The Coronavirus Aid, Relief, and Economic Security (CARES) Act offered up to 12 months of mortgage forbearance for COVID-19-impacted borrowers with federally backed residential mortgages. The forbearance covers around 70 percent of the 48 million US homeowners with a mortgage. Congress, however, did not address the needs of the 30 percent of borrowers with nonfederal (i.e., privately owned) mortgages. These 14.6 million borrowers may be particularly vulnerable to the economic devastation caused by COVID-19, but providing them the same assistance is challenging.

Borrowers with federally backed mortgages can obtain forbearance under standard terms dictated by the government entity that owns the loan: Fannie Mae, Freddie Mac, the Federal Housing Administration, or the US Department of Veterans Affairs. Non–federally backed loans are held either in bank portfolios or in private-label securities (PLS), the latter composing 2.6 million of the 14.6 million total loans, according to CoreLogic. Though over 10 percent of borrowers of nonfederal loans have received forbearance, the duration of this forbearance, qualification requirements, and repayment options vary. The result is that two borrowers with similar circumstances often receive different treatment because different entities own their loans.

Why is it so difficult to treat borrowers equally?

There is no debate that borrowers affected by COVID-19 should be treated equally, regardless of who owns the loan. At a recent Urban Institute event focused on the 2.6 million PLS loans, experts explored several economic and legal hurdles to attaining equal treatment for servicing of PLS loans.

1.  Lack of standardization. The Pooling and servicing agreement (PSA), which spells out rules that govern PLS loan servicing, vary across the industry. A particularly critical issue lacking standardization and clarity is which entity holds the legal authority to decide the terms of loss mitigation. It can be a particular investor or the servicer, trustee, or bond administrator. This is problematic because each of these entities may have different contractual constraints or discretion regarding loss mitigation decisions, further complicating and delaying forbearance. Some contracts bestow loss mitigation discretion to bondholders, giving them have the right to act in their own best interest, which can conflict with the interests of other bondholders.
   
   Where governing contracts provide direction concerning loss mitigation, lack of contract standardization and ambiguous language yield different interpretations of similar language. In fact, there are reports that different servicers within the same PLS deal are interpreting the same PSA differently, which makes standardized loss mitigation decisions extremely difficult.
2. Lack of specificity. PSAs dictate what the servicer is allowed to do but often lack specificity needed to address every possible circumstance. According to Jay Williams, senior vice president at Ocwen Financial, crises like the current pandemic generally are “not covered in PSAs because no one anticipated it ever happening.”  
   
   For example, a PSA may allow forbearance generally, but not state the duration, eligibility, repayment, and other terms, leaving plenty of room for interpretation. Further, if some amount of payment is forborne, deciding how to divide the reduced cash flows to the multiple PLS tranche holders is often unsettled and complicated, as is determining how to handle the repayment of the forborne amount.
   
   Lack of specificity affects not only whether investors will eventually get repaid but also the value of interest lost in the interim. According to Laurie Goodman, vice president for housing finance policy at the Urban Institute, “a $100 payment forbearance that is paid back 30 years later with no interest has a present value of $35 today.”
   
   PLS tranche holders must be certain about how forborne amounts are treated in the cash flow waterfall of bond payments. Although these details are typically spelled out in the PSA, different contractual frameworks and interpretations exist among and within PLS deals. Agreement among parties and investors on how to address these issues and, to the extent possible, resolve these differences is rife with complexity.
3. Servicer contractual obligations. Servicers have a contractual obligation to the investor that can conflict with doing right by the borrower and providing CARES Act–type forbearance. If providing forbearance violates PSA terms, the servicer could be held liable for damages should investors receive diminished cash flows because of the servicer’s contractual breach, said Eric Kaplan, director of the Center for Financial Markets’ Housing Finance Program at the Milken Institute.

These issues don’t affect agency mortgages because Fannie Mae, Freddie Mac, the Federal Housing Administration, and the Department of Veterans Affairs are the decisionmakers in their respective channels and the government bears the cost of the decision. In the PLS world, one entity could be the decisionmaker, but the cost of that decision could be spread among many other entities. Additionally, agency servicing guides are updated frequently to address new circumstances as they arise, and this has certainly been the case during the pandemic. In comparison, PSAs are locked once they are written at the time of origination.

Though the most effective policy solution would be to align borrower treatment across non-agency and agency channels, the structure of PLS servicing is fragmented and built on fundamentals that are very different from that of the agency space. Furthermore, Kaplan added, “there are significant differences—and often less generous terms—in the provision of forbearance by several balance sheet holders of non-agency whole loans, who generally have full discretion with respect to the provision of forbearance.”

These challenges in servicing PLS loans were at the forefront of the Great Recession and caused significant consumer harm. According to Eileen Lindblom, head of non-agency/RMBS at Flagstar Bank, the PSAs for newer PLS deals “are much better than they were in the last crisis.” At the same time, about 1.6 million PLS loans, or 61 percent of the 2.6 million PLS loans outstanding today, were originated before 2009, according to CoreLogic. Before the Great Recession, PLS borrowers had weaker credit characteristics and higher default rates than they have had since 2009. Since 2009, more stringent underwriting standards have markedly improved the credit characteristics of PLS loans.

Volume and Credit Characteristics of PLS Loans Outstanding

Source: Private-label RMBS performance from CoreLogic.
Note: DTI = debt-to-income; LTV = loan-to-value; PLS = private-label securities; UPB = unpaid principal balance.

How can we better help borrowers with PLS mortgages?

At the event, Lisa Rice, president and chief executive officer at the National Fair Housing Alliance, said that “structural and systemic barriers are causing some of the disparities in borrower treatment and could raise fair lending concerns.” Panelists offered several suggestions to better support borrowers with PLS mortgages and break down these barriers.

• Grant forbearance rights to PLS borrowers. Rice urged support for the Health and Emergency Recovery Omnibus Emergency Solutions (HEROES) Act, which recently passed in the US House of Representatives and guarantees 12 months’ forbearance for 100 percent of the market, including PLS loans. This provision will make PLS borrowers affected by COVID-19 eligible for the same forbearance relief that borrowers with federally backed mortgages are. The HEROES Act also includes a liquidity provision to help servicers address cash flow issues while providing forbearance.
• Reestablish loss mitigation infrastructure. Better communication and coordination could provide borrowers and housing counselors with better access to PSAs so they can thoroughly understand their options. According to Rice, reestablishing the Great Recession–era infrastructure such as the HOPE Loan Port and HOPE NOW Alliance could streamline assistance options.
• Increase PSA standardization. The panelists supported facilitating standard, transparent interpretation of PSAs across servicers to reduce variability in borrower treatment. A bondholder communication platform could facilitate the efficient flow of information to and from investors and speed up decisionmaking. But it is also clear that these changes will not happen automatically. As Chris Hentemann, chief investment officer at 400 Capital Management, noted, changing the system will “require leadership that is focused on this sector.” 

As Congress grapples with the next round of coronavirus relief, policymakers should not forget about the nearly 15 million borrowers with private loans, including the 2.6 million PLS borrowers that were left out of the CARES Act.