Extraordinary expenses in RMBS transactions could either expose senior RMBS bondholders to losses or the structure to ratings volatility, depending on how they are paid, according to a Kroll Bond Rating Agency (KBRA) report.
Extraordinary expenses in RMBS are fluctuating and difficult to anticipate. These expenses can be payments owed to the master servicer, securities administrator, trustee or custodian as indemnification or reimbursement for any claim, loss, liability, cost or expense incurred in connection with a securitization, explained the report.
If the expenses are paid or reimbursed from the trust fund and are senior in priority to payments of principal and interest, it could lead to losses at the senior level, according to the KBRA report. Most recent RMBS deals are structured with these extraordinary expenses senior in priority to payments of principal and interest.
In this case the extraordinary expenses are paid from the net weighted average coupon (WAC). The WAC is used to determine the interest rate paid to bondholders.
“Paying the extraordinary expenses from the net WAC puts bondholders at risk of receiving a lower coupon than the nominal fixed coupon, “explained analysts in the report.
Interest only certificates are especially vulnerable to this structure because their coupons “are generally a fraction of the excess Net WAC over a prefixed coupon.”
But a shortfall in net WAC isn’t considered an interest rate shortfall and therefore has no impact on ratings.
Another mechanism used in RMBS structured today, treats the extraordinary expenses as a “credit event,” such as a loan becoming delinquent and reviewed for a breach of representation and warranty.
In this case, the extraordinary expenses would be paid out of available funds and “any shortfalls should be considered by the subordinate bonds,” explained the report. “Any actual or projected interest shortfalls or write downs could lead to rating volatility.”