Here’s something to ponder ahead of the US bank earning season.
Mortgage modifications — that is, changes to the terms of home loans — have been running rampant just as banks’ non-performing loans and net-charge-offs appear to be peaking. Coincidence?
Banks like JP Morgan, Citigroup and Wells Fargo are very large mortgage servicers and underwriters, which means they’re at the forefront of these modification efforts, including the US Treasury’s Hamp programme. Many of the loans they underwrite have been sold on to securitisations, or to the two Government-Sponsored Enterprises, Fannie Mae and Freddie Mac.
Mortgage modifications aren’t really a problem as long as they’re transparent; they clearly show up in the servicers’ and investors’ books. The problem, however, is that that’s not always the case.
From mortgage analyst Laurie Goodman, and team, at Amherst Securities:
[Non-Hamp] Modification payment records are often incomplete. It is not unusual for the servicer or trustee to report the new interest rate, but not specify how long the new rate will last. When this is done, Intex [the biggest provider of securitisation modeling software in the US] assumes it is only good until the next reset unless the user specifies otherwise. In reality, many ARMs are converted to fixed rates, with the reduced rate good for 5 years or longer.
There are many situations in which a modification is suspected—the rate changes, there is a capitalization event, principal balance changes etc, but no modification is reported. In this case, Intex labels the loan a “suspected modification” but does not use this information. Users can go in manually loan by loan and change the assumptions.
Besides the transparency problem, not reporting that a loan was modified has obvious implications for reported cash flows from the bond. According to Amherst:
Consider a simple, one loan example. Assume the loan has been modified to a 5% fixed rate. Meanwhile Intex is assuming that the ARM is rolling to LIBOR +600; forward LIBOR is 4.3% 3 years out. Thus, the cash flows are being calculated off a note rate of 10.3%, versus an actual coupon rate of 5%. In a deal in which credit enhancement is provided, in part, by excess spread and overcollateralization, the model would assume that after paying the coupon, the remainder of the cash flows are available to absorb losses. Hence, without consideration of the modification, this loan would be making a large contribution to the absorption of losses; with the modification (using forward rates for the analysis), the contribution would be very low.
Placing non-Hamp mortgage modifications to one side, there still seems to be a degree of uncertainty as to how to treat those forborne (modified) cash flows. The US Treasury says that for Hamp modifications, at least, altered loans within securitisations should be treated as realised losses.
That is, the amount of principal forbearance should be treated as a loss.
But there still appears to be some interpretation taking place.
In fact, at least one large servicer is still not treating forbearance as a realized loss. This has implications for cash flow allocation within the deal. If the cash flows are treated as a realized loss, the junior tranches will be written down more quickly.