Quietly collecting principal forbearance in legacy RMBS
admin | September 25, 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 the market has focused keenly on new forbearance across various forms of mortgage credit, holders of legacy RMBS have quietly continued to benefit from recovery of earlier forborne principal. Generally robust housing fundamentals and low mark-to-market LTV ratios on the overwhelming majority of legacy loans should provide a strong tailwind to sustained forbearance recoveries, which in turn should provide an attractive source of potential return for mortgage credit investors. Investors can get concentrated exposure to forbearance recoveries in both existing outstanding legacy mezzanine bonds as well as bonds previously been written off but still eligible to receive forbearance principal.
The opportunity for investors to recover forborne principal in the legacy market is sizable. There is nearly $32 billion in outstanding forbearance reported on loans in legacy RMBS trusts as well as an estimated $15 billion in potentially unreported forbearance, according to Amherst Pierpont calculations. And while strong housing fundamentals and low mark-to-market LTVs should help forbearance recoveries across the legacy universe, those recoveries can be idiosyncratic. As such, an analysis of historical forbearance recoveries across the legacy universe should point to the securitization shelves better positioned than others for higher future recoveries.
Forbearance recoveries: they’re still a thing
As delinquency rates across various forms of mortgage credit began to spike in the spring, investors began to discount options on forbearance recoveries embedded in legacy RMBS trusts. Somewhat surprisingly, the spike in delinquency rates provided little, if any, deterrent to forbearance recoveries. Over the past six months, legacy RMBS trusts have recovered an average of $48 million a month in reported forbearance, 17% more than the average monthly recovery over the past two years. Recoveries of unreported forbearance have been consistent over the past six months as well. Recovery rates on both reported and unreported forbearance have been consistent with longer term trends as well. Recovery rates on reported forbearance over the past six months have averaged 63% of the forborne amount, in-line with the two year average recovery rate of 62%. Unreported forbearance recoveries in the form of reversals of prior losses have averaged 7.9%, consistent with the two-year average of 8.7% (Exhibit 1)
Exhibit 1: Tracking monthly forbearance recoveries
Tracking recent recoveries
Looking at forbearance recoveries over the past six months across both reported and unreported forbearance, certain shelves have exhibited higher nominal and percentage recoveries than others. Looking first at total recoveries of reported forbearance since the start of the pandemic shows the CWALT shelf has exhibited the highest nominal recoveries of any legacy shelf, returning just over $14 million in forborne principal, representing 75% of the reported forbearance amount on loans that abated from CWALT trusts over the period. Of shelves that returned a meaningful amount of forbearance over the past six months, the AHMA shelf had the highest recovery rate, recovering 99% of reported forbearance of loans that abated during the period. In terms of reversals of outstanding losses, or unreported forbearance, the LBMLT shelf has recovered roughly $2.6 million since March, representing roughly 30% of outstanding losses on loans that prepaid or liquidated from the shelf since then. The CHASE and ARSI shelves had the highest percentage recoveries on outstanding losses at 41.8% and 40.7% respectively. (Exhibit 2)
Exhibit 2: Stacking up recent forbearance recoveries by shelf
Longer term trends
Longer term trends are generally broadly consistent with near term ones as Countrywide shelves generally exhibit both high nominal recoveries of reported forbearance as well as generally favorable percentage recoveries. The CWALT shelf has seen over $50 million in recoveries on reported forbearance over the past two years with recovery rates averaging just over 80% of total forborne amounts on loans that have abated over the observation period. Recovery rates across the CWL and CWHL were 74.9% and 84.1% respectively. Of shelves with larger nominal recoveries, the ACE and AHMA shelves had the highest percentage recoveries of reported forbearance while the LXS shelf had the lowest, recovering just 37.2% of reported forbearance on loans that abated from LXS trusts over the past two years. With respect to unreported forbearance, the INDX shelf has exhibited the largest nominal recovery of past losses, totaling just over $23 million, representing over one third of losses previously allocated to loans that left these pools. Unreported forbearance recoveries as a percentage of past losses were some of the highest on the INDX shelf, along with the ARSI and BSABS shelves which returned 37.2% and 34.6% respectively. (Exhibit 3)
Exhibit 3: Analyzing longer term forbearance recoveries
Gaining exposure to forbearance
Investors can gain concentrated exposure to forbearance recoveries in a number of ways. One common expression of the trade is through exposure to outstanding legacy mezzanine bonds that have levered upside to forbearance recoveries. Another form of exposure to forbearance recoveries is by owning ‘zero factor’ legacy subordinate bonds which have been written down but have optionality to receive principal associated with future forbearance recoveries. However, purchasing zero factor subordinates may be challenging for some investors in that the bonds offer no current carry but trade with significant rate duration due to not only the principal only nature of forbearance but the fact that these bonds can additionally be written up as a result of excess spread between the coupon rates on loans versus the liability spreads on bonds issued by the trust. And as rates rise, the value of zero factor bonds will be adversely impacted by both the decline in excess spread as liability coupons rise but the declining value of the forborne principal at higher discount rates. Hedging this interest will generate negative carry for holders of zero factor bonds. However, the trade offers somewhat of an implicit hedge in that principal generated from excess spread is implicitly a ‘low for long’ view on a slower economic recovery, while higher principal forbearance recoveries would likely be commensurate with a more robust economy and rising home values.