Explaining Underpayments in RMBS Optional Terminations

Oakleaf examined the 2005-2007 residential mortgage-backed securities (RMBS) called in the past five years to quantify amounts we considered to be termination price underpayments arising from forborne principal outstanding at the time of the call. Based on our analysis, it would appear that the servicers excluded from the termination price roughly $400 million of forborne principal out of the $7.6 billion of unpaid principal balance (UPB) outstanding at the time of the call. This represents a call price underpayment of 5.4% in RMBS optional terminations.

Oakleaf attributes this underpayment calculation to the interpretation of UPB and related terms in the governing agreements (i.e. pooling and servicing agreements (PSAs)). Generally, the UPB or stated principal balance is defined as the mortgage loan principal balance as of the cutoff date, less any principal collected or advanced up to the determination date of the clean-up call. Legacy RMBS PSAs generally don’t explicitly provide that the UPB portion of the call price should be reduced by forborne principal.

Oakleaf has been reporting on this issue since September 2021 as part of its analytical work for existing clients. Oakleaf helps investors identify and quantify underpayments due to termination price miscalculations in past optional terminations and can also help investors quickly respond to upcoming RMBS optional terminations.

The practice of excluding forborne principal amounts from optional termination price calculations continues to be challenged by investors. A Trust Instruction Proceeding (TIP) filed by Deutsche Bank regarding the call price for seven RMBS trusts and the treatment of forborne principal is currently working its way through the courts, with the next hearing scheduled for September 29, 2022. The servicers’ exclusion of modified loans’ forborne or deferred principal in the termination price calculation is at issue in this case.

Oakleaf analyzed 188 peak vintage (2005) RMBS called over the past five years through February 2022 to determine forborne principal amounts outstanding at the time the trusts were terminated.[1] 

Using Bloomberg loan level data, we identified 158 of 188 RMBS that reported cumulative realized losses on active loans in the month prior to the call. Because the loans were outstanding, we assumed that the realized losses with respect to those loans consisted of either principal forgiveness or principal forbearance offered as part of a loan modification. We believe that most of the realized losses consisted of forbearance since principal forgiveness was infrequently used as a loss mitigation strategy post-crisis.

For the 59 RMBS with cumulative realized losses on active loans over $1 million, the UPB outstanding in the month prior to call totaled $3.41 billion. We compared that amount to principal collected in the month of the call reported in the trustee remittance reports and found that the principal amounts collected and distributed in the month of the call approximated the prior month outstanding UPB.

Oakleaf conducted a similar analysis on 2005 callable RMBS and noted reported realized losses on active loans totals over $3.7 billion, or 15%, of the current UPB, which potentially could result in termination price underpayments if the calls are exercised – and if servicers continue their current practice of not paying forborne principal as part of the call price.

RMBS governing agreements grant one or more trust parties the option to terminate (“clean up”) the trust when the trust’s assets have paid down to less than 5 or 10% of the original amount of the assets at issuance. The option to clean up the trust is generally owned by the servicer, master servicer, or the depositor.

The terminating party may purchase the trust’s assets (including mortgage loans and REO properties) from the trust for a termination price set forth in the PSAs. The termination price typically includes the UPB of the underlying mortgage loans at par, plus accrued interest, plus the fair market value of the real estate owned (REO) assets.

Servicers frequently modify mortgage loans to grant the borrowers permission to defer payment of some portion of the principal balance of the loan. These payment deferments are known as forbearance, or non-interest bearing principal. Servicers have generally not included forborne principal in the calculation of termination price, despite governing agreement language that can be argued to require it.

Oakleaf provides investors full transparency into their RMBS investments with a unique combination of servicing analysis, proprietary bond administration models and cashflow analytics, loan-level collateral reviews, trustee surveillance and a comprehensive document library containing thousands of governing agreements and RMBS litigation histories.

Oakleaf helps investors identify and quantify underpayments due to termination price miscalculations in past RMBS optional terminations and is working (together with our law firm partners) to ensure certificateholders receive all cash they are entitled to as per their rights under the PSAs.

Oakleaf also helps investors quickly respond to upcoming RMBS Optional Terminations. We can independently recalculate the termination price to determine whether it is understated and the impact on each class of certificates. With this information, certificateholders can communicate with trustees to ensure they receive all cash they are entitled to.

If you are interested in learning more about Oakleaf’s service offerings, please contact John St Martin.