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Will the Foreclosure Mess Dog Your Bond Fund?

Its bark is worse than its bite.

Miriam Sjoblom, 11/09/2010

Sloppy mortgage record keeping and foreclosure delays have captured headlines lately, but the controversy won't likely have a major impact on bond funds that invest in mortgage-backed securities.

Allegations that mortgage servicers cut corners preparing foreclosure paperwork have prompted all 50 state attorneys general to investigate servicing practices. Beginning in late September, GMAC, followed by other large servicers, temporarily halted foreclosures in the 23 states in which foreclosures require county court proceedings. In early October, Bank of America BAC and others stopped foreclosures in all 50 states while they took a closer look at their internal procedures. (Bank of America and GMAC have since said they would resume them.)

The media has focused mainly on the robo-signing controversy. When a lender initiates foreclosure proceedings, one or more of its employees are required to review all the loan documentation and verify that appropriate state procedures have been followed. Then the representative signs an affidavit declaring they have "personal knowledge" of the case in the presence of a notary. In some cases, employees allegedly signed thousands of affidavits without actually reviewing the files and without a notary present.

The robo-signing allegations have spurred claims that the foreclosure proceedings themselves are fraudulent. Market participants are also debating other legal technicalities, such as whether lenders can prove they have the legal standing to foreclose by producing mortgage notes. In the securitization process, mortgage notes can get passed among a number of parties. In some cases, the mortgage note may be missing or not properly endorsed as it changed hands. For many, the Mortgage Electronic Registration System, or MERS, is the mortgagee of record, acting as a central clearinghouse that tracks who owns each mortgage and its servicing rights. Some have questioned whether MERS has the legal standing to initiate foreclosures, even though courts haven't disputed this in the past.

Yeah ... So?
The foreclosure controversy doesn't impact mortgage bonds issued by government agencies Ginnie Mae, Fannie Mae or Freddie Mac. The agencies already buy back delinquent loans independent of the foreclosure process. Because the agencies pay par value for these loans, the economic impact to bondholders is the same as when borrowers refinance their mortgages.

A modest number of mutual funds invest heavily in nonagency residential mortgage bonds, so the typical intermediate-term bond fund shareholder probably has minimal exposure to these securities. After prices on nonagency mortgage bonds plummeted in 2008, many higher-quality bond-fund managers washed their hands of the sector. The rating agencies also downgraded large swaths of formerly AAA rated mortgage bonds to below investment-grade status in late 2007 and 2008 (1 cent on the dollar of principal impairment triggers a CCC rating, even if a bond is trading at 50 cents). That makes many of these bonds ineligible for vehicles with investment-grade-only mandates.PAGEBREAK

For the smaller group of funds with sizable nonagency residential mortgage stakes, foreclosure concerns appear overblown. Bond-management firms with top mortgage research capabilities--such as TCW MetWest, PIMCO, Western Asset, and DoubleLine--agree that issues raised by the investigations and foreclosure moratoriums are mainly technical in nature. If a judge finds that proper foreclosure procedures were not followed, servicers will have to amend documents or start proceedings over again. Bondholders don't expect to see their claims invalidated while homeowners and underwriters battle these issues out in the courts, though.

Ironing out the legal and procedural kinks could add months to an already drawn-out process, though, which could hurt the value of some nonagency mortgage bonds. Foreclosure delays result in additional costs that reduce recovery values, which, on the margins, could harm some senior nonagency mortgage bondholders who'd prefer speedier write-offs.

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