Servicing Loans Crucial to Success of the Bailout Plan

The widely discussed economic rescue plan, commonly called The Bailout, will help to backstop much of the nation’s troubled debt, but many questions remain unanswered as specific details on the plan are scarce. But, experts say, mortgage servicing and collections will play a big role in the program.

The “Economic Recovery Amendment to the Paul Wellstone Mental Health Parity Act” (H.R. 1424) is ostensibly an economic stabilization plan that authorizes the Treasury Department to purchase up to $700 billion in “troubled assets” from the nation’s financial institutions. To do this, Treasury is setting up an entity called the Troubled Asset Relief Program (TARP), similar to the Resolution Trust Corporation that helped liquidate assets of institutions caught in the savings and loan crisis of the late 1980s.

According to a summary of the legislation from Steptoe & Johnson – a Washington, D.C. law firm that has established a task force to aid financial institutions, sellers and purchasers of assets, asset managers and program managers on the economic stabilization legislation – the Treasury Department will be given up to two years to make the purchases, and is expected to hold the troubled assets until they could be sold profitably (or with minimal losses) at some future point. 

Most notably, institutions that participate in TARP will have to agree to limits on bonuses and severance pay for top executives.  And companies that sell their troubled assets directly to the government will have to give the government equity or debt positions to help offset any losses the government experiences from the troubled assets.

The Treasury Department will also be able to establish an insurance program for troubled assets modeled on the one for bank deposits administered by the Federal Deposit Insurance Corporation, with owners of troubled assets paying premiums in exchange for the government’s guarantee that those assets will perform as originally promised. 

Many of the key specific details of the program, such as what price the government will pay for the assets or how it will exactly define a “troubled asset” are to be determined by the Treasury secretary.

“It is clear this is just the first step,” says Eva Weber, analyst for Aite Group, a research and advisory firm for the financial services industry. “There are still a lot of questions out there, like what will the foreclosure rate be and how much will Treasury pay for the bad loans."

Weber also has doubts about the effectiveness and timeline of the plan. “Some financial institutions will continue to struggle,” she said. “Those that are the most heavily invested in these types of loans will be the ones that are the hardest hit.”

While the details of the plan are scant at this time, most experts say the intent is unambiguous. But once the government actually takes possession of the assets, it is unclear what it will do to manage the receivables.

“From what we’ve seen, the concept is to get liquidity going in the market,” said John Collins, partner, with Steptoe & Johnson. “In order to do that, you have to be able to get collections of receivables going. If you have an asset that is non-performing, it doesn’t do anything for you in terms of the long-term flow of credit.”

Collins expects some modifications of mortgages and other debt in order to drive improved collections. However, he and other analysts don’t necessarily expect the Bank of America program, announced earlier this week, to become a model for other debt modifications.

Under the B of A program, which was agreed to in order to settle a civil lawsuit against recently-acquired mortgage company Countrywide, the bank will – where possible – modify the terms of certain loans where borrowers are seriously delinquent or likely to become so after their interest rate or monthly payment resets.

Bank of America will first try to refinance borrowers into government-backed loans under the federal Hope for Homeowners program, which will generally require a reduction in the principal of the borrower’s loan. Another option is to reduce the borrower’s interest rate to make the loan more affordable. In some cases, borrowers’ interest rates may be reduced to as low as 2.5 percent, then rise in a stepwise fashion over time. Under the program, borrowers’ mortgage-related payments cannot exceed 34 percent of their monthly income.

“Everyone is interested in collections,” Collins said. “But they have to be done under the conditions in which you operate.” With the economy soft and the job market weak, collectors will have to try to work out deals that recover some funds, but perhaps at a much slower pace than would have been the case a few years ago, according to Collins.

Craig Focardi, research director for the banking practice at TowerGroup, adds that getting the bad loans off the balance sheets should enable lenders to start providing credit again. There have been various news reports that credit has evaporated over the last several weeks.

Mortgage servicers would still be the first point of collection for most of these loans, according to Focardi. However, the Treasury Department would likely dictate the terms of servicing, including the aggressiveness of collections.

“The government will probably take a softer approach,” Focardi said. “It’s in everyone’s interest to keep these loans performing and keep people in their homes.”