A Q&A on coronavirus forbearance in GSE MBS and CRT

| March 20, 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.

Forbearance measures recently announced by Fannie Mae and Freddie Mac to aid borrowers affected by coronavirus appear poised to have differing impacts on MBS and CRT. Premium agency MBS and derivatives seem reasonably insulated or even helped while CRT could extend if delinquencies rise enough to slow principal cash flows. CRT deals with fixed severities look exposed to losses based on guidance that will count forbearance as delinquencies. Payment assistance of this potential magnitude is not without operational complexity, and there are still significant uncertainties around what the long-term impact on ultimate default rates may be. There’s also the not insignificant issue of funding principal and interest advances.

Q: What is forbearance? Are there different kinds of forbearance? Is it the same thing as forgiveness?

 Forbearance and forgiveness are not the same. Forbearance of loan principal allows temporary or permanent payment assistance for borrowers experiencing short- or long-term hardship. Forgiveness is permanent debt relief where some portion of the borrower’s principal obligation is extinguished. Fannie Mae and Freddie Mac have offered forbearance.

Under existing GSE frameworks, forbearance can come in two forms: temporary payment forbearance or permanent principal forbearance. In temporary payment forbearance, borrowers can temporarily stop making loan payments but will have to make up those payments either at the end of the forbearance period or at some point afterwards, which can vary borrower to borrower. Permanent principal forbearance is a loan modification where a borrower no longer pays interest on a portion of the loan balance but still repays the principal when the loan either matures or prepays. To address the coronavirus, Fannie Mae and Freddie Mac have offered only temporary payment forbearance.

Q: Can current GSE offers of temporary payment forbearance affect prepayments?

Yes, depending on how forbearance is treated, the risk associated with elevated prepayments due to buyouts on delinquent loans may increase or be mitigated.

Guidance published this week by Fannie Mae states that for loans in payment forbearance, ‘Fannie Mae’s current practice is to keep the loan in the MBS even if the loan is reported as being four or more months delinquent.’  And ‘If the loan is either brought current or immediately enters into a repayment plan at the expiration of the forbearance plan, it will remain in the MBS. If a loan does not become current at the expiration of the forbearance plan, the servicer may extend the forbearance period, which would generally allow the loan to remain in the MBS or evaluate the borrower for another loss mitigation option.’

Under the reasonably safe assumption that Freddie Mac’s policies will closely mirror those of Fannie Mae, this insulates MBS investors from an immediate surge in buyouts.

 Q: What about GSE Credit Risk Transfer deals? Will payment forbearance affect those?

Yes, with implications for cash flow timing and losses.

Investors in GSE risk transfer deals appear likely to face rising delinquency rates as a result of how the GSEs have chosen to treat payment forbearance. Based on conversations with individuals involved in the decision, the GSEs will calculate delinquency status based on the borrowers’ last payment date irrespective of payment forbearance. If a borrower made a March payment but was extended forbearance in April, for example, that loan will still register as 30-days delinquent as of May. The delinquency will roll to a later stage delinquency every month after that during the forbearance period.

A rise in delinquencies could affect CRT cash flows. The flow of unscheduled principal to all deals, and both scheduled and unscheduled principal in more recent transactions, depends on delinquency rates. The reference pool of collateral must pass certain performance tests, one of which is a delinquency test. The test measures the level of delinquencies in relation to the total amount of risk transferred on the reference pool.

The delinquency test differs modestly between the STACR and CAS programs. Under the STACR program, investors will be locked out from receiving principal if the 6-month average of certain stressed loans exceeds 50% of the amount of credit enhancement provided by the entire structure to the reference pool. That set of certain loans includes any more than 60 days past due, in bankruptcy, foreclosure or REO, or modified in the 12 months prior to the reporting period. If a STACR deal represents 5% of the total principal balance of its reference pool, for example, principal will be shut off to the deal if total stressed loans breach 2.50% of the reference pool balance. Triggers in CAS deals use a 40% threshold, but calculate the balance using loans greater than 90 days past due and do not include modified loans.

The clear implication for CRT investors is extension risk. In light of recent price performance, which has flipped most of the CRT universe from premium prices to, in some cases, a material discount to par, slower return of principal affects performance.

While it’s too early to tell, borrower performance in this instance may be different from prior episodes where forbearance was extended in the wake of natural disasters. In earlier instances of hurricanes or floods, there have been short term spikes in delinquencies which have abated, generally in a matter of months. Given the potential drag to local economies associated with longer term slowdown or shutdown of businesses, the delinquency and default tail associated with the virus may be far more severe that the common behavior we see in areas hit by natural disasters.

