Rod S. Dubitsky
Executive Vice President, Global Structured Finance Specialist
Mr. Dubitsky is an executive vice president in the Newport Beach office and global structured finance specialist in PIMCO's Advisory group, which advises institutions globally on complex portfolio risks and valuations, and other challenges. Prior to joining PIMCO in 2009, he was managing director and head of asset-backed securities research at Credit Suisse, where he helped create residential mortgage-backed securities (MBS) surveillance and analytics systems. He was ranked as a leading analyst in asset-backed securities by Institutional Investor magazine in 2002-2008. Mr. Dubitsky was previously a senior analyst focusing on MBS at Moody's Investors Service and an agency MBS portfolio manager at BankAmerica. Before that, he was chief investment officer of a savings and loan and also worked at the Office of Thrift Supervision during the savings and loan crisis. He has 23 years of investment experience and holds an MBA from the Fuqua School of Business at Duke University and an undergraduate degree from the State University of New York, Binghamton.
In early October a contested foreclosure action on a tiny house in rural Maine lit the fuse of a blast that has reverberated throughout the markets, spreading renewed fear of a second downturn in the housing market and potential gridlock in the mortgage market. Specifically, the contested foreclosure action led to a deposition of an employee of GMAC Mortgage (a subsidiary of Ally Bank, fka GMAC Bank), which appeared to reveal that GMAC was cutting corners while executing the foreclosure process. The deposition led GMAC to freeze the foreclosure process, and other servicers quickly followed GMAC into the servicer confessional and likewise froze foreclosures. Further, the 50 state attorneys general launched an investigation.
In the U.S., each state has foreclosure requirements that can be characterized as either judicial or non-judicial. Judicial foreclosure goes through a fairly lengthy process and requires servicers to appear before a judge and to file a lawsuit. Non-judicial foreclosure is generally a much faster process and often simply requires the servicer to file a notice of default, followed by a cure period and ultimately culminating in a public auction of the property.
Because of the more formal legal process, most of the initial problems were in judicial foreclosure states, although some financial institutions imposed moratoria in both judicial and non-judicial states. Thirty U.S. states utilize the non-judicial foreclosure process (according to RealtyTrac) and therefore effectively bypass the court system.
Though many servicers are in the process of fixing the flawed procedures, and the long-term market impact of these revelations is uncertain, in our base case scenario we see moderate risks to housing prices and to residential mortgage-backed securities (RMBS) investments. Though the story is months old and several issues have been clarified since the story initially emerged, much uncertainty remains and many additional challenges have been raised with the foreclosure process as well as with the securitization process in general.
A Brief History of "Robogate"
Though there are several complicated threads to the story, the primary flawed processes employed by mortgage servicers can be easily summarized: 1) employees of the servicers were attesting to facts in affidavits that in fact they often didn't have explicit knowledge of and 2) contrary to requirements, the affidavits in many cases weren't signed in front of a notary. (We note that this should not imply there are no other broken servicer processes.) As an affidavit is a sworn statement of fact that needs to be witnessed, these two shortcuts rendered the affidavits defective. No witness and no real knowledge of the facts being attested means an affidavit is not acceptable to the foreclosure court. The media dubbed this trend of rapid, automated signing of affidavits "robo-signing" and the ensuing uproar "robogate."
The secondary thread of the story that seems to be growing in importance is potential flaws associated with the mortgage documents and the process of transferring the documents during the securitization process. The upshot of the latest stories is that flaws in the transfer of mortgage documents associated with the securitization could increase the complexity of the foreclosure process and, in the extreme scenario, jeopardize the economic interest of the trust in the associated mortgage. Though the document flaws (as distinct from the affidavit flaws) currently appear to be limited, we are watching this thread closely to see if the issues are more pervasive.
Though some of the earlier moratoria have been lifted, it's not entirely clear that the servicers' processes have improved enough to satisfy the attorneys general and foreclosure judges. Further, for some servicers who have not imposed a moratorium and have indicated that their procedures were correct, in some cases evidence has emerged that calls into question the procedures of even these "compliant" servicers.
The attorneys general, who have yet to conclude their review, are rightly concerned over the possibility that streamlined foreclosure processes either 1) resulted in some foreclosures that shouldn't have occurred (though we expect this is rare) or 2) didn't give borrowers an adequate chance to resolve their mortgage payment difficulties (e.g., via a loan modification or other resolution). However, we don't believe the attorneys general want to see permanent gridlock in the REO (Real Estate Owned "“ i.e., foreclosed homes) housing market; after all, many voters buy foreclosed homes and most voters don't like seeing empty homes blighting their neighborhoods and failing to contribute property taxes.
