RMBS: Paulson sets out sub-prime plan


Louise Bowman
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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. Many of these borrowers face dramatic increases in loan payments, frequently of several percentage points. The conditions for fast tracking – which fixes borrowers’ existing interest rate for five years – are relatively onerous. In short they are met when an owner of a property (not a speculator) meets a FICO score test (ie. is sub-prime) and the servicer establishes that, upon reset, loan repayments rise by greater than 10%. Another key condition is that the borrower does not qualify for the FHASecure programme or other refinancing options.

CreditSights’ Christian Stracke argues that the benefit of loan modification to bondholders is highly sensitive to assumptions on foreclosure rates, the timing of those foreclosures, loss severity in default and the discount rate on future cashflows.

"Modelling expected cashflows in various modification scenarios, we find that it is by no means implausible that extensive modifications could leave bondholders worse off than they would otherwise have been had modifications not been offered," he says.

This viewpoint is shared by many securitization experts – and there is a strong possibility that lawsuits will follow. If widespread loan modification takes place, the prospect of bondholders taking legal action against servicers must be high – simply because of the complete uncertainty of how beneficial such action is on the net present value of deals’ cashflows.

Normally the primacy of capital market conventions is a given but the political wind is not blowing in support for sub-prime investors and/or lenders at present. In fact the Democrats are gunning to introduce loan forbearance measures in the House of Representatives that would severely undermine the contractual arrangements and obligations that support RMBS. The possibility that RMBS investors would find their economic position impaired by an all-encompassing loan modification scheme was a high possibility but one that has been diminished by the limitations of the Treasury initiative.

Deutsche Bank’s head of securitization research, Karen Weaver, argues that the plan appears to streamline servicers’ procedures for dealing with loans that would qualify for modification in any event. "While this plan will likely result in more modifications on the margin, and make them happen sooner, we do not believe the plan will have a significant impact on sub-prime MBS performance," she says.

In fact Deutsche forecasts that only 90,000 loans – just 5.5% of outstanding – will qualify for a five-year freeze.

This view differs somewhat from that of Bank of America’s analysts, who suggest that some 27% of sub-prime loans categorized in terms of outstanding balance or 24% categorized by loan count could be eligible for the fast track modification programme.

What appears to be clear is that any short-term panacea for the housing market would surely cut the prospects of a revival of the private-label RMBS sector as investor confidence in servicers’ contractual obligations would be seriously damaged. Anyway the scheme does not get to grips with those mortgages that are already delinquent or being foreclosed on, leading some participants to argue that the plan will have little impact.

"I don’t think it’s very material at all," says Jeffrey Kirsch, chief executive of American Residential Equities. "Most of these loans that we see don’t fit within the [scheme’s] parameters because they are not performing. The figures we are seeing from servicers is that a big percentage of the 2/28 and 3/27 are in default before they get to reset, some 18%." American Residential Equities is a specialist firm dealing with non-performing mortgage assets. Kirsch thinks that the loan modification plan will still prove too bureaucratic to be effective.

This is effectively confirmed by Deutsche’s Weaver, who says that virtually any approach that does not take a loan-by-loan analysis of loss mitigation will expose servicers to liability. Servicers can change loan terms if they can prove that will reduce losses but that may prove difficult if a blanket method of modification is embraced.