I'm going to take a short break from the usual fare here at HW to focus more commentary on details surrounding an expected Treasury-led rate freeze for certain subprime borrowers. Bloomberg reported Wednesday that the Treasury-brokered plan will freeze interest rates on subprime mortgages for five years, plus this gem:
The freeze may apply to mortgages issued between January 2005 and July 2007 that are scheduled to reset between January 2008 and July 2010, said a person familiar with the plan. Borrowers whose credit scores are below 660 out of a possible 850 and haven't risen by 10 percent since the loan was sold will be given priority.
So that takes care of at least one potential issue -- the definition of "subprime" as well as potentially setting the stage for mass modifications that won't require loan-by-loan assessment of "ability to pay." But performing loan modifications is one thing, while doing the legal work required to modify the note is often another; and doing a mass of loan modifications all at once is another thing entirely. Which leads us to some interesting coverage in American Banker: Wall Street wants to establish uniform investor reporting standards, focused around loan modifications. At issue here is something known as trigger events and trigger dates, so we're going to get into the weeds a bit. From the American Securitization Forum:
Structures that utilize excess spread and over-collateralization as a form of credit enhancement are common in securitization of sub-prime residential mortgages (and more specifically home equity loans). These transactions typically allow for principal reduction of mezzanine and subordinate bonds while the senior-most bond is outstanding after a specified step down date (often after 3 years). Most transactions of this type employ Trigger Events tied to collateral delinquency and loss performance that will alter the base cashflow allocation method and maintain over-collateralization if there is deterioration in the performance of the collateral in order to protect higher rated bonds. There are typically two types of Trigger Events: a Cumulative Loss Trigger Event and a Delinquency Trigger Event. A Cumulative Loss Trigger Event occurs if cumulative losses on a collateral pool exceed a specified level of losses. A Delinquency Trigger Event occurs when a measure of delinquency as a percentage of current balance exceeds a specified number (or series of numbers or a formula based calculation, often based on a specified credit enhancement measure). When a Trigger Event occurs, over-collateralization is not allowed to step down and the base waterfall is altered whereby distributions are allocated in a different manner generally intended to protect the senior-most classes. The occurrence of a Trigger Event impacts senior, mezzanine, subordinate, residual, and net-interest margin (NIM) holders in different ways. Senior class bondholders benefit from the maintenance of credit enhancement. Mezzanine and subordinate bondholders also benefit from the maintenance of credit enhancement but are subject to average life extension because they continue to receive no principal payments for the duration of the failed trigger. Generally speaking, residual and NIM holders are negatively impacted since cash that would otherwise be directed to them is redirected to the senior-most bondholders.
In plain English, the above says that if performance is good enough for long enough, the reserves set aside to cover losses are no longer as neccessary, so investors in lower classes receive extra money. If performance is bad enough, however, this distribution doesn't take place and the overcollateralization is maintained in order to protect senior note holders. The problem with any loan modification is that a lack of clear reporting standards often means servicers can vary widely in reporting loan status, and servicers themselves may not be consistent from file to file -- and this means that it's very tough to know when a loan is considered current or not. By having modified mortgages to show up as current for investor reporting purposes, when they are anything but, ABS deals risk passing their trigger dates and beginning what most certainly would be considered an inappropriate release of principal to both mezzanine and equity investors. Not a big deal when only 1 percent of the subprime population is seeing modification activity; but certainly a HUGE deal when talking about modifying what may be a sizeable number of loans. American Banker offers some insight into the solution now being worked on:
The American Securitization Forum is coordinating efforts to establish uniform reporting requirements and other standards. [Diane Pendley from Fitch Ratings] said she expects the forum to put out standards soon, perhaps as early as this week. "It's our understanding that it will include a statement in there as to where the modified loans would continue to show delinquent, for I believe it could be up to a year" for the purposes of releasing capital meant to protect senior tranches.
This is important news, because of what it would mean for the security structures in question -- many would hit a delinquency trigger event that would prevent a step down in overcollateralization, at least ensuring some modicum of stability at the AAA level. That being said, if what I'm seeing is correct, there are important issues to consider here. There is, first of all, clearly the "so what?" factor. After all of this analysis, we're still talking about a pretty small population of borrowers, in my opinion. Certainly not enough to stem the tide; after all, this is no longer about subprime resets. The problems we're seeing are driven moreso by lost equity, high leverage, and borrowers finding themselves upside down even if their payments aren't resetting. Something tells me that if all this effort entailed helping just some small segment of borrowers, the ASF would not be working in lock-step with Wall Street to develop and implement standard criteria for reporting loan modification activity. Does that make this effort a blueprint for future efforts, then? If so, borrowers had better pray they've got a conforming loan -- because there won't be much in the way of liquidity elsewhere if investors are sent such a message. (Was this what motivated Countrywide CEO Angelo Mozilo to lobby in today's WSJ for an increase in the conforming lending limit? ) The second issue in play here is liability -- another American Banker story reports:
Servicers are worried that investors may sue if mortgages are modified. Sources said they do not expect the Bush administration to offer any kind of safe harbor from litigation. Instead, the plan will emphasize that the administration believes the modifications are legal under existing pooling and servicing agreements... "We want to be assured … that they take care of the liability and the tax ramifications of making these broad modifications," said Erick Gustafson, vice president of government affairs at the Mortgage Bankers Association.