Most Likely Overall Impact Is Moderate
At this point it doesn't appear the legal right to foreclose will be severely impaired across a large number of mortgages, nor will the ability to foreclose likely be subject to massive or terminal delays. Rather, thus far it appears that servicers will ultimately be able to execute foreclosures on the overwhelming majority of mortgages. Most of the problems and flawed procedures, in short, appear to be fixable, and in our base case scenario we see the long-term impact on housing prices and RMBS as likely to be moderate.
That said, robogate and its fallout do have several implications for investors. First, the servicers will be affected by 1) higher costs (in both the short term, as the backlog is cleared, and the long term, as staffing needs to be stepped up) and 2) potential legal liability, as the various infractions may result in legal action on the part of borrowers or the attorneys general. Second, potential gridlock in the housing market and further delays in resolving the housing overhang do pose the risk of an adverse impact on home prices in the longer term, though the short-term effect could be positive as distressed supply is pulled from and kept off the market. Third, RMBS investors will likely be affected as delayed liquidations result in longer duration and higher losses (due to greater costs, resulting from the longer timelines). On the other hand, credit IO RMBS will likely benefit, as the IO (interest only) period will last longer, thereby increasing the value of the interest component of their cash flows (a credit IO is a bond that is impaired to the degree that no principal is expected to be received and the only value is remaining interest payments). Fourth, we note the foreclosure delay's impact will depend on the bond structure, since structural nuances vary across and within deals.
The final implication for investors is very difficult to quantify: If borrowers know they have a reasonable basis to legally contest the foreclosure, the recent revelations may embolden many more borrowers to do so. Even borrowers who know they can't afford the home may choose to contest foreclosure if it increases the free rent period or if they have hope of improving their financial situation during the prolonged delay. Borrowers may cite an array of reasons to contest foreclosure: affidavit irregularities, lost notes, improper standing to foreclose, misapplied payments, incorrect ARM calculations, excessive delinquency-related expenses (late fees, inspections, force placed insurance), failure to offer a loan modification (which is required in some jurisdictions), or problems associated with the origination of the loan. In most cases, we believe delay will be the worst outcome from an investor's perspective. We believe most title/note mortgage assignment issues appear to be fixable (at some time and expense), and more to the point, while some borrowers will challenge and successfully avoid foreclosure, most borrowers who challenge are likely only delaying the inevitable (as most such borrowers simply can't afford the home). Nevertheless, it's another area of uncertainty.
And on a positive note, we have no doubt that some borrowers were rushed to foreclosure when in fact they may have had a legitimate ability to pay, and to the extent the foreclosure timeout can save additional borrowers, that is clearly a good thing.
In PIMCO Advisory, we're accounting for the impact of foreclosure freezes on RMBS prices by running delays ranging from three to 12 months across base case and stress scenarios; the values of the bonds generally don't change more than a few points in the more extreme scenarios. In addition to longer foreclosure timelines, we are assuming higher loss severity because servicers will need to advance more delinquent interest while the foreclosure is pending. One element that is difficult to quantify is whether servicers will incur substantially more fees that may in turn be passed along to RMBS investors, thereby adding to loss severity. Though some expenses will likely be borne by investors, at this point we're not assuming much additional loss severity other than that strictly from the extended timelines.
Further, it's not clear at this point whether the delay should only be applied to current foreclosures or whether foreclosure timelines will become permanently longer as servicers and courthouses now take longer to process each foreclosure. We are currently applying our lags to the existing foreclosure and REO pipeline, while leaving our process for current loans unchanged. Assuming servicers increase staff to clear the backlog and adequately fix their procedures, we believe it's reasonable to assume that foreclosure timelines will revert to pre-robogate levels (which already reflected lengthened timelines).
Less Likely but More Dire Consequences Are Possible
Following the foreclosure moratorium, market participants raised two issues that would theoretically have far more dire consequences for RMBS investors in particular and the mortgage market in general. Thus far, the likelihood of either of these worst-case scenarios appears remote, but they are worth considering.
This material contains the current opinions of the author but not necessarily PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment, legal or tax advice, or a recommendation of any particular security, strategy or investment product. This material should not be relied upon by the recipient in any manner (including, without limitation, in evaluating the merits of any particular investment decision). You should consult your professional advisers, including legal and/or tax counsel, about specific questions and concerns relating to the matters discussed herein. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in any projections or other forward-looking statements contained herein. No part of this material may be reproduced or retransmitted in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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