Tuesday, 4 September 2007

Modifications and spread compression

For a CDS on a corporate loan or bond, restructuring is often a credit event so in a CDO of corporate debt, adverse modification of the loan causes a loss which flows up the waterfall (albeit sometimes a minor one if the restructuring is purely a technical one).

This is not true for a CMO of retail mortgages. If a retail mortgagee is in trouble, the CMO docs often permit a modification of the loan at the discretion of the servicer. That's huge. The servicer might well have no economic interest in the cashflows of the mortgage yet they often have the discretion to modify them to the probable detriment of the CMO tranche holders.

And the FED wants them to. This is from Interagency Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages via Calculated Risk:


Servicers of securitized mortgages should review the governing documents for the securitization trusts to determine the full extent of their authority to restructure loans that are delinquent or in default or are in imminent risk of default. The governing documents may allow servicers to proactively contact borrowers at risk of default, assess whether default is reasonably foreseeable, and, if so, apply loss mitigation strategies designed to achieve sustainable mortgage obligations. The Securities and Exchange Commission (SEC) has provided clarification that entering into loan restructurings or modifications when default is reasonably foreseeable does not preclude an institution from continuing to treat serviced mortgages as off-balance sheet exposures. Also, the federal financial agencies and CSBS understand that the Department of Treasury has indicated that servicers of loans in qualifying securitization vehicles may modify the terms of the loans before an actual delinquency or default when default is reasonably foreseeable, consistent with Real Estate Mortgage Investment Conduit tax rules.


The last sentence is particularly telling:


Servicers are encouraged to use the authority that they have under the governing securitization documents to take appropriate steps when an increased risk of default is identified


Now this is presumably in the interests of the home owners. I can see why the FED is doing it. But did the tranche buyers know this could happen? Caveat emptor.

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