By the Numbers
Forbearance recoveries and returns in legacy RMBS
Chris Helwig | February 19, 2021
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.
As investors in mortgage credit continue to grapple with low rates and tightening spreads, one pocket of the market seems poised to deliver extra return. Recovery of forborne principal in legacy private MBS looks likely to enhance spread and yield on bonds levered to these recoveries. Mezzanine bonds backed by Alt-A and Option ARM collateral appear to offer the most attractive prospects.
Despite pandemic-related delinquencies, recoveries of principal forbearance across the legacy market have remained strong over the past year, likely buoyed by overall strong housing fundamentals and low mark-to-market LTVs on most loans backing legacy trusts. Generating excess returns from recovery of forborne principal remain a sizable opportunity. As of the January remittance, an estimated $15.6 billion of outstanding forbearance has been reported across legacy trusts. And while recoveries through the pandemic have remained strong, they have not been uniform. Concentrating exposure to collateral profiles with better prospects for recoveries should be the primary way to produce outsized returns.
Differences across loan type
Generating outsized returns from forbearance recoveries requires somewhat of nuanced approach as certain cohorts are showing stronger recoveries than others.Even within a cohort, forbearance can potentially be recovered one of two ways: by a loan prepaying or liquidating. Understanding what recoveries are on both re-performing and non-performing loans is instrumental to selecting profiles with potentially better recoveries.
Roughly 80% of outstanding reported forbearance is tied to re-performing loans. Comparing recent recoveries on RPLs shows that over the past year Option ARM RPLs have shown substantially better recovery rates than Alt-A or subprime cohorts (Exhibit 1). Over the past year, RPLs that prepaid from legacy trusts recovered 90% of the forbearance attached to them on average roughly 20 percentage points greater than the broader legacy universe and almost 40 percentage points greater than those of subprime RPLs over the past year.
The other 20% of reported forbearance is tied to non-performing loans. Differences in recovery across loans is also evident in non-performing loans where forbearance recoveries on Option ARM non-performing loans averaged 84% of the forborne balance over the past year. Forbearance recoveries on subprime NPLs, however, averaged just 52% while recoveries on the Alt-A cohort were 70%.
Exhibit 1: POA collateral has exhibited elevated forbearance recovery rates
Differences across loan attributes
While historical recovery rates may provide a reasonable guide to future recoveries, understanding how the characteristics of outstanding loans with forbearance is changing over time may be equally if not more important. Loan attributes such as mark-to-market LTV, the amount of forbearance relative to the performing balance of the loans and the likelihood that these loans will pay off rather than default will all have an effect on whether some or all of the forbearance attached to a loan will be recovered.
A breakdown of the universe of outstanding forbearance shows that the $15.6 billion of outstanding reported forbearance in the legacy universe has an average mark-to-market LTV of 56 net of forborne principal. Forbearance represents approximately 30% of the performing principal balance. The amount of principal forbearance relative to the performing balance has historically been a strong indicator of recoveries as lower amounts of forbearance relative to performing balances have exhibited higher recoveries. Amherst Pierpont estimates that approximately 82% of those loans will ultimately prepay or pay off at maturity while the remainder of the loans default and liquidate. These are largely consistent with the profile of loans with forbearance that have left private MBS trusts to date, suggesting that future rates of recovery may be comparable to prior ones, or potentially greater assuming future home price appreciation.
Breaking down outstanding forbearance by cohort, roughly 52% or $8.2 billion of outstanding forbearance is attached to subprime loans while 24% of the balance is tied to Option ARM loans and another 21% is associated with Alt-A collateral. All cohorts exhibit relatively low mark-to-market LTVs and comparable amounts of forbearance relative to the performing balances. However, the survivorship rate of Option ARM loans with forbearance is expected to be somewhat higher than those of the Alt-A and subprime cohorts (Exhibit 2).
Exhibit 2: Stacking up collateral attributes on outstanding forbearance
Differences across securitization shelves
Beyond collateral attributes, certain securitization shelves have delivered outsized recoveries relative to the broader market. While overall recovery rates have remained strong over recent months they have varied substantially by shelf. Controlling for shelves that recovered a minimum of $5 million over the past six months shows that recoveries have ranged from as much as 95% to as little as 4%. Shelves backed by large populations of Option ARM collateral such as WAMU, INDX, DBALT and BSMF have some of the highest recovery rates. Certain shelves saw diluted recovery rates merely as a function of lower recovery rates on liquidated loans. As the WMALT, WAMU and CWHL shelves show recovery rates of 99% to 100% on loans that prepaid during the observation period (Exhibit 3).
Exhibit 3: Stacking up shelf level forbearance recoveries
But wait, there’s more
There are some additional factors to consider when thinking about generating returns from forbearance in the legacy market. Obviously the timing of these recoveries will matter and investors should target shelves not only with high recovery rates but a relatively consistent stream of recoveries flowing through various legacy trusts. The timing of returns also highlights interest rate risk that could offset returns related with these recoveries. Since forbearance is by definition a long-dated, principal-only cash flow, all else equal the value of that PO will fall as rates rise, potentially curbing returns associated with recoveries. Additionally, mezzanine and subordinate bonds will have the most leverage to forbearance recoveries. As a result, Option ARM and Alt-A mezzanine and subordinate bonds may offer a cleaner exposure to forbearance recoveries as subprime mezzanine bonds will not only be levered to forbearance but excess spread as well, potentially generating substantially greater interest rate exposure and less concentrated exposure to forbearance.