BofA Principal Forgiveness Plan Bad for Junior Bondholders: BarCap
The earned principal forgiveness program announced today by Bank of America (BAC) bears adverse implications for the payout of certain non-agency mortgage-backed securities (MBS), according to commentary by Barclays Capital. In particular, the program presents a "clear negative" for junior mezzanine and subordinate debt holders, as well as moral hazard risk as borrowers intentionally default to receive principal forgiveness. The BofA plan will focus on borrowers eligible for -- but not currently in -- HAMP trials, BarCap researchers said in commentary provided to HousingWire Wednesday. BofA will target certain subprime and pay-option adjustable rate mortgages (ARMs) with mark-to-market loan-to-value (MTM LTV) ratios greater than 120%. Under the program, BofA will first forbear principal down to 100% MTM LTV to reduce monthly payments to the 31% debt-to-income (DTI) threshold. This could be combined with rate reductions and term extensions if the monthly payment remains above 31% DTI after forbearing to the 100% MTM LTV threshold, according to BarCap. The second part of BofA's plan calls for the forborne amount to be forgiven as the borrower remains current over five years -- thus earning the forgiveness of the forborne amount. BofA will forgive 20% of the forborne amount for each of the first three years the borrower remains current. In the fourth and fifth years, the forgiven amount will be adjusted to account for any home price appreciation so that the LTV does not fall below 100%, BarCap said. Researchers found that of the securitized subprime and option ARM loans serviced by Countrywide/BofA, 40-45% of delinquent borrowers and 20-25% of current borrowers have MTM LTV ratios above 120%. If these borrowers saw around 30% of forbearance and the loss is recognized immediately, BarCap calculated the program could result in a write-down of the bottom 9-10% of the capital structure. BarCap said although it's unclear whether the forborne amount will be recognized as a loss, such will likely be the case, as the only argument against not recognizing the loss is the probability of recovering some of the forborne principal when the loan is paid in full. It would take significant house price growth for BofA to recover principal in these cases. The program could lead to more moral hazard, researchers wrote, especially if it is extended to other sectors like jumbo hybrids, as more borrowers intentionally become delinquent to receive principal forgiveness. It also represents "a clear negative" for junior mezzanine and subordinates, but could be "a mild positive" for super-senior non-recourse (SSNR) pieces if moral hazard is controlled. "SSNRs would benefit assuming that forbearance is treated as a loss similar to HAMP, thus writing down subs and mezz bonds and stopping cash flow from leaking to the subordinate/mezzanine bond," BarCap researchers wrote. "However, if moral hazard flares up, this will likely counter the benefit and reduce the overall principal recoveries on the deal, hurting the SSNR." BarCap noted it could lead to lower last cash flow prices -- as most Countrywide subprime deals have sequential triple-As — which could benefit the front cash flows if re-defaults are improved. On pro rata deals, it should lead to faster crossover on low credit enhancement deals and could also lead to slower crossover on deals with high credit enhancement It also could be positive for second-lien holders, especially monolines that have wrapped this risk. The first-lien modifications are not HAMP mods, after all, and although BofA signed on to the Second Lien Modification Program (2MP), BarCap noted the servicer might not be required to modify the second lien behind these loans. "Even if BofA offers the same level of debt forgiveness as on the first lien on the second, the monolines will gladly trade off an upfront loss of 30% plus annual loss on interest of 8-9% to avoid an upfront 100 dollar loss on each second- lien loan," researchers said. Write to Diana Golobay. Disclosure: The author holds no relevant investment positions.