How Principal And Interest Rate Modifications Affect U.S.

RMBS
Primary Credit Analyst: Cesar Romero, New York (1) 212-438-4666; cesar.romero@standardandpoors.com Analytical Manager, U.S. RMBS: Sharif Mahdavian, New York (1) 212-438-2412; sharif.mahdavian@standardandpoors.com

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Related Criteria And Research

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How Principal And Interest Rate Modifications Affect U.S. RMBS

As mortgage loan modifications, or loan mods, have increased in the wake of the housing bust, Standard & Poor's Ratings Services has watched closely to see which forms of modification have the best success rate when it comes to minimizing borrower defaults. We've particularly focused on two forms: reductions to mortgage interest rates and reductions to principal balances. We've found that even though rate reductions are the most common form of modification, principal reductions offer the most benefit to borrowers looking to avoid default (see, "Principal Forgiveness, Still The Best Way To Limit U.S. Mortgage Redefaults, Is Becoming More Prevalent," published April 26, 2013, for more information). But we've also found that these two forms pose different levels of risk to residential mortgage-backed security (RMBS) cash flows. The specific structural provisions and interest and principal payment mechanisms in RMBS transactions help determine how the modifications affect bondholders. According to the Office of the Comptroller of the Currency, servicers have completed more than 3.1 million loan mods from 2008 through March 2013. The U.S. Treasury Department reported that nearly 2 million of these loan mods have been processed through the federal government's Home Affordability Mortgage Program (HAMP). In May, the Obama Administration extended the life of HAMP and other related mortgage assistance programs through December 2015. Considering that the housing market is still recovering from the credit crisis, we believe the extension means loan mod growth will continue into the foreseeable future. Interest rate reductions clearly remain the most common mod tool among servicers, representing nearly 50% of all modifications completed to date (see chart 1*).

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How Principal And Interest Rate Modifications Affect U.S. RMBS

Chart 1

In contrast, principal reductions remain in the minority at roughly 10%. Principal forbearance makes up nearly a quarter of loan mods. With a typical forbearance, a borrower's monthly payments are lowered by amortizing them over a period that exceeds the loan's stated maturity. The remaining balance becomes due at the stated maturity as a balloon payment. This differs from principal reduction in that it doesn't reduce the total principal left outstanding. The remaining modifications include other less used types, such as rate term adjustments, which extend the maturity date of the mortgage, and balance capitalization, which reduces monthly interest charges by adding the unpaid amounts to the outstanding balance due. Among the top five servicers in the mortgage industry, the volume of principal reductions as a percentage of all modifications performed in a given month has more than tripled since 2011, demonstrating the highest growth rate in the past several years (see chart 2).

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How Principal And Interest Rate Modifications Affect U.S. RMBS

Chart 2

While most popular among servicers, interest rate reduction may bring the least benefit to a borrower because it ignores the loss in home equity while still obligating the borrower to pay back the full mortgage balance, and its recidivism rate still hovers above 50%. In contrast, a borrower stands to benefit the most from a principal reduction due to the substantial equity increase from reducing the mortgage balance to less than the home's market value. However, the borrower's redefault and eventual liquidation of the property can cause higher RMBS loss severity than if the property were foreclosed upon with no modification. Just as no two borrowers will necessarily perform equally under a loan mod, the same can be said for securitizations with modified collateral-regardless if interest rate reductions or principal reductions are involved. Reduced interest rates on RMBS collateral can have varying effects on RMBS based on the affected transaction's structural features. For example, on a deal with clearly defined interest coupons paid from all available funds, WAC deterioration can lead to collected principal being drawn to cover interest due, which could cause eventual write-downs on the subordinate classes and erode credit support on the senior classes. In comparison, on a deal that contains pass-through WAC coupons paid from available interest, a material WAC deficiency could short interest on both subordinate and seniors bonds, without necessarily impairing credit enhancement.

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How Principal And Interest Rate Modifications Affect U.S. RMBS

Moreover, because the WAC being paid to the investor is now less than what was expected at origination, the imputed promise of interest could be compromised, which we have discussed in recently published criteria (see, "General Criteria: Principles For Rating Debt Issues Based On Imputed Promises," published Oct. 24, 2013). As these criteria state, where a securitization instrument's interest obligation is directly linked to the WAC of the underlying assets in the pool, a severe WAC deterioration resulting from credit events (such as loan mods) would be a breach of the imputed promise. Subsequent sector-specific criteria for U.S. RMBS would determine how we define a "severe deterioration in the WAC." We expect these criteria to have a modest rating impact on RMBS. When it comes to principal reductions, investors can also have different outcomes based on the deal structure. A write-down in loan principal will cause an immediate reduction in credit enhancement, and bondholders would face greater exposure to collateral losses. But for deals with cumulative loss triggers, senior bondholders can receive extra principal diverted from subordinate classes once the triggers are tripped, thereby accelerating their recovery. As noted above, structural provisions and interest and principal payment mechanisms in RMBS transactions influence how loan modifications affect bondholders in RMBS transactions. Any type of modification brings with it nuances that may benefit the borrower while having a varied impact on investors. *Note: We applied a custom methodology to determine whether a nonagency loan had been modified and in what form because of the different reporting mechanisms used and information available among the multiple participants that service loans backing various RMBS transactions. When we didn't classify a particular loan as modified, yet supplemental reporting indicated that there was some form of debt reduction resulting in a collateral loss, we then categorized the modification as "other debt reduction."

Related Criteria And Research

Related Criteria
General Criteria: Principles For Rating Debt Issues Based On Imputed Promises, Oct. 24, 2013

Related Research
Ratings On 413 Classes From 91 U.S. RMBS Deals Placed On CreditWatch Negative, July 12, 2013 Ratings On 321 Classes From 89 U.S. RMBS Deals Placed On Creditwatch Negative, June 6, 2013 Principal Forgiveness, Still The Best Way To Limit U.S. Mortgage Redefaults, Is Becoming More Prevalent, April 26, 2013 The Best Way to Limit U.S. Mortgage Redefaults May Be Principal Forgiveness, June 15, 2012

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