Application of losses differ across CRT deals. Earlier vintage CRT transactions employed a fixed severity schedule. When loans become more than 180 days delinquent, the deal classifies them as Credit Events and they are removed from the pool. The deal then applies a fixed severity to the loan, which increases based on the percentage of cumulative Credit Events. According to Fannie Mae, losses on CAS securities from 2013-C01 through 2014-C03 will be applied on loans greater than 180 days delinquent irrespective of payment forbearance. Losses on CAS 2014-C04 through 2015-C03 will be applied once a loan has gone more than 180 days delinquent; however these deals can reverse the credit events if the loan is current either at the end of the forbearance period or up to three months after the end of forbearance. For actual loss deals, loans in payment forbearance are not considered credit events. It appears likely that the treatment should be roughly uniform in in STACR fixed severity and actual loss deals.

Given this, payment forbearance in excess of six months appears that it will have a disproportionately outsized impact on fixed severity deals especially the earliest deals where there is no mechanism to reverse credit events. Any large scale extension of payment forbearance could trigger a significant spike in credit events that would flow through as losses to bondholders.

Q: What happens at the end of the forbearance period? Does it matter for MBS or CRT?

 Depending on the borrower’s ability to repay at the end of forbearance, delinquencies could remain elevated. The borrower can come out of forbearance and make all payments otherwise due during the forbearance period, a portion of them and enter into a payment plan on the remaining ones, or the servicer can offer a permanent modification that can come in the form of an interest rate modification, a term modification, some type of balance modification or a combination thereof.

In the case where the borrower is able to catch up on the forborne payments, they are returned to a performing current state with no impact to their credit. While treated as delinquent in the CRT, the GSEs will not report the borrower as delinquent to credit reporting bureaus. Based on conversations with individuals involved in these decisions, in the instance where the borrower enters into a payment plan for any portion of the forborne payments, the borrower will remain delinquent until those payments are recouped by the enterprises.

This has implications both for CRT deals and the borrower. For example, in an instance where the borrower enters into a payment plan to make up three delinquent payments over three years, the borrower will be 90 days past due for the first year, 60 days past due the second year and 30 days past due the third year. The borrower will not be marked as current until all the forbearance has been repaid. This could keep delinquency rates elevated on deals where borrowers are unable to catch up. Additionally, this would adversely impact the borrowers’ credit.

Q: What are servicers required to do to extend forbearance?

 Very little, in fact it appears that these efforts are tantamount to streamlined forbearance. Similar to payment forbearance extended in natural disasters, once a loan becomes 31 days or more delinquent, servicers can extend payment forbearance for a period of three months without having prior communication with the borrower. According to Fannie Mae’s existing forbearance polices, any extension of payment forbearance beyond three months would requires the servicer to achieve Quality Right Party Contact. Additionally, per Fannie Mae Lender Letter (LL-2020-02) issued earlier this week, ‘The borrower must have experienced a hardship resulting from COVID-19 (for example, unemployment, reduction in regular work hours, or illness of a borrower/co-borrower or dependent family member) which has impacted their ability to make their monthly mortgage loan payment.’ But ‘The servicer is not required to obtain documentation of the borrower’s hardship.’

This streamline forbearance is in all likelihood a response to the lack of capacity among servicers to execute large scale special servicing on hundreds of thousands or potentially millions of loans. One of the potential issues with large scale forbearance is servicers’ inability to get these loans back into a performing state once the payment forbearance period has ended. There is real risk to more loans going into late stage delinquency or default and potentially foreclosure as a result of operational and documentation errors associated with mortgage servicers that are operationally taxed beyond capacity.

Q: Who’s paying for all this?

 Unclear, but given existing strains on mortgage servicers’ liquidity as a result of decline in values of MSR portfolios and the rise in value of short TBA hedges on origination pipelines, mortgage servicers, especially non-bank servicers appear ill-equipped to make advances to MBS trusts associated with payment forbearance. Instead, the advances will likely have to be funded by the enterprises either directly through their retained earnings or potentially the sizable draw that both enterprises both have from Treasury, which total more than $250 billion collectively. However, until this issue is resolved it seems possible that servicers may be reluctant to offer forbearance modifications if there is even a remote possibility that they will bear the costs associated with advancing principal and interest on loans with payment forbearance.

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