Step-dancing through legacy MBS
admin | September 7, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Servicers of legacy mortgage loans with modified interest rates have started to show meaningful differences in the pace at which rates step up. Since the higher rates generate more cash flow for legacy MBS and reduce interest rate risk, differences across servicers matter. The average age of the modified loans turns out to be a valuable rule of thumb. By that measure, Ocwen flashes a warning sign.
Sparse data on modifications
Identifying modified loans with potential for the interest rate to step up continues to be a challenge. Many servicers followed HAMP guidelines or close approximations, first lowering rates for troubled borrowers then extending term and finally allowing principal forbearance. But many servicers did not. Unknown modification terms and sparse data from servicers and trustees make the search difficult. Modified rates usually step up to some market level. But the rates may step up after different periods, in different increments and to different final rates. There is risk and opportunity.
Looking at the universe of rate modified re-performing loans, roughly one-third of them have experienced a rate increase as of the August remittance cycle. However that number varies across major servicers. SPS had only 17% of rate modifications that have stepped- approximately half the universe average–while Chase/EMC, Nationstar and Citi all have had more than 40% of their rate modifications step up.
Exhibit 1: Step ups vary significantly by servicer
This disparity begs the question whether a large population of modified loans sits in the wings with rates about to step up, generating more cash flow for investors and reducing the risk that the floating-rate securities come up against an available funds cap.
The average months since modification for loans that have not yet stepped up turns out to be an important clue. There is a fairly wide distribution in average months since modification across servicers ranging from three years to just over five years. A pool that has an average of more than five years post-modification may have a lower population of loans that could step up than a pool with less seasoning post-modification, assuming typical HAMP or HAMP-like modification terms. This first thing we notice when looking at the distribution of age since modification is that SLS has both the lowest percentage of loans that have stepped up (83%) but also the lowest average months since modification (36 months), suggesting that there may be significant upside to these loans stepping up but that upside may not be realized for two years or more.
Exhibit 2: Average months since modification vary by servicer
But averages are just that, averages. The distribution of rate modified RPLs that have not stepped up is even more telling. The legacy universe, Nationstar, who has seen nearly half their rate modified RPLs step up and Ocwen, who has a large percentage of RPLs that have yet to step offer good examples.
The universe has an average of 46 months since modification. Looking at the distribution of those loans, 72.2% are less than 60 months post modification while 27.8% are more than 60 months post-mod, suggesting roughly three quarters of RPLs that haven’t stepped have a good chance of seeing a rate increase. The Nationstar numbers look quite similar with 76.7% of loans that have not seen a rate change are less than 60 months since modification.
Ocwen looks materially different. Approximately 50% of modified Ocwen RPLs have seasoned more than 60 months. Admittedly, the biggest concentration of loans is between five and six years post-modification and could still step up in the near future. Additionally, there is a conspicuous absence of loans that haven’t stepped in the seven- and eight-year post mod buckets, suggesting that loans that seasoned post-modification have stepped. However, in all likelihood the longer these loans season past six years without seeing a rate change, the less likely a rate change might occur. If these loans are in actuality fixed rate modifications, there are meaningful implications for both current valuations and rate durations for bonds backed by Ocwen serviced, seasoned RPLs. Especially those at the bottom of the capital structure that are levered to excess spread as rates and liability yields rise while asset WACs are stuck at lower fixed rates.
Exhibit 3: Distribution of non-stepped RPLs by age and servicer