sudden increase in delinquencies and defaults in the subprime sector. So, it is not surprising that historically-based ratings would take a while to adjust to the downturn.

**In addition to being slow to downgrade subprime ABS, the ratings agencies may also suffer from the incentive structure inherent in their business model.** Issuing investment banks pay the rating agencies to analyze and rate the collateral underlying credit sensitive MBS and ABS. Two ratings are typically used. Given that there are more than two rating agencies, a potential problem surfaces when the issuing investment banks pay for the ratings, in that a ratings agency could give favorable ratings in return for repeat business. However, the incentive for ratings agencies to be overly generous with their ratings must be offset by the reputational effects of being too generous; that is, the ratings agencies must maintain credibility to generate repeat business.

**Rising Loss Severity Increases the Incentive to Modify Loans**

**Loss severity on subprime loans has reached 45 percent.** According to a study by Standard and Poor’s, loss severity on a subprime mortgage has reached 45%.<sup>29</sup> A loss severity of this magnitude makes it a prudent decision to recast the subprime mortgage if the savings from avoiding default outweighs the cost of reducing the interest rate on the loan. Unfortunately, there are a large number of investors in the subprime market, so loan modifications as a means to avoid foreclosure can vary dramatically across borrowers,

**Loan modifications as a course of action.** In order to minimize losses, the servicer on a loan (the party to whom the mortgage payment is sent and the party that monitors the performance of the loan) can recast or change the terms of the mortgage loan. For example, the servicer can extend the loan (e.g., 300 months remaining extended out to 360 months remaining in order to lower mortgage payments), lower the mortgage interest rate, or convert the loan to a different, lower risk product (e.g., adjustable-rate to fixedrate mortgage). The problem becomes more complex if the loan has been sold to an investor since the servicer is charged with operating in the best interest of the investor. So, the question is as follows: would the investor (or financial institution) be better off keeping the loan terms as is and suffering the default and subsequent loss severity or modifying the loan terms in order to avoid a default.

**Short sales as an alternative to loan modifications.** If loan modification is not possible, another approach potentially available to the borrower is the “short sale,” Since a typical foreclosure can result in a loss severity of 45%, a lender may be willing to settle for an amiable settlement by having the borrower sell the house and give the proceeds to the servicer. While the investor (lender) still suffers the loss of the house price, it avoids the other costs of foreclosure such as interest expense, property taxes, legal fees, and maintenance that would result from a prolonged foreclosure. Often, the borrower asks the servicer/lender not to enter the short sale as a default since this would destroy the borrower’s credit score.  Lenders generally only agree with such a course of action if the

> 29 <u>http://www2.standardandpoors.com/portal/site/sp/en/us/page.article/4,5,5,1,1204835910066.html</u>

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