Finally. The U.S. Treasury Department and the nation's largest mortgage lender have introduced programs that appear more likely to lessen foreclosures and hopefully stabilize house prices. However, only a slice of investors in the MBS housing those mortgages may clink champagne glasses.

The Treasury's Home Affordable Modification Program (HAMP) has been roundly criticized for enabling only 170,000 homeowners to modify their loans of the 1.1 million that have completed the process in the last year. Amherst Mortgage Insight analysts estimated seven million mortgages already in delinquent status or foreclosure, and another five million homeowners whose mortgages exceed their homes' values.

"It is our fear that, if these units were to be placed on the market, a 'death spiral' would result - prices would drop, increasing negative equity and; likely forcing additional borrowers to default and be foreclosed on, adding still more pressure to housing supply and forcing prices lower," said Amherst analysts in a March 26 report.

In the same report, the analysts went on to say that the Treasury program attacks the primary problem of underwater mortgages.

"We believe principal reduction programs, if implemented correctly, are apt to dramatically raise the success rate on [mortgage] modifications," the Amherst report said, adding, "Not only is this good public policy and good for borrowers, but it is very positive for the valuation of senior RMBS."

Bank of America's program resembles the Treasury's in structure. However, it is aimed only at HAMP-eligible subprime, option ARM and prime 2/1 hybrid mortgages that are at least 120% of home value. The bank estimated thatit will be able to offer principal reduction to about 45,000 customers.

Matthew Tomiak, partner at 12th Street Capital, which specializes in ABS and MBS, said that "blip" will have a negligible effect on the housing market, especially considering the HAMP approval process is sure to lower that number even further. The BofA program works by first forbearing principal to drop the borrower's monthly payments until they reach 31% of his or her monthly income.

The forbearance eliminates interest accrual on the forborne amount until it is repaid, the house is sold or the loan reaches term - whichever comes first - and that effectively prevents the borrower from profiting on the forborne principal. The second step in BofA's program is to forgive the forborne amount in annual steps as long as the borrower's payments remain current over a period of five years - the borrower "earns" forgiveness.

Loan forgiveness, Tomiak noted, has been a very controversial step because it requires some investors to permanently give up a portion of their investments. For that reason, he called the BofA program a "very public test" of the forgiveness approach that, if successful, could have a broader impact down the road. Its success will be tested by the modified mortgages' recidivism rate - the rate at which they fall back into delinquency.

Tomiak said that between the loan modification approval process and another at least six months to test the program's recidivism rate, it will probably be at least a year before BofA can call the program a success."But at least the test is being done," Tomiak said.

Early signs of the program's recidivism rate could arrive sooner. BofA stated that it anticipates implementing the new principal reduction program in May, suggesting that the bank is likely prepared to begin approving quickly the already HAMP-eligible mortgages, said Dean Di Bias, manager of Advantus Capital's high-yield portfolio. The fund was formed two years ago to invest specifically in senior and subordinated distressed MBS and ABS.

"Loan servicers are highly process oriented, so I would presume [BofA] has done a lot of the legwork already in order to roll the program out a month from now," Di Bias said. He added, "Frequently, the investor community starts to see recidivism numbers released within 90 days."

BofA's program appears likely to pale beside the Treasury's HAMP enhancements, which resemble the BofA program but require mortgages to be just 15% or more above the market-to-market value of the home, and a loan forgiveness earning period of three years instead of five. The Treasury's description of the enhancements said "they will be implemented in the coming months," rather than giving a specific date.

If the programs are successful, investors in subordinated MBS will take the biggest hits, and senior-bond investors will see a mixed bag. Di Bias said the residual portions of MBS - the lowest rung on the capital structure typically retained by issuers - have already been wiped out, and the value of subordinate bonds has dropped appreciably.

In some cases, subordinated bonds' collateral has also been wiped out, resulting in many of them trading at the future value of their coupon payments until the bond is written off entirely. So a $100 bond paying 5% interest that's expected to be written off in three years would be worth $15.

In both programs, however, the forborne portions are anticipated to have to be taken as current period losses, potentially knocking out most or even all subordination to the senior bonds.

"That's accelerating losses and has a negative value implication for the subordinated market," Di Bias said, adding that the senior mezzanine portion of the capital structure, between senior and subordinated bonds, will likely also suffer, although to a lesser degree.

Tomiak noted that it's never in senior bondholders' best interests to see the collateral below them erode, but interest paid to subordinated bondholders on collateral that no longer really exists - due to nonperformance or forbearance - eats into cash flow that could otherwise benefit the seniors. So it's in the senior bondholders' best interest to see them take losses sooner rather than later. "They want to eliminate bonds receiving a relatively high interest rate that are related to collateral that is not performing and funded partially by advances, which will only increase eventual severity," Tomiak said.

But depending on the cash-flow rules of the bond, not all senior lenders may like the outcome. Some senior bonds are divided into several tranches that are repaid principal in sequence. When all subordination is eroded, the rules change and principal is repaid pro rata. That means tranches that would have been repaid first will be receiving less principal and will have to wait until the bond's term for full repayment, while those sequentially last will begin receiving principal much sooner.

"A lot of investors bought these [last paying] bonds deeply discounted. It was an arbitrage opportunity depending on how the housing crisis played out, where you could gain substantial value if things worsened," Di Bias said.

Tomiak said the cash-flow rules on prime mortgage-based MBS almost always turn pro rata when subordination disappears. But in 2005, many MBS based on subprime and Alt-A loans shifted to keeping sequential payout. Nevertheless, last week's announcements prompted a "little run in pricing," Tomiak said, adding, "People raised offer prices on seniors, but that doesn't mean there were buyers."

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