Wednesday, 6 June 2007

Servicer-related convexity in RMBS

An aban- doned shoe and a banana skin on Old Street to begin a post on the willingness of ABS servicers to abandon their trades if things go badly. Specifically, Tanta on Calculated Risk makes a good point about rising defaults in RMBS:


Foreclosure waves create additional losses just by being foreclosure waves. You can try to rush for the exits all you want; it takes too long to get out of this door if there are too many people in line [...] when declining home values [...] get to a certain point, the foreclosure volume gets to a point such that the operational risk explodes, which drives those loss severities even deeper.


So when house prices go down not only do you have rising losses in RMBS, these losses increase costs dramatically at the servicer. Therefore you also have massive pressure on servicing fees because if you don't agree to let the servicer raise them to cover these costs, they default, and the back up servicer will demand higher fees anyway. There is not sufficient liquidity for all holders to be able to get out at anything like the marked price once this starts happening. As Tanta puts it:


"Look, bondholders, you'll either approve some modifications or your servicer will fold beneath you and any substitute servicer will be able to name its price because you need them waaay more than they need you,"


In most ABS the holder is short a (real) option for the servicer to demand a change in fees, and this option is really worth something. Moreover its moneyness is highly correlated with default levels. If you hold, say, non Agency AAA, are you getting paid for being short this option?

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