Industry Update: the Future of eClosing and RON

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S&P: Principal reductions perform better than rate decreases

RMBS investors face potential losses either way

Only 10% of loan modifications studied by CoreLogic (CLGX) in the past four years involved principal write-downs, while interest rate reductions remained the preferred tool for minimizing the risk of foreclosure across the United States.  

But analysts with Standard & Poor’s Ratings Services claim in a new study that principal reductions overall perform much better than loans receiving a mere interest rate reduction.

In a report titled, "How Principal and Interest Rate Modifications Affect U.S. RMBS," the ratings giant notes that the recidivism rate – or likelihood of a new default – hovers above 50% for rate reductions, while borrowers who obtain the benefit of a write-down and equity gains generally have a better chance of staying current on their mortgages afterward.

The only problem is what benefits the borrower is often a nuisance for investors in residential mortgage-backed securities.

If a borrower obtaining a write-down does fail to pay and re-defaults, S&P says the eventual liquidation of the home will lead to higher loss severity rates for RMBS investors.

In fact, the resulting losses will be worse than if the home had just been foreclosed on early on.

While rate reductions carry their own risk, principal reductions will automatically cause a reduction in credit enhancements, leaving bondholders to face greater exposures on collateral losses, S&P pointed out.

However, if the deal includes loss triggers, senior bondholders can pull extra principal from subordinate classes once the stated triggers are met.

Interest rate reductions come with their own downside, the report suggested.

For example, on a deal with interest coupons paid from all funds clearly defined, the weighted average coupon — or average gross interest rate of the underlying mortgage pool — can lead to more principal being pulled from a deal to cover interest that is due when an interest reduction disrupts the deal.

This could eventualy lead to write-downs on subordinate classes and declining credit support for senior classes, the report claims.

"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," the S&P researchers concluded.

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