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Trustee holdback risk returns to the legacy market

| September 27, 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.

The trustee on 22 WFMBS securitizations surprised investors this month and generated an immediate principal loss by withholding $56.5 million in cash to cover potential future expenses. HSBC as trustee had the right to withhold the cash. Legacy investors have seen trustee holdbacks before with the largest previous action coming in the summer of 2017. Since then trustee holdbacks have been few and far between as the scope of active litigation that might drive up trustee expenses has diminished. This one is clearly linked to a decision by the issuer to call the deals, which could reprice currently callable WFMBS trusts.

The affected trusts

The holdback came from $1.35 billion of called principal from 2006 and 2007 Wells Fargo fixed-rate and hybrid ARM deals, generating an additional 4.2% in losses across the set. The holdbacks were not uniform, with some trusts experiencing a $500,000 litigation reserve while others took a $4 million hit for potential future expenses. Historically these reserves have been estimated based on the trustees’ potential need to perform additional due diligence on all loans that were securitized in the trust, not just those that resulted in a loss to the deal. Trustees have had to reserve against the total original loan count as the courts have not allowed plaintiffs to demonstrate damages based upon a sampling of loans.

In the case of this month’s called deals, the per loan holdback, calculated as the total deal level holdback divided by original loan count, varied significantly across the deals. Loan-level holdbacks ranged from as little as $300 per loan to more than $4,200 per loan with a weighted average of just over $1,100. In the case of the Wells trustee holdback in the summer of 2017, withholding came to $3,000 per loan.

The lack of consistency across the HSBC holdbacks caused as much as 37% of additional losses to the WFMBS 2006-17 trust, which took a $500,000 write down on more than $1.3 million in outstanding balance prior to the deal being called. Other called trusts fared better with WFMBS 2007-3 taking an additional 70 bp of holdback related losses. It is not immediately obvious why some trusts saw smaller holdbacks versus larger ones or why the holdback was simply either one amount or the other without some variance based on original loan count. (Exhibit 1) The holdbacks come as somewhat of a surprise as some of the larger trustee claims against HSBC have already been dismissed or settled with the NCUA’s pending $5.8 billion action against the trustee being the only sizable active claim.

Exhibit 1: The impact of holdbacks across affected WFMBS trusts

Source: Bloomberg, Intex, Amherst Pierpont Securities

Looking through the documents on some of the affected trusts shows that the depositor retained the sole rights and discretion to collapse the trusts. Per the WFMBS 2007-8 prospectus:

the Depositor may, subject to certain conditions, purchase all outstanding Mortgage Loans in the mortgage pool and thereby effect early retirement of the Certificates … The exercise of this option will be in the Depositor’s sole discretion.

 The named depositor on the trust is Wells Fargo Asset Securities Corporation, so it appears that Wells Fargo exercised the call. As with the idiosyncratic nature of the holdbacks, the exercise of the call raises questions. Seasoned WFMBS trusts have often been in the money historically without the call being exercised, potentially driven by a lack of appetite to put legacy loans back on the balance sheet. Given this, the large scale collapse of the twenty two trusts likely came as a significant surprise to investors.

Impact on the bonds

The impact to investors varied significantly across the capital structure. Comparing expected losses in the ALIAS Pay Model Fair Value Yield-to-Call scenario to actual realized write-downs shows that approximately $66 million of bonds across 20 CUSIPs incurred an additional loss of 10% or more as a result of the holdbacks. An additional 65 bonds totaling more than $400 million in unpaid balance prior to the call experienced an incremental loss of 5% to 10% with $835 million taking an additional loss of less than 5%. (Exhibit 2)

Exhibit 2: Sizing up the holdback impact

Source: Amherst Insight Labs, Amherst Pierpont Securities

Investors have likely discounted holdback and call risk across Wells Fargo trusts, with good reason, as they have been sparse over the past two years. This month’s holdbacks have reintroduced that risk and along with it the concept of tranche warfare with subordinate and mezzanine classes being disproportionately affected and effectively subsidizing the cost of litigation while senior bond holders, who are pursuing the actions, stand to gain. At a minimum, it will in all likelihood reprice the entire capital structure on currently callable Wells Fargo trusts.

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