It looks like the rubber is finally beginning to meet the road when it comes to massive loan modification activity and its effect on RMBS and derivative investors. Case in point: Ocwen Financial Corp. (OCN), a large subprime servicer, has left MBS investors both angry and nervous after several deals serviced by the company experienced significant interest shortfalls on senior ABS securities in the month of May. An interest shortfall occurs when bondholders do not receive the full interest they are due for reasons that include delinquencies, defaults and prepayments. In this case, driving the shortfalls were both a dramatic increase in loan modification activity at the West Palm Beach, Florida-based servicer, as well as the judgment of the trustee involved in accounting for the surge in modifications. By “dramatic increase,” we’re talking about monthly loan modification activity that rose more than six fold between the end of last year and April of this year — in fact, Ocwen modified nearly 900 loans in April, after modifiying less than 200 in January and well below 25 loans in December 2007, according to a review of available data by Housing Wire. The company has modified more loans in the first four months of this year than it modified during all of 2007; in fact, Ocwen modified more loans in April alone than it modified during all of last year. Analysts at Credit Suisse (CS) this week noted the interest shortfall in a research report, and said that Ocwen had significantly stepped up both interest reductions as well as principal reductions in modifying troubled loans. The company also reduced its so-called required trial mod period to three months from a prior six month trial, as part of a strategy to reduce its advance cost, Credit Suisse said. “Ocwen had materially increased its modification program activity and many modifications involved principal reductions in addition to interest rate reduction and/or forgiveness of other payment and cost amounts,” said Diane Pendley, a managing director at Fitch Ratings. Trustees “blindfolded” At least part of the shock investors felt this month on Ocwen-serviced deals was because the trustee, Wells Fargo & Co. (WFC), was forced to determine how to account for the flood of modifications. Fitch Ratings, in a press statement Friday, noted that Wells didn’t have sufficient information to determine the proper allocation of funds and/or losses, due to limitations in the reporting format used to obtain data from servicers. In plain English, HW’s sources said this means that Wells didn’t really know what was principal reduction, what was interest forgiveness, and what funds (or lack thereof) needed to be allocated where. So it had to guess, and allocated losses to interest rather than principal — the result is that senior bondholders took a hit rather than junior holders. That sort of has a way of ticking off senior bondholders rather inordinately. Trustee confusion over loan modification activity underscores the pains the securitization market is undergoing as it develops policies and procedures for handling a flood of bad loans; it also underscores how a lack of data standardization across servicers in reporting loan data can lead to problems upstream. The OCC’s John Dugan underscored the severity of this problem in remarks earlier this month, noting that wide variations in reporting standards across servicers made it difficult for the agency to get a read on actual loss mitigation efforts. April was the first month in which a sizable number of mods were reported through to the trustee for the May distribution, Fitch’s Pendley noted. Fitch also noted that Wells “had recently developed an enhanced reporting format, based on the trustee’s participation on an industry task force on the issue.” For its part, Wells Fargo said it has since circulated the new format among servicers; the new format is designed to give it enough information to determine the proper allocation of funds and/or losses. But the fact that the bank wasn’t initially receiving enough information to properly allocate funds to investors underscores just how fragile certain aspects of the massive secondary mortgage market really can be, a source told HW. “There are plenty of risks we try to price in,” said one trader involved in some of the Ocwen deals, who asked not to be identified. “The trustee operating blindfolded isn’t something that I’ve ever had to consider. Nor should I.” Despite investor unease, it’s not clear if the interest shortfall will ultimately help or hurt investors. “It is too soon to determine the impact of the recent Ocwen mod increases on investors,” wrote Credit Suisse analysts, in a report dated June 17. “Should the newly modified loans successfully re-perform, ABS investors would be better off.” Substantial amounts of re-performing loans would eventually make up the shortfall, Fitch Ratings said — the only question is whether Ocwen’s recent modifications will ultimately be able to stick, and the servicer has not disclosed its re-underwriting criteria to investors. “The likelihood and expected timing of recoveries will determine whether a bond’s current rating will be affected by the occurrence of an interest shortfall,” said Fitch managing director Vincent Barberio.