In the wake of the subprime "rate freeze" program announced yesterday by President Bush and discussed here ad nauseum, Fitch Ratings released some analysis of how the program is likely to affect investors in various subprime RMBS deals and associated derivatives. The bottom line? It's tough to say at this point. Fitch cited "a complex interaction of variables that can be difficult to analyze" in noting that senior classes are likely to far better, while subordinated subprime RMBS classes may be negatively impacted. The primary complexity here is how the modification program affects excess interest. From the press statement:
Excess interest is an important source of credit enhancement which compensates for loss of cash flow due to mortgage losses. Uncertainty around the benefit of loan modifications is centered on the relative reduction in loss, versus reduction in excess interest that could be incurred. On balance, Fitch believes that stabilization of loss rates can outweigh excess interest reduction when analyzing the impact on senior RMBS. Greater refinancing opportunity can also help senior bond performance, as it will cause those bonds to prepay and reduce the risk of principal loss. For subordinated RMBS, excess interest is a much greater component of credit enhancement, and in some instances only substantially lower loss rates would offset a reduction in excess interest.
Fitch also noted the potential problems associated with slowing repayments, sort of the "default later, instead of defaulting now" issue. HW readers who read an earlier post ("More on the Bailout: Tripping on the Trigger") will remember a discussion of how excess interest is released to subordinate bondholders as a deal matures over time. Fitch notes that because the rate freeze essentially keeps borrowers in an "unseasoned" state, traditional loss assumptions around deal seasoning may not hold up over time -- doubly so if you consider the potentially substantial decreases in housing prices that could occur between now and then. For more information, visit http://www.fitchratings.com.