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In the seemingly unending, boundless commentary on the subprime debacle, one point which seems to have escaped analysis is the effect the mess will have on the ability to settle mortgage foreclosure actions. For many residential cases it will be considerably more difficult now. To be sure, the economy of the housing and mortgage industries progress through inevitable cycles, and there have been relatively short periods of difficulty over the last five decades or so. In any event (the Great Depression aside) mortgage foreclosures in any volume in New York were not seen until about 1987. But at most times since then, mortgage lenders could assume that the overwhelming majority of mortgage foreclosure actions would not proceed to their ultimate conclusion — the foreclosure sale. Rather, the case would somehow be resolved before the sale date. The borrower might sell or refinance the property and thereby satisfy the mortgage. Alternatively, some form of forbearance agreement or, less frequently, a mortgage modification agreement would save the day. Sometimes salvation could be found through the bankruptcy process. All these methods, however, became less available because of what the subprime era has wrought. SHIFTING MARKETS In times gone by, borrowers typically visited their local savings bank for a loan to purchase a house. More stable communities, less mobility of people, more consistent interest rates and invariable mortgage products, often combined with the lender’s personal acquaintance with the borrowers, led to loans unlikely to go into default. Indeed, mortgages were typically taken founded upon a borrower’s ability to pay according to the immutable terms of the mortgage documents. Disparate trends combined, though, and pushed the mortgage lending arena away from the usual and traditional. People whose credit might not have been deemed sufficient to qualify for a mortgage were being evaluated anew. The goal was to aid those who might be disadvantaged to reach for the hallowed goal of home ownership. At the same time, there were profits to be made in issuing more mortgages. Coinciding with these new views was an underlying shift in mortgage lending from portfolio lenders — those who owned and maintained the loans in their own accounts — to the securitization of loans. Then too, among the myriad loan permutations that arose were the interest-only variety, layered teaser rates, negative amortization, floating rates, and low documentation or no documentation loans. Among approximately $600 billion of subprime mortgages originated in 2006, for example, about 75 percent were funded by the securitization process. This statistic of 75 percent is all the more portentous when noting that so many securitized subprime mortgages originated in 2004 and 2005 with a hybrid structure are fixed rate for only two or three years, then adjusting to a variable rate for the remainder of their 27- or 28-year durations. Because the interest differential between the initial rate and the fully indexed rate typically varies from 300 to 600 basis points, untold thousands of borrowers are or will shortly encounter sharply elevated interest rates that they may be unable to pay. (How many of these borrowers will be aided by amelioratory federal legislation is not entirely clear, but it certainly will not be all of them.) CREDIT CRUNCH The mentioned recasting of the mortgage world — further explained in extensive depth in all the media over this last year or so — has generated a maelstrom of events so often categorized as the subprime meltdown. This, and the related or resultant credit crunch has then directly affected what distressed borrowers could do to escape from their travail. Some of these events and consequences are the following: • Property values are declining in many areas;

• Those who may want to buy properties are encountering far more difficulty in obtaining mortgage financing, which itself then joins in driving property values down further; • Mortgage lenders that might have been sources of funds to prospective borrowers have themselves filed for bankruptcy; • Elevated skittishness by mortgage buyers has led them to mandate mortgage originators to repurchase loans that have violated the loan sale agreement — for example, an initial payment difficulty or a borrower misrepresentation. This means that the monies loan originators might have possessed to fund new loans are increasingly unavailable, committed instead to loans bought back for their own portfolios, something they never intended; • The value of subprime mortgage in securitized pools is often not quantifiable. This further depresses the market for those securities and so makes funds available for lending still scarcer; • Agencies that rate mortgage pools are downgrading them, thus further reducing liquidity and reinvestment. Subprime events notwithstanding, there is always some percentage of borrowers either in default or defendants in foreclosure actions. As noted, those actions either proceeded to foreclosure