Regulators and politicians seemed intent last week for HEL investors to share in the pain of subprime borrowers who are unable - or may soon be unable - to make their monthly mortgage payments.
Although GSEs Fannie Mae and Freddie Mac, among others, are devising plans to help a greater number of subprime borrowers refinance, the growing consensus throughout Congressional hearings held in Washington last week seemed to be that loan modification programs are a better fix than a so-called bailout plan to stem the growing tide of delinquencies.
HEL investors generally agree that modifying a loan for a troubled subprime borrower would have a better outcome on overall pool losses than foreclosure. However, the success depends largely on how troubled that borrower is. Some feel that pressure for mandatory loan restructuring could result in cash shortfalls for certain HEL and CDO noteholders who did not necessarily sign on to take the risk of such modifications when they bought the securities.
But according to regulators, the loans should not have been made in the first place, and investors should shoulder some of the blame. "I think we should hold the servicers' and investors' feet to the fire on this," Federal Deposit Insurance Corp. chairman Sheila Blair said last week. "It was clear to investors that these were high risk. I think everybody needs to share the pain now."
The federal bank, thrift and credit union regulatory agencies released a joint statement last week urging financial institutions to work with homeowners who are unable to make mortgage payments. The regulators said they will "not penalize financial institutions that pursue reasonable workout arrangements with borrowers who have encountered financial problems." And while the regulators noted that workout arrangements may not be "economically feasible or appropriate" in all cases, specific standards of feasibility or appropriateness were not outlined, causing uneasiness among some market participants.
"I think they're not really looking at it right," said Mark Adelson, head of structured finance research at Nomura Securities. "The politically correct thing is to say that the borrower, who is also a voter, is a victim that needs to be helped. But the borrower, in a lot more than the majority of cases, is the architect of his own problems."
Which investors may benefit most from the modifications? According to JPMorgan Securities analysts, residual holders will.
"Ironically, loan modification will be most beneficial to the ultimate liquidity provider in the subprime market - Wall Street dealers who also frequently hold residuals," the analysts wrote last week. "Perversely, dealers will earn public relations kudos for loan modifications that aid borrowers, but stand to benefit most from the changes." Particularly, if the modifications only delay loan losses, those benefits could come at the expense of the bondholders, the analysts said.
Because loan workouts increase the likelihood that a deal will pass its performance triggers at the step-down date, releasing credit enhancement to residual and deeply subordinated investors, the highest risk could be shifted to mezzanine ABS investors, JPMorgan analysts wrote.
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