Friday, January 23, 2009

Cram-Downs Will Drive MBS Downgrades, Analysts Say

By Paul Jackson at the Housing Wire:

Key industry analysts have been raising a red flag in the past few weeks regarding the possible impact of a plan that would allow bankruptcy judges to modify the terms of mortgages during debt restructuring, suggesting that allowing so-called cramdowns to take place will likely lead to further significant write-downs in an already battered secondary mortgage market — leaving banks with even larger-than-expected holes on their balance sheets.

Analysts at Bank of America (BAC: 6.24 +9.28%), while suggesting on Jan. 13 that such provisions would likely lead to a spike in bankruptcy filings, also said that aspects of the proposed bankrupcy law would serve to limit potential investor losses. In particular, the legislation as proposed establishes a floor on how much debt could be crammed down by a judge, while the fact that all assets must be disclosed to the court in filing for bankruptcy would prevent borrowers from going BK purely to obtain a lower payment.

Nonetheless, many analysts remain concerned. Bloomberg’s Jody Shenn noted in a Jan. 12 story that analysts at Keefe, Bruyette and Woods projected that the cram-down legislation would speed losses to most MBS investors, driving downgrades anew and placing banks under renewed capital pressure.

There are other issues to be considered here, of course, that are more nuanced. Among them is the role of private mortgage insurers, who generally will not cover losses tied to a borrower bankruptcy. Bank of America analysts called attention to this issue on Jan. 21 — and it’s a vital issue for any investor. Here’s why: most MBS deals using mortgage insurance as a form of credit enhancement have thinner “padding” for investor losses, meaning that cram-downs would eat through overcollateralization at a faster rate for MI-enhanced deals than for other MBS deals. (Can you spell d-o-w-n-g-r-a-d-e?)

And just think of the perverse incentives here, too: on a mortgage involving MI, the servicer and investor must get the MI provider to sign off on any loan modification — how likely will the MI provider be to do so, when they just push losses directly onto the investor via a borrower bankruptcy?

Bloomberg’s Shenn addressed the ongoing buzz among analysts again earlier this week, noting that a good number of private-party MBS deals — viturally every prime and Alt-A deal done — also have so-called “carve-out provisions” in them that allocate some bankruptcy losses among all investors, rather than the traditional bottom-up, first-loss approach traditionally seen in most structured deals.

There is upside here, however, as analysts at BofA, and Barclays Capital have all noted in recent weeks: the downside risk of bankruptcy as contemplated under the proposed change would be so severe for investors and servicers that both parties would likely have a strong (and perhaps perverse) incentive to modify loans, without having to worry about violating the terms of the pooling and servicing agreements that bind their efforts. Of course, the question is which investors and what kind of securities, as always.

But the bottom line to be gleaned from the above is this: there is always a law of unintended consequences when large-scale and complex changes are contemplated by regulatory and government agencies. Cram-downs are clearly no exception.

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