sale, or loss-mitigation procedures rescued the borrowers, or the latter saved themselves via reinstatement or mortgage satisfaction. In more placid times, fewer cases arrived at foreclosure sale. In more difficult times — such as now — more actions reach the ultimate stage. It seems evident that the circumstances surrounding the subprime crisis will impede the settlement avenues that once were available, making foreclosure sales inevitably more common. How foreclosures once were avoided — and why this will be less availed of — is manifest. PROPERTY SALE It seems like just yesterday that property values were incessantly rising. When that was so, as it was for years, a borrower in a financial quagmire could typically sell the property for a sum sufficient to satisfy the mortgage. Even if the borrower had suffered other liens on the property, the ever expanding equity cushion arising from precipitously greater real estate values seemed to outpace the accumulation of debt. The subprime scenario, however, created a confluence of events that torpedoed the typical rescue path via escalating prices. First, many subprime loans require little or no money down so that equity was either thin or nonexistent at the inception. Second, there was a decline in property values inherent in the subprime disaster combined with the related inability of new purchasers to obtain mortgage financing to make the purchase. In short, the market for properties owned by distressed borrowers was drying up, making it difficult and often impossible to sell as a method to satisfy the mortgage. This path, then, is far less available. REFINANCE Whether the subprime era is the result of a credit crunch or whether it was the nature of subprime loans that elicited the illiquidity is an opinion best left to others. It suffices to say that both unwelcome events oppress in tandem. So, a subprime borrower seeking to refinance finds fewer lenders inviting applications and among those who are lending, credit is generally less available and the standards considerably stricter. A borrower once qualified for a mortgage loan may no longer be acceptable. Even if he is, a lower property value may not support the amount of the loan needed to pay off the mortgage in default. Thus, the refinance route too is of considerably reduced utility. CHAPTER 13 BANKRUPTCY The nature of a Chapter 13 filing is that the borrower immediately resumes submitting regular mortgage payments beginning with the next due date. Shortly thereafter, the borrower (now debtor) is obliged to submit a plan for court approval that will amortize all past due debts over a period not to exceed five years. For the borrower in temporary distress through illness, marital litigation, or loss of employment, the Chapter 13 has often offered rescue welcomed by lender and borrower alike. In the subprime era, the reason for mortgage default is often an interest rate resetting at a higher number, creating a payment the borrower just cannot afford to pay. If the borrower could not pay the lender before the rates changed, he won’t be able to pay now, particularly when some of his funds must be applied to arrears. Consequently, the solution that Chapter 13 once presented no longer exists for many. DEED IN LIEU OF FORECLOSURE This is an oft-used method when the borrower realizes that the property will be lost in foreclosure and that he may be liable for a deficiency. To reduce the accrual of debt — which increases the deficiency — immediately deeding the property to the lender can help. Or, saving the lender the time and expense of the foreclosure by promptly conveying the deed can be exchanged for a waiver of the right to pursue the deficiency judgment. While a foreclosure sale extinguishes the liens and encumbrances that are junior to the mortgage (so long as jurisdiction over the holders of those interests was obtained in the foreclosure action), a deed in lieu of foreclosure carries with it the burden of all those interests. In that respect it is like any other sale. In these days of subprime travail, strapped borrowers are more likely to have pursued junior financing or suffered judgments that attach to the mortgaged promises. To the extent this is so, deeds-in-lieu become less available. FORBEARANCE This is perhaps the most common path to settle the mortgage foreclosure action. The mortgagee refrains from prosecuting the foreclosure action for a certain period of time, during which payments are made, eventually to aggregate a sum sufficient to reinstate the mortgage. As it might be with Chapter 13, however, the borrower may be unable to meet any forbearance agreement requirements for the same reason that it can no longer make the mortgage payments if the interest rate has increased to a point beyond the borrower’s means. MORTGAGE MODIFICATION Examination of the Chapter 13 and the forbearance agreement alternatives suggests that today the only avenue that may provide reprieve for many borrowers is a modification of the mortgage. That is so at least to the extent that so many borrowers cannot service