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Credit Default Swaps Incentivize Loan Servicers To Deny Loan Modification RequestsThe Credit Default Swap market exploded over the past decade to more than $62 trillion just before the height of the recent financial crisis, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market, which was valued at about $22 billion at the end of 2007, and it far exceeds the $7.1 trillion mortgage market. What is a credit default swap? In its simplest form, a credit default swap (CDS) is an insurance-like contract that promises to cover losses on certain securities in the event of a default. A CDS is supposed to operate just like a wind or casualty insurance policy, which protects against losses from high winds and other casualties. Specifically, CDSs are privately negotiated, bilateral agreements that typically reference debt obligations such as a specific debt security (a "single named product"), a group or index of debt securities (a "basket product"), collateralized loan agreements, collateralized debt obligations or related indexes. A Typical CDS Transaction In a CDS transaction, a party, or "protection buyer," seeks protection against some sort of credit risk. The protection buyer normally makes periodic payments - known as "spreads" - to a counter-party, or "protection seller," with reference to a specific underlying credit asset (often known as the "reference obligation"). The issuer is known as the "reference entity," which is often, but not invariably, owned by the protection buyer. The protection seller typically: (i) Delivers a payment to the protection buyer upon the occurrence of a default or credit event (often a triggering event that adversely affects the value of the reference obligation and/or the financial health and credit-rating of the "reference entity" or "reference obligor"), and (ii) Provides collateral to the protection buyer to ensure the protection seller's performance. Most CDSs are in the $10-$20 million range with maturities between one and 10 years, according to the Federal Reserve Bank of Atlanta. If a default or credit event occurs or the value of collateral provided to the protection buyer by the protection seller is deemed insufficient by the calculation agent (typically the protection buyer), the protection seller must make payments to, or increase the collateral held by, the protection buyer. Alternatively, in the event that the reference entity defaults on its obligations related to the reference asset, the protection buyer may require the protection seller to purchase the reference asset for face value, or some percentage of face value agreed upon in the CDS agreement, less the market value of the security. RMBS Servicers & Affiliates Buy CDS CDSs not only impacted the securitization market on Wall Street and financial centers around the world, but also homeowners across the country that have been contemplating or seeking to obtain a loan modification. Before exploring the impact that CDSs may have on homeowners or their ability or inability to obtain a loan modification, as the case may be, this article shall first discuss the major players involved in the CDS market. This is important as most of the CDS market participants are also directly or indirectly involved with servicing of securitized residential mortgage backed securities (RMBS). Major League CDS Players Only a handful of the biggest and most elite financial institutions in our global financial village are engaged in the credit default swaps market. Federal law limits those who may participate in the CDS market to "eligible contract participants," which are defined as and include institutional investors, financial institutions, insurance companies, registered investment companies, corporations, partnerships, trusts and other similar entities with assets exceeding $1 million, or individuals with total assets exceeding $10 million. It should come as no surprise then that commercial banks are among the most active in the CDS market, with the top 25 banks holding more than $13 trillion in CDSs. According to the Office of the Comptroller of the Currency (OCC), these banks acted as either the insured or insurer at the end of the third quarter of 2007. JP Morgan Chase, Citibank, Bank of America and Wachovia were ranked among the top four most active commercial banks. These banks also, directly or indirectly, serve in the capacity as mortgage loan servicers of residential loans, which are charged with the responsibility of collecting, monitoring and reporting loan payments, handling property tax, insurance escrows and late payments, foreclosing on defaulted loans and remitting payments. Pooling and Servicing Agreements Restrict RMBS Servicers from Offering Loan Modification Agreements The RMBS servicer's ability to negotiate a workout is subject to a number of constraints, most notably the pooling and servicing agreement (PSA). Some PSAs impose a flat prohibition on loan modifications. Numerous other PSAs do permit loan modifications, but only