In unreported forbearance, there is unexpected redemption
admin | July 26, 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.
A growing number of private MBS loans with no record of principal forbearance have shown unexpected recoveries in excess of the reported loan balance when the loan leaves the deal. These surprises generally come from inaccurate data on loan modifications. As the market becomes more attuned to this, trustees and market data providers are reconciling these inaccuracies and updating forbearance amounts, delivering immediate upside to bondholders. Depending on capital structure, these recoveries can drive bond prices up substantially. And since $75 billion of legacy MBS may have some unreported forbearance attached, the opportunity is significant.
A scalable opportunity
One example of this type of potential price appreciation is LBMLT 2006-WL1 M2. This deal saw total reported forbearance on the trust increase by more than $22 million after the trustee reclassified earlier losses as recoverable principal. Discounting the bond’s cash flows at a constant 4% yield and assuming a 50% recovery on existing and newly recognized forbearance, the bond price rises from $55 to more than $80.
Putting an exact number on the opportunity set across legacy MBS is challenging. Unreported forbearance recoveries show up through two channels after a loan is modified. In some cases, the forbearance has been reported as a prior loss, which is reversed in part or whole when the loan leaves the trust through prepayment or liquidation. In other cases, loans show recoveries on balance reductions never recorded as a loss. Given these scenarios we estimate $75 billion of outstanding principal, or roughly 25% of the outstanding legacy universe, may have some unreported forbearance attached to it. A projected 85% survivorship rate on those loans leaves nearly $25 billion in outstanding losses that have potential associated recoveries (Exhibit 1).
Exhibit 1: Sizing up the potential opportunity in unreported forbearance
Disproportionately large amounts of recoveries have come from certain platforms. The recovery of unreported forbearance is generally associated with trusts where Deutsche Bank or Bank of NY Mellon acts as trustee. Additionally, certain shelves like the Washington Mutual’s WAMU and WMALT shelves as well as Indymac’s INDX and IMJA shelves show disproportionately large absolute and percentage recoveries on outstanding losses (Exhibit 2).
Exhibit 2: Absolute and percentage recoveries by legacy MBS shelf
An example: ARSI 2006-M3
One of many specific examples of this phenomenon is ARSI 2006-M3. Over the life of the deal, $78.5 million of loans have left the pool with no reported forbearance. Those loans carried roughly $8 million in outstanding losses and balance reductions prior to termination. They experienced a 12.0% recovery on past losses and a 20.6% recovery on previous balance reductions. The deal has an additional $16.1 million in outstanding losses and $28.3 million in balance reductions. Upon an analysis of balance modifications using a combination of remittance reports and data available through Loan Performance, the entirety of the losses and reductions look like forbearance. Applying a 60% recovery rate to the $44.4 million in potential unreported forbearance gets an additional $26.6 million in principal.
Exhibit 3: Outstanding losses converted to reported forbearance – ARSI 2006-M3
The legacy market remains rife with idiosyncrasies. Not all trustees record balance modifications or subsequent recoveries the same. For example, Deutsche Bank as trustee does not record any balance modifications on loans prior to 2014. Washington Mutual remittance reports do not report forbearance recoveries, and additional forensic work is required to distill reversals of prior losses and balance reductions.
Forbearance gets turned on
The heavy lifting associating with mining the market for hidden principal has proven to be worth it. Over the past 12 months, according to Amherst Pierpont analysis, data providers have added back nearly $3 billion of previously unrecognized recoverable principal. This number represents almost the entirety of outstanding losses on loans that previously had no forbearance attached to them and a potential reversal on 50% of all outstanding losses in the related trusts. Six shelves, including JPMAC and ARSI have made up half of the recently recognized principal balances (Exhibit 4).
Exhibit 4: Total updated forbearance by top 10 shelves
Unreported forbearance by all appearances is a growing albeit localized phenomenon in the legacy market. Investors’ ability to value potential recoveries and bonds most levered to them is an attractive source of potential return in mortgage credit.