Extraordinary expenses pose structural challenges for RMBS
Current deals face looming credit risk, ratings volatility
Most of the post-crisis residential mortgage-backed securities deals are structured in a way that doesn't account for 'extraordinary expenses' upfront. This alone can build credit risk into the deals and cause ratings volatility.
An extraordinary expense is a specific cost, such as an indemnification amount or negotiation expense — paid or reimbursed directly from the trust fund. These expenses are senior to principal payments and interest in typical transactions, Kroll Bond Ratings explained.
However, unlike regular trust expenses, extraordinary expenses may fluctuate significantly and are difficult to anticipate, explained Kroll Bond Ratings senior director Michele Patterson and senior managing director Glenn Costello.
They added, "Certificateholders should be aware of this risk and understand how it could impact deal cash flow."
An interesting feature of an extraordinary expense is its unpredictability, which leads to unknown expense fluctuations within the deal -- posing greater risks for the securities.
One area of borrower specific behavior that could come back as an extraordinary expense would be unexpected legal challenges from a borrower directed against the securitization trust, explained Costello.
Two different mechanisms are used in RMBS transactions to account for the degree of extraordinary expenses to track potential credit loss and ratings volatility.
Extraordinary expenses can be viewed as either an amount, such as legal fees, which are paid by the trust fund for the benefit of all certificateholders – as is the case when a deal is structured to allow these expenses to come out of the net weighted average coupon.
The other argument is that these expenses are caused by a credit event — like when a loan becomes delinquent and is reviewed for breaching representations and warranties.
Based on this reasoning, extraordinary expenses should come out of available funds and the subordinate bonds should shoulder any shortfalls, Kroll says.
However, current RMBS deals structured with extraordinary expenses seem to reduce the Net WAC, which is used to determine the interest rate paid to certificateholders — causing senior certificates to receive a lower coupon than the normal fixed coupon.
However, since the interest rate on the senior certificates is capped, a Net WAC shortfall is not considered an interest shortfall because it would typically have no impact on the rating, Kroll analysts further explained.
Since payments are made on the certificates in order of seniority, any shortfall caused by extraordinary expenses in a structure would be borne first by the most subordinate certificateholders, which could lead to interest shortfalls.
In a more severe case, it could lead to writedowns on the bonds, depending on the amount of extraordinary expenses paid in that period.
"Any actual or projected interest shortfalls or writedowns could lead to rating volatility, particularly given the inherently uncertain timing and extent of potential extraordinary expenses," the Kroll Bond Ratings analysts concluded.