London, UK: Neglected shopfronts (Photo by BuildPix/Construction Photography/Avalon/Getty Images) Getty Images
Wall Street must first give a rating to securities that are mortgage-backed and commercial real estate mortgages. Rating agencies review a comprehensive list of data points that each loan is subject to in order to determine if it deserves a rating. This review covers, among other things, the documentation of the loan, collateral, valuation, estimated probability of default, sponsorship, as well as whether the borrower structure is adequate to protect the loan against bankruptcy risks. Rating agency processes can seem like a lengthy and thorough proctological exam for anyone who is trying to close a securitization.
The agencies ask the following question when rating any loan: What would happen if the loan was foreclosed? It would include the costs of prosecuting foreclosure. The lender's expenses during foreclosure to pay real property taxes and insure and preserve collateral would be included. These expenses will increase the longer the foreclosure process takes. While loan documents may require that borrowers reimburse all expenses, most borrowers in foreclosure don't have the money. This is why the loan was declared in default.
The collateral for the loan can often become less valuable, resulting in indirect costs to the lender, even if they do some maintenance.
The longer the foreclosure process takes in a particular state, it is more complicated and will result in more collateral loss. Longer foreclosures cause larger losses for lenders.
It is therefore not surprising that rating agencies use state foreclosure laws and procedures to estimate loss from hypothetical loans defaults.
These issues are not being addressed by rating agencies, despite my informal, but reliable inquiries. Instead, they use a generic timeline to estimate the likelihood of the lender losing money. They don't consider the speed of the actual process in each jurisdiction where collateral is located. Because it is difficult to quantify and evaluate the impact they will have on lenders' likely loss, agencies don't consider specific foreclosure timelines.
It is obvious that slow foreclosures lead to higher lender losses. However, rating agencies are unable to quantify these variations and so ignore them. These same rating agencies also obsess about single-purpose entity covenants in loan documents. For example, whether the borrower has separate letterhead or a separate phone number.
Rating agencies would include foreclosure times into their ratings. Loans in states with slow foreclosures would be penalized. A securitization agent would prefer loans that are originated in fast states because they might have better ratings. This should eventually have an effect on the pricing for loans in slow-foreclosure countries. These loans should be less appealing to loan originators and the system of securitization, so they should have a higher interest rate.
New York borrowers would be disappointed by this because New York has one the longest foreclosure times in the United States. In New York, a foreclosure can take anywhere from 18 to 48 months. This is true regardless of whether the borrower has done nothing to defend themselves and accepted the fact that its property was underwater and less than the loan amount. New York foreclosures are slow because the state process is very complex. It is not like other states. The process requires the involvement of a judge throughout.
Rating agencies could have paid more attention to the foreclosure timelines in their rating process. Slow states such as New York may eventually realize that their inefficiency will cost them money indirectly. People who securitize New York loans might not like that securitization process devalues them. They may try to change it.
It would be a good idea to consider the additional cost to New York borrowers in order for them to have better foreclosure procedures. This would decrease the losses that lenders face from foreclosures, and it would also reduce the local blight and deterioration that can often occur during these proceedings. Any such law change could include protections for borrowers against wrongful foreclosures.
