Loan Modification Programs of Limited Benefit to RMBS

by: Research Recap

Loan modification programs may have a modest positive ratings impact on prime Residential Mortgage-backed Securities, but subprime, Alt-A and Option-ARM RMBS are unlikely to see any significant improvement, according to Standard & Poor’s. Furthermore, loan modifications could encourage more delinquencies, negating any potential benefits.

Standard & Poor’s Ratings Services recently conducted a study examining the potential impact of loan modifications on U.S. RMBS. The study examined four 2006-vintage transactions from each product sector that displayed average collateral characteristics and four that displayed adverse performance, subjecting them to a broad range of test scenarios.

Key findings from the study:

  • Some transactions may see benefits in the form of fewer write-downs and improved ratings from successful loan modifications. However, investors should consider the potential loss in yield from the reduction in the loan interest rate and/or principal amount as a consequence of loan modifications.
  • Although interest-rate reduction can potentially provide the greatest benefit as far as reducing borrowers’ monthly principal and interest (P&I) payments, we think that the most frequently used loan modification strategy will be some combination of interest-rate reduction and principal forgiveness.
  • We believe that the combination strategy will be most effective because borrowers might still walk away from a mortgage, even with a lower payment, if the value of the house is less than what they owe.
  • While interest-rate modifications may result in lower overall collateral losses, a reduction in interest rates may also reduce the amount of excess spread available in the transaction to protect against future losses, which may ultimately increase principal write-downs to the securities.
  • Generally speaking, the senior securities for all product sectors retained greater credit support (the lower classes saw fewer write-downs) and experienced some ratings benefit from our loan modification scenarios.
  • Most of the subordinate classes from the sample subprime, Alt-A, and pay option ARM classes benefited from fewer write-downs due to loan modifications, but did not experience any significant improvement from a ratings standpoint.

With the opportunity for loan modifications, borrowers may now have an economic incentive to become delinquent on their mortgages. We expect that the total loss severity experience will be higher for loans that are modified but then redefault. Hence, an increase in delinquencies resulting from this “moral hazard” issue could negate any potential benefits from “appropriate” loan modifications.