when they are in the best interest of investors. In such cases, the RMBS servicer's latitude to negotiate a loan modification depends on the PSA. Some PSAs permit modification of all loans in the loan pool, while others limit modifications to five percent (5%) of the loan pool (either in term of number of loans or aggregate gross houston fast loans without credit check amount). PSAs often include various and sundry restrictions on loan modifications, including, for example, mandatory modification trial periods, specific resolution procedures, caps on interest rate reductions, restrictions on the types of eligible loans and limits on the number of modifications in any year. The PSA is not the only limitation on the loan servicer's ability to enter into a "workout." For instance, sometimes the servicer needs to get permission for the workout of a delinquent loan from a multitude of parties, including the trustee for the securitized trust, the bond insurers, the rating agencies who originally rated the bond offering, and possibly the investors themselves ("Barclay's Capital Research" 11). Thus, when the servicer of a pool of RMBS requires authorization to exceed the limits on its loan modification discretion, according to the PSA, the modification is generally neither cost-effective nor practically possible for the servicer to obtain the myriad of needed consents, especially for one loan amidst a huge pool of securitized loans. As a result, the request for a loan modification is summarily denied without even considering the factual underpinnings of the request or the dire circumstances the borrower's are currently fighting to survive. This is shameful. Other Impediments to Loan Modifications: The CDS Profit Motive As discussed above, a loan servicer might rebuff loan workout attempts because the applicable PSA forbids workouts. In addition, when a borrower becomes delinquent on his/her mortgage payments, the loan servicer may have to advance all the missed payments to investors -- in excess of its spread account. This is not a savory solution to the servicer. Further, a loan modification might trigger "recourse obligations" by the lender where the servicer is an affiliate of that lender. The loan servicer may not be able to recoup the added, labor intensive costs of negotiating a loan modification (either because the loan size is too small or the servicer is paid on a fixed-fee schedule). Finally, the servicer may deny a borrower's request for a loan modification simply because it bought CDS protection against a default and would probably only profit from the CDS if foreclosure proceedings were filed. (See, e.g., Credit Suisse (2007); FitchRatings (2007a, p. 3); International Monetary Fund (2007, p. 47); J.P. Morgan Securities Inc. (2007, pp. 3-4)). RMBS Servicers Hit Pay Dirt When Foreclosure Proceedings Commence Although seldom reported, RMBS loan servicers have and will continue to strategically employ CDSs to protect against loan defaults, usually to the detriment of borrowers seeking houston loan online only payday modifications. In some cases, the RMBS loan servicer bets against itself or the pool of loans they are servicing by purchasing a credit default swap on the pool of RMBS that it services. These CDSs only pay off when the servicer files a foreclosure complaint. (See Patricia A. McCoy & Elizabeth Renuart, The Legal Infrastructure of Subprime and Nontraditional Home Mortgages 36 (2008), available at As a result, loan servicers, blinded by their desire to bolster their returns by cashing in on their CDSs, fail to hear the pleas of distressed homeowners who desperately request loan modifications, even when loss mitigation strategies, such as refinancing the loan, selling the home or accepting a deed in lieu of foreclosure, are economically viable. Given these and many other impediments, it is no surprise that few houston payday advances no credit check modifications are actually offered, let alone accepted. This helps explain why the Special Inspector General for the Troubled Asset Relief Program called HAMP's failures "devastating" in its report. (See http://www.housingwire.com/2011/01/26/sigtarp-hamps-failure-devastating-permanent-mods-flat-in-december.) Conclusion Until servicers face large and significant costs for failing to make loan modifications or until they are actually at risk of losing money if they fail to make modifications, no incentive to make modifications will work. What is lacking in the system is not a carrot; what is lacking is a stick, according to a statement by Russ Feingold, Member, Senate Committee on the Judiciary during a Hearing Before the S. Comm. on the Judiciary, 110th Cong., 2nd Sess. (Nov. 19, 2008). Senator Feinggold said "One thing that I think is not well understood is that because of the complex structure of these securitized mortgages that are at the root of the financial calamity the nation finds itself in, voluntary programs to readjust mortgages may simply be doomed to failure."
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