In Residential Mortgage Backed Securities, When Is A Loss Not A Loss?

Ocwen Loan Servicing LLC (Ocwen), the largest servicer of subprime loans, recently revealed that in May 2013 it realized more than $1.4 billion of previously undisclosed losses on certain residential mortgage-backed securities (RMBS) primarily backed by subprime mortgage loans. These losses were from loans for which Ocwen had acquired the servicing from Homeward Residential Inc. (Homeward).

The specific issue regarding these undisclosed losses stems from how Homeward, the servicer at the time, reported principal forbearance modifications made to the mortgage loans in 2010-2012 to Wells Fargo Bank N.A. (Wells), the master servicer/securities administrator or trustee for each of the RMBS transactions affected and how Wells interpreted these modifications. It is our understanding from Homeward that it intended these modifications to be treated as principal losses to the loans, in which case the losses would have been passed through to the related RMBS.

This matter raises several important questions:

  • Was this an isolated incident?
  • How are principal forbearance modifications made by servicers to mortgage loans backing rated RMBS being reported to the respective master servicer/trustee?
  • If they result in principal losses to the loans, are the losses being passed through to the related RMBS in a timely manner?
  • Will there be other reclassifications of principal forbearance modifications as realized losses?
  • Are different servicers reporting principal forbearance modifications differently, which may mask the actual performance of the loans and of the related RMBS?

Resolving the Homeward reclassification issue and answering these questions could result in significant rating changes to the related RMBS, particularly to higher-rated classes, where the associated mortgage pools have had losses in line with previous expectations.

According to Homeward, when it reported the forbearance modification information to Wells, Homeward believed that, as discussed below, it was indicating that the amount of each principal forbearance modification was a loss to the loan, which should have resulted in a loss to the related RMBS. However, Wells did not interpret the reported forbearance modifications as actual realized losses, and therefore it did not allocate such losses to the related RMBS. Wells stated that it, as the master servicer/trustee, could only report and pass through losses as directed by the servicer.

From July 2012 on, for a reason unknown to Standard & Poor’s, Wells began to classify principal forbearance modifications on Homeward-serviced loans as losses to the related RMBS However, when Ocwen acquired Homeward in late 2012, it discovered that losses from Homeward’s forbearance modifications had not been passed through to the related RMBS prior to July 2012. Therefore, in the May 2013 reporting period, Ocwen reclassified these losses to make them consistent with how Homeward-serviced loans had classified their losses since July 2012. This is also consistent with how Ocwen reports principal forbearance modifications for its serviced loans. Upon performing this reclassification, Ocwen notified Standard & Poor’s Ratings Services of this event and sent us the list of affected transactions along with the associated loss amounts for each. Based on this list, we subsequently placed our ratings on 338 classes from 97 U.S. RMBS transactions on CreditWatch with negative implications, pending a review of each transaction to determine the appropriate ratings implications, if any. Simultaneously, we are determining whether this practice affected any other transactions. If so, we plan to take similar rating actions on those RMBS.

Although the reclassified losses were supposedly passed through to the associated RMBS during the May 2013 period, as we reviewed the May 2013 remittance reports, we identified discrepancies in the reported forbearance loss amounts versus the loss amounts Ocwen provided. Some transaction reports displayed no forbearance loss amounts, while others reflected forbearance losses inconsistent with the amounts Ocwen reported to Wells. We have requested additional forbearance loss amount data for each transaction along with an explanation of why the discrepancies occurred. Regardless, allocating any past losses in a lump sum to the related RMBS could have an adverse effect on the ratings assigned to such RMBS.

While researching this forbearance modification issue, we discovered that different servicers treat the reporting of principal forbearance modifications differently. Specifically, some servicers elect not to treat principal forbearance modifications as a realized loss at the time of the modification, whereas others elect to treat such principal forbearance modifications as a realized loss. Although it’s possible that the principal forbearance amount could be partially or fully realized at the time the property is sold or mortgage refinanced, we believe that most of these amounts will eventually result in losses to the related trusts. As such, we might take rating actions in cases where we believe that losses will eventually be realized–even if they’re far in the future. We are currently researching which servicers elected this treatment and which transactions, if any, might be affected.

In addition, we have proactively reached out to servicers that have recently purchased loan portfolios to determine if we should expect to receive any similar reclassifications regarding these loan portfolios. We plan to also inquire whether any reclassifications might occur as future servicing acquisitions are announced. In turn, we will take rating actions as we deem appropriate.

We believe that the reporting differences of principal forbearance modifications among servicers could stem from a U.S. Treasury Department directive on this topic. In June, 2010 the Treasury Department issued a directive (Supplemental Directive 10-05 “Home Affordable Modification Program [HAMP] – Modification of Loans with Principal Reduction Alternative”) delineating the accounting treatment to be employed by servicers and other transaction parties for HAMP modifications, including principal forbearance (Supplemental Directive). In this directive, servicers were required to report to the trustee or securities administrator any non-interest bearing principal forbearance modification on HAMP-qualified loans as a realized loss. The Supplemental Directive then required the trustee or securities administrator to allocate such losses to the trust. Servicers acting in accordance with the Supplemental Directive were protected from liability under this program, as HAMP was deemed to be a qualified loss mitigation plan. Although the Supplemental Directive only addressed principal forbearance modifications made through HAMP, we understand from Homeward that it opted to treat all principal forbearance modifications–both HAMP and non-HAMP–in the same manner and report them as realized losses In turn, Homeward indicated to us that it expected the trustee or securities administrator for each transaction to follow the same logic and allocate such losses to the trust.

On the other hand, GMAC Residential Funding Co. LLC (RESCAP), another master servicer that Ocwen recently acquired, treated HAMP and non-HAMP principal forbearance modifications differently. As the Supplemental Directive only addressed principal forbearance modifications under HAMP, RESCAP followed this directive and reported HAMP principal forbearance modifications as a realized loss, which the associated trustee or securities administrator then allocated to the related trust. However, it did not report non-HAMP principal forbearance modifications as losses, and therefore these were not allocated to the related trusts. RESCAP estimated that on the loans for which it acts as primary or master servicer, this unrealized loss amount could total more than $1 billion.

Per the Supplemental directive, the mechanics were such that if a loan was granted a forbearance modification, the scheduled balance of the loan was reduced by the forbearance amount and interest was now due only on this reduced scheduled balance. However, the forbearance amount was still indicated for such loan and was still due at maturity or when the property was sold or liquidated. For example, if a principal forbearance modification of $100,000 was granted on a $500,000 mortgage loan, interest was only due on the remaining scheduled balance of $400,000. And even though the remaining balance of the loan was still reported as being $500,000, the servicer could treat the forbearance portion ($100,000) as a loss. If the servicer did not treat the forbearance as a loss, the related RMBS was not affected and therefore would still have had a balance of $500,000. This could have caused a situation where there might not have been enough interest collected to pay the full amount due on the securities, resulting in interest shortfalls. We monitor interest shortfalls to the rated securities and take rating actions based on our published interest shortfall criteria.

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