New forbearance deferral eases extension risk in CRT
admin | May 15, 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.
The decision by Fannie Mae and Freddie Mac to allow borrowers to defer repayment of forbearance should help mitigate one potential source of extension risk in credit risk transfer securities that pay claims on actual losses. An existing structural enhancement in later vintage deals may help mitigate extension as well, but the effect should be more pronounced in Fannie Mae’s CAS REMICs than in comparable STACR deals.
The enterprises’ May 13 announcement put to rest any uncertainty about whether they would offer deferral. Both enterprises will allow borrowers to append up to 12 months of forbearance to the maturity of their loan. The announcement has material implications for prepayment, delinquency and buyout rates and may mitigate some concerns about extension risk across both CAS and STACR bonds.
Once a borrower ends forbearance, servicers will provide a range of options to repay missed payments and return to a regular payment schedule. The top of the reimbursement waterfall would be for the borrower to pay back all past due principal and interest as well as associated taxes and insurance. However, given potential hardship and lost income, the GSEs will not require this. It appears the overwhelming majority of borrowers will likely be unable to repay the full amount due at the end of forbearance. Alternatively, borrowers can make up those payments over time through a repayment plan. However there are practical limitations to repayment plans. According to both agencies’ seller/servicer guidelines, servicers cannot offer payment plans longer than 12 months without authorization from the agencies. Nor can they require borrowers to pay more than 150% of their monthly payments. Borrowers who rack up more than six months of forbearance cannot be put on a 1-year payment plan as the payment would exceed 150% of their scheduled monthly payment. If the borrower is unable to repay through a payment plan, the past due payments are capitalized and deferred to the maturity date of the loan, but will not accrue interest on the capitalized balance.
All borrowers granted payment forbearance will be considered delinquent during the forbearance period. Borrowers in payment plans will be marked as delinquent for the purpose of delinquency rate calculations until all missed payments are fully recouped. Borrowers granted deferrals will be considered current once they make their first full scheduled monthly payment after exiting forbearance.
CRT investors have expressed concerns that large amounts of forbearance coupled with a disproportionately large amount of borrowers being put on repayment plans at the end of the forbearance period could cause delinquency rates to remain elevated for protracted periods of time, locking structures out from unscheduled principal in all CRT deals, and both scheduled and unscheduled principal in latter ones, potentially creating significant extension risk.
Now that the GSE deferral option has been formalized, extension seems increasingly improbable for a few reasons. First, repayment plans for borrowers with six or more months of forbearance seem unlikely. Second, given the significant uncertainty around the economic impact of COVID-19, servicers may hesitate to increase borrowers’ debt burdens through payment plans as this may exacerbate any hardship on borrowers. Increased debt burdens may cause borrowers to fall behind again and require more special servicing, forbearance or permanent modification. Additionally, Freddie Mac will reimburse servicer advances once the deferral has been ‘settled’.’ Ostensibly this means around the end of forbearance when a determination has been made whether to put the borrower into a payment plan. Advances made on loans put into repayment plans may be repaid by the borrower over a longer period. Assuming servicers have reasonable latitude to determine whether borrowers should be granted deferrals, this could give servicers incentive to offer deferrals instead of repayment plans.
Other potential mitigants to extension risk are provisions in both Fannie Mae and Freddie Mac CRT that allow the deals to receive unscheduled principal regardless of whether delinquency trigger levels have been breached. Later vintage CAS REMIC structures and Freddie Mac STACR deals issued in late 2019 and beyond include a structural feature called the Supplemental Subordinate Reduction Amount. (SSRA) This feature allows both CAS and STACR bonds to receive both scheduled and unscheduled principal if the percentage of outstanding CRT relative to the reference pool balance meets a certain threshold. In that instance, the amount of unscheduled principal greater than the target percentage will be allocated to the senior-most bond remaining in the capital structure. This effectively turbos down the most senior bond that would have otherwise been locked out as a result of the delinquency trigger being tripped and should help mitigate extension risk, specifically on mezzanine classes of deals with this feature. If prepayment rates remain elevated, this feature will become increasingly more valuable as deals approach their SSRA targets. However these targets are not the same across all deals and are lower in Fannie Mae CAS deals than in STACR deals with the SSRA (Exhibit 1)
Exhibit 1: CAS deals have lower SSRA targets than STACR
One potential caveat to this is that higher WAC 2019 vintage CRT that have been prepaying the fastest may me more susceptible to permanent or flex modifications if the borrower is unable to resume making their previous scheduled payments at the end of the forbearance period. The waterfall for flex modifications target the borrower’s rate, loan term and then balance so rate modifications that would be allocated as monthly principal losses would occur before term modifications that would not generate losses. Higher LTV, higher DTI loans may be particularly susceptible to flex modifications and increased flex modifications would deplete credit enhancement, potentially preventing deals from reaching their SSRA targets.