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Senior, Subordinate Bondholders Split on HAMP Debt Forgiveness

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In March, the US Treasury Department launched an initiative to encourage greater use of principal write-downs under the Home Affordable Modification Program (HAMP). Investors in mortgage securities are beginning to anticipate the knock-on effect these write-downs will have on payouts. The HAMP write-downs apply only to borrowers with 115% or higher loan-to-value (LTV) ratios. Servicers will initially forbear some or all of the balance exceeding 100% of the home’s value, down to a 31% debt-to-income ratio. Then, the servicer will forgive the forborne amount in three equal installments over three years, contingent on the borrower’s ability to remain current on payments. Mortgage-backed securities (MBS) investor reactions to the debt forgiveness initiative have been mixed. For example, senior and subordinate bondholders often have split views on this issue, according to independent credit-rating agency DBRS. "In a traditional debt forgiveness scenario, the principal forgiven will be treated as security losses and be absorbed first by subordinate holders," DBRS said in e-mailed commentary Monday. "Many investors who in recent years bought subordinate bonds based on their 'interest-only' values will see these bonds deplete faster than initially anticipated. Senior investors, while losing some immediate credit enhancement, may benefit from such modifications as overall cumulative losses should hopefully lessen in the long run." Even within the senior bondholders’ class, DBRS noted that super senior and senior mezzanine investors may also disagree on debt forgiveness. Although both are senior bonds, certain senior mezzanine tranches may benefit to a greater degree if the subordinate write-downs cause the “cross over” from sequential to pro-rata pay among all senior bonds to occur sooner, thus allowing the senior mezzanine bonds to start receiving principals sooner than expected. "If done properly, DBRS believes that transactions should, in the long run, benefit from principal forgiveness," the rating agency said. "Although securities average lives may be extended, some borrowers could prepay and cumulative losses could be reduced if the housing market recovers in the next few years." Write to Diana Golobay.

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