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RMBS: Paulson sets out sub-prime plan

But political palliative unlikely to have big impact, say analysts.

The mood in financial markets lightened temporarily on news that US Treasury secretary Hank Paulson, together with US loan providers and servicers, plans to limit the negative impact of impending interest rate resets on US borrowers. It is estimated that 1.8 million sub-prime loans will reset by the end of 2009. Some 1.2 million of the borrowers are unlikely to be able to afford the higher rate that their loan will reset to. But while the possibility that the housing market might be offered some relief boosted certain sectors, the concern in structured finance circles was that residential mortgage-backed securitizations would be negatively affected by the reduction in loan payments.

The elimination of higher loan reset payments via modifications will reduce excess spread (the difference between loan interest payment and the interest paid out on the securities) in RMBS transactions and thus have an impact on the credit enhancement in subordinated and mezzanine tranches. That said, it is possible that widespread loan modification could reduce credit losses – by reducing foreclosure and loss severity in default rates; but whether this will offset the impact of reduced credit enhancement is moot.

First-lien, sub-prime adjustable rate mortgages that were originated in the two-year period starting January 2005, securitized and whose coupon will reset in the two-year period beginning January 2008, are eligible for what is called the fast track loan modification process.

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