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Screening for upgrade candidates in seasoned RPLs

| January 31, 2020

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.

Mezzanine tranches of seasoned re-performing loan securitizations continue to offer an unusual combination of convexity and potential returns from upgrades. The loans show relatively steady prepayments and the structures deleverage and build credit support, often driving ratings upgrades and spread tightening on bonds with significant spread duration. But some mezzanine RPL classes are better convexity and upgrade candidates than others.

Tracking historical performance

Both Cerberus and CarVal historically have dominated issuance of seasoned RPLs through their Towd Point (TPMT) and Mill City (MCMLT) programs, respectively. Mezzanine tranches issued in their early transactions have seen material upgrades. Both programs use a sequential-pay structure, directing principal to the most senior bond and paying it off until going on to the next.  This approach means that bonds below the currently paid class build credit enhancement absent any material losses at the bottom of the structure. This structure affords investors optionality to rolling up the credit curve as the deal deleverages and benefits from price return associated with spread tightening on mezzanine bonds, which have significant spread duration.

In some cases, rating agencies have upgraded bonds from ‘BBB’ to ‘AAA’ in light of prepayments and deleveraging along with low levels of delinquencies and defaults. Looking at ratings transitions across the two programs shows earlier vintage bonds originally rated ‘A’ or ‘BBB’ have all seen rating upgrades although with some notable differences in the number of upgrades.

All bonds originally rated ‘A’ or ‘A-‘ issued in 2015 and 2016 have since been upgraded to ‘AA’ or ‘AAA’ across the two programs (Exhibit 1). All ‘BBB’ and ‘BBB-‘ rated bonds issued in 2015 and 2016 issued by Mill City have also been upgraded to ‘AAA.’ The Towd Point shelf has seen less pronounced upgrades of their early vintage ‘BBB’s. Of their 2015 ‘BBB’ classes, 59% have been upgraded to ‘AAA’ while 41% are currently rated ‘AA.’ While 25% of their 2016 ‘BBB’ rated bonds are currently rated ‘AAA’ with an additional 75% rated ‘AA.’

Exhibit 1: Stacking up upgrades across seasoned RPL mezzanine bonds

Source: Amherst Pierpont Securities, Fitch Ratings, Moody’s Analysis is exclusive to M1/M2 classes of TPMT shelf and M2/M3 classes of MCMLT shelf. Transitions are based on ratings upgrades from the primary NRSRO on each shelf with Fitch Ratings being the primary NRSRO for TPMT and Moody’s the primary for MCMLT. Absent those agencies being on a deal an alternative agency was used to reflect ratings migration.

Given the strong history of upgrades across both programs it makes sense to look across later vintage mezzanine classes to try to find bonds more likely to get upgraded sooner than later. Bonds more likely to get upgraded should be backed by faster prepaying collateral with benign credit performance. One nuance to seasoned RPL securitizations is that since these are often backed by highly modified pools of loans, principal modifications, or forbearance, are securitized as part of the principal balance. Securitizing forbearance can impact both prepayment and credit performance and have a pronounced effect on potential ratings upgrades. Large amounts of securitized forbearance drives the effective WAC of the pool lower as a portion of the securitized balance has a zero coupon. And as the WAC declines, so does potential incentive for borrowers to refinance. Additionally, since the forbearance is part of the par principal of the trust, any shortfall in recovery of that forbearance when the loan leaves the pool would result in a loss to the trust.

The universe of 2018 and 2019 RPL trusts are by and large prepaying slower than earlier vintage deals. Given the fact that these deals are backed by highly seasoned re-performing loans, later vintage deals are not by definition subject to slower speeds as a function of loans prepaying faster as they move up a seasoning ramp. Instead, slower prepayments across later vintage deals seem to be driven more so the securitization of lower WAC pools with greater amounts of forbearance as a percentage of the pool’s principal balance. (Exhibit 2)

Exhibit 2: Newer vintage RPL trusts have lower WACs and higher amounts of forbearance

Source: Intex, Bloomberg LP, Amherst Pierpont Securities

While the overall level of prepayments in later vintage trusts, certain deals appear to be better candidates for upgrades sooner than others:

  • Towd Point 2018-6. Looking at the Towd Point shelf, the 2018-6 transaction has an average 6-month speed of just 8 CPR but both the original ‘A’ and ‘BBB’ bonds have built roughly 200 bp of credit enhancement and are roughly 250 bp shy of the original credit enhancement of the bonds a full notch above them at issuance. Additionally, this deal has the one of the lowest amounts of securitized forbearance of all 2018 and 2019 Towd point issuance at just 8.2% of the current pool balance as of the January remittance and the deal has a an average 6-month CDR of just 6 bp.
  • Towd Point 2018-1. Another Towd Point deal that may have upgrade potential is the 2018-1 transaction, both the original ‘A’ and ‘BBB’ bonds have built credit enhancement in excess of the original ‘AA’ and ‘A’ bonds and the deal has the lowest amount of securitized forbearance across the TPMT shelf at just 5.8% of the principal balance as of the January remittance. However, the deal does have modestly elevated serious delinquencies, as 3.5% of the loans are more than 60 days delinquent. However, if these delinquencies cure, the mezzanine bonds appear to be poised for an upgrade.
  • Mill City 2017-3. The 2017-3 deal has seen the mezzanine classes upgraded a full ratings notch. The deal is continuing to deleverage with average six month speeds in excess of 11 CPR with a relatively small amount of seriously delinquent loans and securitized forbearance. The originally rated ‘A’ M2 class currently has nearly 33% credit enhancement, just two points shy of the original ‘AAA’ support while the original ‘BBB’ M3 class has built more than 25% enhancement since issuance and could be in line to be upgraded to ‘AA.’ The 2018-1 transaction has also seen the original ‘A’ and ‘BBB’ bonds upgraded a full ratings notch but could be poised for further upgrades given low delinquencies and amounts of forbearance coupled with steady prepayments.

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