In a report released today, DBRS said that RMBS deals should benefit from principal forgiveness as a form of loan modification in the longer term. 

Analysts said that even if securities average lives might be extended, some borrowers could prepay and cumulative losses could be lessened if the housing market recovers in the next few years.  

The rating agency will continue to monitor the industry on its use of principal forgiveness modifications to find out the impact of this type modification on security performance. 

As a modification technique, DBRS said that debt forgiveness has long been seen as controversial in the mortgage industry because of its moral hazard risk as well as the potential effect on security performance in the different parts of the capital structure.

As such, the use of this particular form of modification by mortgage servicers has been very limited so far, even with the government pushing servicers to use it via the Home Affordable Modification Program (HAMP). 

Data presented by the rating agency showed that  capitalization and rate reduction modifications comprise the majority while principal reduction modifications are currently merely 2.80% of the total done as of 1Q01.

In terms of investor reaction, DBRS analysts said that the reactions to debt forgiveness as a loss mitigation tool is still mixed. 

First, senior and subordinate bondholders are usually split on this issue. In a traditional debt forgiveness instance, the principal forgiven will be viewed as security losses and be absorbed first by subordinate holders. 

Many buysiders who bought subordinate bonds based on their “interest-only” values will experience these bonds deplete faster than first expected.  Senior investors, while losing some immediate credit enhancement, can benefit from such modifications as overall cumulative losses should eventually lessen, DBRS analysts explained. 

Second, even within the senior bondholders’ class, super senior and senior mezzanine buyers might also not agree on debt forgiveness. Even though both are senior bonds, certain senior mezzanine tranches might benefit more when principal is forgiven, analysts said. 

This is possible if the subordinate write-downs cause the “cross over” from sequential to pro-rata pay among all senior bonds to happen quicker. This is allowing the senior mezzanine bonds to start receiving principals sooner than expected.

Ocwen's Case, An Example 

Ocwen Financial Corp. launched a modification program targeting distressed homeowners. The program called the Shared Appreciation Modification (SAM) program reduces a delinquent homeowner’s principal owed. This is with the caveat that the servicer will actually share a part of the house’s appreciation if it increases in value by the time its sold or refinanced.

A borrower who qualifies to take part in the SAM program would have the principal of their loan written down to 95% of the current value of the home. The SAM program does not write-down principal all up front. Instead, the principal is forgiven in one-third increments in the span of three years, so long as the homeowner remains current on their modified mortgage, DBRS explained.

When the house is later refinanced or sold, the homeowner must share 25% of the appreciation with the mortgage owners and the borrower retains the remaining 75%. This program is very similar to the HAMP introduced by the U.S. government last year, DBRS analysts noted. 


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