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Risk and reward in the Countrywide Article 77 petition
admin | February 8, 2019
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. This material does not constitute research.
The market now generally sees the recent effort by Silian Ventures, LLC, to litigate a change in pay rules for 278 legacy Countrywide trusts as a low probability, high return play. But the litigation does pose risk to Silian itself, or at least to investors in the targeted interest-only classes. While the court may rule in favor of Silian or uphold the pay rules implemented by the administrator, BNY Mellon, another possible outcome could effectively render most of the targeted interest-only classes worthless.
The downside risk from the litigation for the plaintiff or affected investors lies in the possibility that the court may instruct the trustee to calculate the excess paid to the IO at the pool rather than loan level. As it stands, BNY Mellon effectively calculates the difference between net WAC and the ratio strip rate on all loans designated as ‘non-discount’ and pays that difference to the WAC IO, which means that all loans whose rate is in excess off the ratio strip rate contribute interest on a monthly basis to the WAC IO. However, this may not be the case if the Article 77 petition determines that the calculation should be done at the pool rather than loan level. For example, under the current methodology the calculation would be performed as follows:
Loan A: $100,000 UPB, 7.0% Net WAC
Loan B: $100,000 UPB, 3.0% Net WAC
Ratio Strip Rate: 5.5%
Loan A Contribution: 7.0% -5.5% * 100,000/360 * 30 =$125
Loan B Contribution: 3.0%-5.5% * 100,000/360 * 30= $0
Total contribution = $125
If the methodology were to change to the pool level the calculation would be:
Pool Contribution: (7.0% * 100,000 + 3.0% * 100,000)/200,000 = 5.0%, 5.0%-5.5% * 200,000/360 *30 = $0
Total Contribution = $0
If this were to be applied retroactively the coupon on the IOs in contested trusts would have been much lower. The overwhelming majority of the IO classes would not have made a coupon payment over the past four years. (Exhibit 1)
Exhibit 1: IO coupons can go to zero if coupons are calculated at the pool level
Source: Amherst Pierpont Securities
Looking at the potential asymmetry of calculating the IO coupon historically using the original note rate versus downside associated with using a pool level weighted average suggests that the historical upside is $180 million while the downside can be as much as $500 million. However, that $500 million interest deficiency will not be able to be recouped by investors in principal and interest bonds as most of the IO classes will have no coupon going forward. Redirecting future cash flow to principal and interest bonds would only result in approximately $100 million in incremental interest over the life of the trusts to principal and interest bond holders.
In terms of timing, the Article 77 petition was adjourned form January 31 to March 21 in New York State Supreme Court (Docket # 150738/2019). The current method of calculating the IO coupon looks unlikely to change until the Article 77 proceeding is resolved. If recent precedent holds, that would be between 12 and 18 months. According to a recent Law 360 article, representatives from BNY Mellon stated:
“In certain other trusts that are materially the same as the covered trusts and issued under the same registration shelves, the master servicer, rather than the trustee, is required to calculate the excess interest amounts,” the bank said. “In calculating the excess interest amounts for these so-called ‘uncertificated’ IO trusts, the master servicer has employed the same dynamic method as the trustee.”
The dynamic method simply refers to using the updated current modified rate on all ‘non-discount’ mortgage loans as opposed to a ‘static’ methodology that would use the original net WAC of those loans. Any change to the calculation method before a court instruction seems extremely remote.
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