the debt at the existing amount or interest rate. This modification might be accomplished by extending the term and reducing the payments, or reducing the interest rate or modifying it for some period of time, then adding a balloon payment at the conclusion. Indeed, it would seem that under the circumstances presented by the subprime crisis, modification of the mortgage may very often be the only way for many properties to be saved. That leads then to the overarching inquiry: Does the servicer of the mortgage possess the authority to modify the mortgage? The answer is almost byzantine and is not grounds for optimism. When last there was a meaningful turmoil in the housing market some 16 years ago, most mortgage pooling and selling was done by the government sponsored enterprises Fannie Mae and Freddie Mac. Even though the loans were in a pool, these GSEs had the authority to modify the loans. Freddie Mac’s documentation reserves this right to itself. On the other hand, Fannie Mae’s trust documents provide the right to buy a mortgage out of a pool after it is delinquent for four months. Consequently, Fannie Mae can recapture the control needed to modify a mortgage that would otherwise be constrained or impossible if it remained securitized. The serious concern does not involve the mentioned GSEs. To explain the quandary, when an originating lender sells the mortgage, it no longer retains the authority to restructure that loan. Instead, that power is conveyed to a servicer that even then can only do what the securitization documents may permit. In any event, invariably the servicer and the trustee of the securitized mortgages is mandated to act in the best interest of the investors in the securitized loans. The goal is maximum recovery on a defaulted loan on a present-value basis. If that end is reached by a modification, then there is room for all parties to agree. But if foreclosure of the mortgage is seen to yield the greatest return, the servicer may be forced to pursue that even if it will be hurtful to the borrower. RESTRAINTS ON MODIFICATION If the time-tested ways to stave off a foreclosure sale are now playing a diminishing role, mortgage modification will often be the only way to preserve the borrower’s title. Although this may not be such a problem for Fannie and Freddie — at least insofar as they have the ability to make it work if it is possible at all — it can be far more challenging for others. Securitized loans are typically established as Real Estate Mortgage Investment Conduits. To obtain the tax advantages of such a structure, the loans securitized in a REMIC often must be treated as a static pool — that is, they cannot be modified. Although that is clear as general proposition, many documents will nonetheless provide that after a loan has been delinquent for a certain period, modifications may be available in accordance with REMIC statutes. But then the servicer might be required to support its intentions with an appropriate legal opinion. It is thus apparent why the REMIC construct can cloud the ability to modify. It is the pooling and servicing agreement that creates the rules for how each securitization functions and how rules may be varied. How a servicer might modify a loan would be a subject of a PSA, and these rules can be both lengthy and restrictive. Any attempt to modify a PSA may be exceptionally difficult and could require the cumbersome consent of a significant percentage of all investors in the pool. Whether the PSA is flexible or strict in this regard depends upon the particular language that is sometimes precise, sometimes vague. These things vary, and one questioning whether this servicer has the right to modify would need to examine the PSA with some considerable care. There can yet be further constraints upon the servicer. For example, some securitizations might require approval of the rating agency and the bond insurer before loan modifications exceed 5 percent of the total transaction. Likewise, the servicer might be bound to obtain prior written consent of credit enhancement providers or guarantors for any modification or amendment of a mortgage that causes more than 5 percent of the original pool of loans to have been modified or amended. In conclusion, credit and mortgage lending have suffered what may be an unprecedented upheaval. With property values heading down and loans to purchase less available, the ability to settle mortgage foreclosure actions in the amenable ways that used to be available has faded. To a great extent this leaves mortgage modification as the predominant, perhaps singular savior. But the further problem is that mortgage servicers may be unable to provide such a remedy no matter how well founded they may think it is. These are tougher times all around.

Bruce J. Bergman, a partner with Berkman, Henoch, Peterson & Peddy, of Garden City, N.Y., is the author of Bergman on New York Mortgage Foreclosures (2007). This article first appeared in the New York Law Journal , an ALM publication.

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