RMBS Optional Terminations: A Closer Look into Forbearance Underpayments

The mortgage loans owned by legacy RMBS trusts have been modified by servicers in significant numbers. Such loan modifications include temporary and permanent reductions in the loans’ interest rates, recapitalization of borrower arrearages, forbearance of principal, and other types of modifications.

A forbearance modification to a mortgage loan generally involves a deferral of a portion of the principal balance on the loan. Generally, under a forbearance agreement, the borrower is permitted to defer payment of principal, and is permitted to avoid or defer the associated interest. Generally, under a forbearance agreement, the principal is still unpaid and due and payable, albeit on a different and delayed amortization schedule. Each modification is governed by a loan modification agreement executed between the servicer (on behalf of the trust) and the borrower. The loan modification agreements are recorded and kept in the servicer’s records.

Forbearance modifications are common, to the point where most legacy RMBS securitizations own numerous mortgage loans whose borrowers have been granted forbearance modification agreements by the applicable servicers.

In RMBS trusts with forbearance modifications, the terminating party (which I call the “terminator” in this article) purchasing the mortgage loans stands to benefit tremendously if the termination price (i.e., the price paid by the terminator in exchange for the loans) is miscalculated so that it ignores the forborne component of the loans’ unpaid principal balance. Stated otherwise, if the terminator ignores forborne principal balance when calculating the termination price, the terminator stands to benefit tremendously. This is because the result of such a miscalculation is that the terminator receives the right to collect the forborne principal component of the unpaid balance for free.

Of course, there’s no such thing as a free lunch, even in the esoteric world of RMBS optional terminations. If the terminator is getting something for free because of a miscalculated termination price, someone must be paying for it, and in this case it’s the trust and the trust’s investors- namely, the certificateholders. If the termination price is too low (because of a miscalculation related to forborne principal balance) the amount of cash paid to the trust’s certificateholders in the month of termination is also too low. Stated otherwise, if the terminator ignores forborne principal balance when calculating the termination price, one or more of the certificateholders are short-paid by that same amount and are left holding the bag.

In a word: Yes, and practically every time. Oakleaf Group has audited many RMBS Terminations for certificateholders, and as part of these audits, we generally observe that forborne principal was excluded from the termination price.

Consider trust AMSI 2005-R2 (Ameriquest Mortgage Securities 2005-R2) which was called in January 2020. In the call, $63.4m was paid as a termination price. This amount roughly corresponds to the trustee’s accounting of active loans in the month of termination (which was $63.2m). Yet, when Oakleaf Group performed a loan-level audit of the servicing record for this trust, we identified $4.7m in forborne principal balance in the month prior to the month of termination. Based on this audit we concluded that the termination price on this trust was underpaid by at least $4.7m, and that certain certificateholders (including M5, M6 and M7) were underpaid.

Recently, Ocwen and Deutsche Bank rescinded termination notices on two trusts. There is little public information about why Ocwen changed its mind regarding the termination, except in Ocwen’s recent quarterly investment conference (hat tip to Brandon Ivey at Inside Mortgage Finance) in which Ocwen stated:

With respect to our previously announced fourth quarter transaction, we received a request from the trustee Deutsche Bank asking us to pause the cleanup calls. They wanted to confirm the call price met the requirements of underlying PSAs. We believe the call price we’ve calculated is consistent with the applicable PSAs in our course of conduct with Deutsche Bank and relevant third parties and with established industry practice. We intend to work with Deutsche Bank in their analysis, including if Deutsche Bank chooses to seek input from a court of competent jurisdiction. Meanwhile, we have agreed to pause our calls to allow that analysis to take place.^[1]

If you have held RMBS Certificates which have been called, and upon which there were losses at the time of the call, please contact us to determine whether you were harmed by a forbearance related miscalculation at the time of termination. We can quantify the harm to your certificates and discuss potential avenues available to certificateholders to recover such losses.

What’s next? In a future article we lay out other miscalculations which we frequently observe in RMBS Terminations.

[1] Ocwen Financial (OCN) Q3 2021 Earnings Call Transcript, The Motley Fool Transcripts. 8 November 2021.