures that can stave off mortgage foreclosures and the hefty losses associated with them.

Also, most subprime securitizations are structured so that if loan delinquencies reach a certain level -- called the trigger level -- cash flows from the lowest-rated (or unrated) classes of bonds get turned off and redirected to higher-rated classes of bonds, such as those rated AAA.

However, if loan modifications prevent those trigger levels from being reached, it benefits the holders of lower-rated classes of bonds at the expense of the holders of the higher-rated bonds.

Investors' reaction to loan modification "depends on where you are in the capital structure," said Gary Greenberg, senior vice president and mortgage strategist for Payden & Rygel Investment Management in Los Angeles.

Generally speaking, for holders of the investment-grade classes of bonds -- from AAA to BBB -- it's most likely a net negative based on altered expectations of cash flows, he said.

For the lowest-rated classes of bonds, on the other hand, it's probably a net positive, at least if the modifications really improve the performance of the loans, he said.

The bottom line is market participants don't seem to think easing loan terms will solve the subprime mortgage bond sector's troubles. Loan modifications are "not an unequivocal positive" for investors, Deutsche Asset Management's Grady said.