In light of the brouhaha over loan modifications
between Bear Stearns and some hedgies, I thought the following release
from Fitch earlier this week was very appropos to bring up now.
Increased usage of loan modifications as a loss mitigation tool may cause larger numbers of poorly performing loans to be reported as not delinquent, which could allow for early overcollateralization (OC) release, according to Fitch Ratings, which has amended its rating criteria for U.S. subprime RMBS/HEL ABS to better reflect this trend in rating opinions. The changes will be effective for transactions closing in August 2007.
The Fitch release suggests this is a market-wide trend, and not just something Bear Stearns is doing. And in general, heavy reliance on loan mods would be a Very Bad Thing for bond investors under the current rating system. More from Fitch on this:
While Fitch recognizes the value of loan modification programs, the extensive levels of modifications that some servicers are contemplating, and that others have already initiated, presents new challenges in analyzing the credit risk of securitizations. Varying practices with respect to capturing and reporting data on loan modifications make it difficult to track the quantity and characteristics of modified loans. For example, some servicers report delinquency status on an initial contractual basis, while others report performance relative to the modified contract terms. Moreover, the performance of mortgages post-modification may vary widely and the timing and amount of re-default and loss is uncertain.
Loan modifications and subsequent loan performance is also of concern when considering the effectiveness of trigger events designed to prevent OC step-down. These trigger events are based on performance tests which compare delinquency rates to available credit enhancement. In a trigger event, the securitization fails the performance test and enhancement to decline as it would if the test was passed. While there has been much discussion of the effectiveness of the standard trigger language in use today, extensive use of modifications, coupled with the reporting of modified loans as contractually current, presents a new situation. It is quite conceivable that securitizations with high levels of mortgage defaults will not fail delinquency trigger tests, thus allowing OC to step down. Fitch believes that recognition of this risk requires a change in rating criteria for subprime RMBS/HEL ABS.
Not surprisingly, Fitch said it is altering the way it looks at RMBS transactions, so that investors aren't getting screwed on a highly-rated deal -- and even warned that its new criteria will lead to some downgrades. But given the above, I can see why bond investors are getting the heebie-jeebies when they see captive servicers like Bear Stearns' EMC Mortgage unit tout their laser-like focus on increasing loan modifications