by Tanta on 6/04/2007 06:22:00 PM

Fitch Ratings has a new Special Report out today, "Changing Loss Mitigation Strategies for U.S. RMBS." (You will have to register if you want to see the full document.) See below for the text of the press release.

My reading of the document is that Fitch's servicing analysts are, like the servicers themselves, not exactly thrilled to be dealing with what could be construed as mistakes that were made somewhat earlier in the process:

The volume of defaulted loans in subprime portfolios has exceeded the expected levels for this product, and with the number of adjustable-rate mortgage (ARM) loans still moving into the reset phase, this number will increase unless an aggressive stance to work out these cases is adopted. This report does not delve specifically into the reasons for these increased defaults, except as they affect the timing and/or opportunities available to the servicer to develop workable solutions.

Quite honestly, if I were Fitch, I wouldn't want to "delve specifically into" that either. As I am not Fitch, I wonder how long they'll be allowed to get away with that. If a rating agency is supposed to do anything, it is supposed to be good at predicting "expected defaults." That these subprime pools have fallen apart so far, so fast, is a problem the servicers have inherited. That some of these servicers have fallen apart so far, so fast, is a problem the bondholders are inheriting in bankruptcy court. One needs to read this report with that context in mind.

Each of the items discussed below have a direct impact on the servicer’s cost to service by requiring additional staff or technology expenditures, increased costs of vendor services, carrying cost of advances, and development and performance of initiatives outside the normal expected scope of activities for a residential servicer. The servicers of subprime loans closely monitor and manage their cost to service and have indicated that, for the most part, they expect the current servicing fees in transactions to cover their increased costs. However, Fitch believes this is an area of concern for certain servicers who either do not have a diversified portfolio or who are not continuing to take in new production, which would improve the ratio of performing to nonperforming loans. This concern could also arise upon the need to transfer a subprime portfolio that contained high default levels, as the number of servicers willing to take on this servicing at current fee structure levels could be limited.

If that doesn't mean "Look, bondholders, you'll either approve some modifications or your servicer will fold beneath you and any substitute servicer will be able to name its price because you need them waaay more than they need you," well, then Tanta's never read a ransom note.

Servicers have also noted that they believe there will be longer foreclosure timelines on the horizon due to the increased volume of filings and repeat actions required after multiple efforts with borrowers. In addition, increased foreclosures are causing delays with county recorders, broker price opinion (BPO) providers, property inspection and preservation vendors and REO networks. Some servicers have indicated that vendors and, particularly, attorney networks may be adversely affected by increased foreclosures, property preservation and inspection orders, and REO listings, noting that vendors must also increase their ranks with experienced staff. In addition, local jurisdictions and courts are becoming backlogged and overloaded with foreclosure cases, which have negatively affected foreclosure timelines and translated into higher costs to carry.

Most Fitch-rated servicers have strict timeline adherence policies and clearly delineated options. However, ultimately, servicers have agreed that current measurements for foreclosure and REO liquidation timeline management will need to be closely monitored and reset as the market reacts to the pressure of quickly changing volumes.

The worse it gets, the worse it gets. I honestly don't know how Fitch expects us to read the two paragraphs above. Are there those for whom this is news? Are they, um, investors in Fitch-rated securities?

Let us be clear. Foreclosure waves create additional losses just by being foreclosure waves. You can try to rush for the exits all you want; it takes too long to get out of this door if there are too many people in line. This has always been true. I read things like the above and wonder whether Fitch's loss models ever considered that when declining home values (a key element in the loss severity calculation) get to a certain point, the foreclosure volume gets to a point such that the operational risk explodes, which drives those loss severities even deeper. The beginning of that paragraph, "servicers have also noted that they believe," quite honestly makes me wonder whether this is news to Fitch.

This report raises the question of the authority given servicers under the RMBS documents, including the limitations of REMIC law and FASB 140 accounting rules. Curiously, it doesn't actually really answer those questions. It simply states:

For the purpose of this report, Fitch is taking the view that modifications within RMBS transactions are permitted and, as such, the focus is more on the processes and controls around the strategy than offering an opinion on the legality of the strategy itself. As stated, Fitch expects each servicer, with the counsel of their legal staff and accountants, to make an independent assessment and determination of the use and type of loss mitigation strategies allowed within their portfolio. However, based on projections from servicers, Fitch believes that over the next 12–18 months, modifications could be used on as many as 5%–10% of the loans, based on the original outstanding balance of the deal, and could be the only viable loss mitigation strategy for as much as 40%–50% of the loans in default or determined to be a reasonably foreseeable default scenario.

Uh, the original outstanding balance of all subprime securitizations in just 2006 was in the neighborhood of $450 billion. $45 billion in mulligans in the second year of the whole thing?

Oh well, at least this time nobody's pretending we have any real idea whether all these do-overs are going to work:

There is no adequate historical data on which to base projections of the redefault rate for loans that have been modified or the effect these will ultimately have on the losses within the RMBS pools. Therefore, it is very important that servicers accept and endorse the request for this information from the various parties. The industry is being asked to accept the belief that the servicers can and will adequately manage and affect procedures that will impact not only the lives of the homeowners but also the return on investments for many investors.

I can hear it now. We bondholders are being asked to just take the servicer's word for it? Whose word did you take for it when you bought this stuff?

To summarize: Fitch does not know how bad this could get. Fitch does not know if all of these servicers can afford it to get bad as it could get. Fitch does not know how legal all these loss-mit options are. Fitch does not know if these loss-mit options will work. Fitch knows that its servicers believe that there are no other good choices. Fitch is working on getting some better trustee reports for y'all. You will be kept posted, otherwise: just watch for the downgrades and step-down failures.