Cash flow and servicing risk on the rise in mortgage credit
admin | April 3, 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.
While leverage and liquidity fueled the initial sharp drop in prices across mortgage credit assets, COVID-19 and a weakening economy continue to create fundamental risk. In addition to a potential spike in delinquencies, defaults and ultimately losses, investors may face disruption if liquidity constraints on non-bank servicers trigger servicing sales, hamper their ability to advance against delinquent loans or potentially drive them to recoup existing advances from monthly cash flow coming into deals.
According to press reports, US regulators will take a wait-and-see approach before providing direct liquidity to mortgage servicers that need to advance principal and interest on loans delinquent because of coronavirus. Servicers, specifically non-bank ones, have had their liquidity strained on a number of fronts. The drop in rates has driven valuations on Mortgage Servicing Rights lower. As the value of these assets have fallen, servicers have had to meet margin calls to maintain advance rates on the MSRs, which in all likelihood were declining along with the value of the asset. Add to this margin calls on short TBA hedges against origination pipelines. Moreover, loans that are currently in the pipeline may not close due to either social distancing, unemployment or other economic effects of the virus. This could leave servicers over hedged in their pipeline, with a hedge appreciating in value but without enough pools to deliver against the short position.
These liquidity issues may manifest themselves in cash flow disruptions to RMBS trusts in varying forms. One potentially pronounced risk, especially for legacy RMBS, comes if existing servicers need to sell base servicing to increase liquidity. Large servicing transfers could drive cash flow disruption as existing or ‘trapped’ advances previously made to trusts are recouped. A trapped advance is a liability of an RMBS trust that sits on top of the payment priority waterfall, above the senior-most bonds in virtually all cases, which allows the servicer to recoup advances made from cash coming into the trust prior to any disbursement is made to bondholders. During the spate of large bank servicing transfers that occurred before changes to rules for capitalizing MSRs under US Basel III, servicers, especially servicers of legacy subprime trusts, recouped large amounts of trapped advances, shutting off cash flow to bondholders, often for multiple months. Legacy trusts look particularly susceptible to this, especially those with large populations of non-performing loans with significant existing advance liabilities.
Servicing transfers may also have other implications for RMBS trusts. With any servicing transfer, there often comes a spike in delinquency rates. Onboarding servicing is often operationally intensive, and delinquencies can rise as the servicing duties move from one party to another. This may become particularly pronounced in today’s market. Existing capacity may be constrained, and the new servicer will likely have to deal with a wave of special servicing for borrowers experiencing hardship from the virus. Additionally, deals with existing sub-servicing agreements in place may be subject to a reduction in net WAC if the sub-servicing needs to be transferred to a new sub-servicer that requires incremental compensation to perform those duties.
Legacy and 2.0 trusts may very well be affected by servicers’ inability to fund advances on delinquent principal and interest to differing degrees. Legacy and prime and non-QM 2.0 RMBS have backstop mechanisms in place. If the servicer is unable to fulfill its duties in advancing principal and interest, the Master Servicer often steps in to advance. In certain 2.0 structures, a Securities Administrator serves as the backstop in the event that the Master Servicer is unable to advance. Post-crisis RPL deals by and large do not require the servicer to advance principal and interest but only require the servicer to advance costs associated with property preservation and, as such may be more exposed to interest shortfalls, which could be recouped if the servicer is able to re-perform the borrower.
While it’s difficult to quantify the potential burden servicers are about to face to meet their duties in terms of both advancing against, and special servicing loans that become delinquent as a result of the virus, the numbers by no means seem small. FHFA director Mark Calabria said this week that he estimates that there could be as many as two million borrowers requesting payment forbearance by May and assuming a average loan size of $178,000 that translates to roughly $356 billion in UPB or roughly 7.6% of the $4.7 trillion outstanding conventional universe. Assuming the conventional world represents the broader US, the role of the servicer in RMBS trusts will likely be front and center for the foreseeable future.
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